ETF Failures: The Next Big Threat

The stock market's next incumbent threat appears to be “failure to deliver” mortgage based securities and exchange-traded fund (ETF) transactions, according to an analysis by CNBC's Herb Greenberg. Sellers and buyers of these securities, at times, do not honor their end of the deal, but the issue is often rectified at a higher fee. According to the Kaufman Foundation's report, "Canaries in the Coal Mine", investors are able to immediately claim their money at a reasonable value, regardless of the reason for the failure. The concern is that when the plumbing of the market breaks, these promises will be impossible to keep, leaving investors out in the cold.

"As an example, illiquid small cap companies are being repackaged in index ETFs such as the IWM, which derives its value from the stocks in the Russell 2000 index. Unfortunately, just because they are a component of a heavily traded ETF, the 13 underlying securities do not suddenly become liquid," stated the Kaufman Report.

The report also found that although stocks and treasuries have seen a lower rate of failures after increased regulation by the Securities and Exchange Commission (SEC), the rate of failures in markets where failures are unpunished, such as ETFs, has increased. Mortgage based securities fail at an annual rate of 46.4%, which equates $115 billion daily. This rate is high due to a lack of “incentive to correct a failure quickly.” While ETFs do not fail at a rate close to that of mortgage based securities, the rate of failure for ETFs, 3.8%, is still 40 times higher than other exchange-traded securities.

ETF failures are not as severe as mortgage based securities failures, but need to be looked at as a concern, nonetheless. Many investors are not aware of the risks, as investors have been assured by brokers and issuers that ETFs are just like equities.

It is clear that ETFs are going to need more regulation than they are currently given, and the SEC is seeking to further monitor the situation prior to any possible market catastrophe occurring.