ETFs: The next crash? | Hacker News Reader

ETFs: The next crash?

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40 pointshardik36 comments

The second comment in the article is interesting. Basically, ETFs are open-ended funds - you can't run out of the ETF securities because you can always create more. So, if the naked short is called, and there are no ETF securities on the open market to buy, the shorter can have an 'authorized participant' create more ETF securities (see link). Note that this is a very different situation than a stock, where there is a fixed amount of the securities available, which can only be created by the company issuing more stock.

See: http://en.wikipedia.org/wiki/Exchange-traded_fund

yes, but the naked short must have the liquidity and solvency to purchase the underlying securities needed to cover her naked short in ETF.

Same as any other stock. No reason ETFs are in any particular danger.

ETFs are a particular danger because the shorts can vastly outnumber the shares. This won't happen in a normal stock.

Say I own 95% of Google and you naked short 7%. I've now got you totally by the balls. You can cover the first 5% if you get every shareholder but me to sell out to you, but then I can charge you whatever I want for the last 2%. You have to pay because you owe someone those shares and I've got a monopoly.

As a result shorts of regular stocks don't get to 11x the number of outstanding shares.

That's not the case with ETFs because the naked shorters can simply create more shares. It's not possible for them to get stuck oweing more shares than they can get. (Well, it is possible if they ran into that problem with the underlying shares, but that's not realistic).

Yes, ETF won't have a short covering rally that is an due to lack of availability of the position.

What you failed to explain is why this is a bad thing.

(It can still have short covering rallies if the price move too much.)

(Also, they can definitely get stuck with more shorts than they can fill. It is called going broke..)

Well the inability to get squeezed covering causes people to gamble on it excessively. We're talking instead of people naked shorting a few percent of the shares, they're naked shorting a few hundred percent. This creates immense counterparty risk for the people who purchase the shares and they don't even know it.

The same counterparty risk is inherent to all naked shorts. What's unique about the ETF is the magnitude. I don't think the article explained that very well. It's possible that the magnitude involved could be destabilizing to the economy.

you either haven't read the article or totally missed it's point (as several other commenters here)

We're trying to figure out if the article has a point at all. Saying "you missed the point" is not helpful.

The point is a normal stock normally has shares equal to 1.x on the market due to short selling, and the x is low. An ETF can have shares equal to 12x. The fact that you can create shares is nice, but it still falls on the counterparty to be able to fund them, and as we saw in the recent meltdown that's not safe.

No, we're trying to figure out who has read it and got the point.

If you fail see the point in the article and risks it uncovers, then there's nothing to discuss really...

The difference between naked shorting and regular shorting is that with naked shorting you only need the liquidity later. And they find out ... you don't have the money!

All "financial innovations" boil down to ways of gambling with other people's money. The brokerage that can do naked shorts in a conventional way are doing it (see LTCM) and the article claims that EFTs open up this club to a wider membership.

I have no idea what you're talking about, or why it's getting upvotes. Naked shorts are "gambling", but it's with your own money, not other peoples. Also, LCTM was not a brokerage. I have a feeling you're wrong about more things, but I'm not confident I can parse your last sentence with 100% accuracy.

If you fail to understand the issue at hand why comment at all?

Ha. Well, not all, but yeah that's definitely pretty popular.

Clearly naked shorting needs to be either banned entirely or, perhaps, regulated in such a way that the buyers realize what they're getting and who the counterparty is.

The problem is that normal shorting is often maligned but a very valuable tool for correcting markets and hedging positions. There's a strong outcry against shorting from people who don't know better, and I think in response the very valid complaints against naked shorting get drowned out.

"Abusive" naked shorting is already prohibited by the SEC, the enforcement, however, is a little suspect.

How is abusive defined?

Structural risk in etfs will always be there as they are not pure holdings of the underlying. For example, USO is a heavily followed (and traded) oil fund. However, it deals mostly in near term derivatives contracts, and it will continually underperform over time if the futures further out in time are priced higher then the near term futures. Other etfs with this problem are UNG and VXX and a host of others.

Structural risk in sector etfs are most likely not as high as what this article states. Any market inefficiencies would most likely be fixed by arbitrage, and arb firms may explain the large amount of shorts in XRT for example.

One of the major risks I see down the road is if gold actually does become a bubble. The major etf everyone watches is GLD, which does deal in physical gold. If a bubble hits its peak and redemptions come in, they will have to sell off some of that gold, which would accelerate the selling, providing a positive feedback loop-- which is what we normally see when a bubble crashes.

Of course, all the risks I just mentioned, as well as the risks shown in the article, are spelled out in each etf's prospectus, so this is nothing new.

I don't get it. The volume of shorts in the markets is a dynamic quantity right? In the absence of new transactions, these shorts would disappear when the shares are physically transferred. Therefore, the risk here is counterparty risk, but I don't see this risk as being peculiar to ETFs right? Furthermore, once you have settled and obtained ownership, the risk is gone right?

This reinforces my belief that the 'market' is just one giant shell game. Invest your money in something tangible like making a product.

Have you thought about all the legitimate uses for a capital market? Say, issuing stock to fund a plant that will make a product? No one denies that investors will play equities for short term gain, but for every one of those there are more who are actually deriving true value from this 'market'.

What shell game? I can buy a share of Microsoft for ~$25 and then I get a vote in how the company is run and receive a percentage of the profits. Microsoft in turn gets to use the equity to build bigger and better things. Seems pretty fair to me.

It's not quite so simple. The $25 you spend on the share isn't used by Microsoft : It's used to pay to the seller of the share.

Until Microsoft needs to issue more shares (or repurchase them), the value of the stock is not meaningful (to the company). Of course, people with stock options care about the value of the stock.

In the same way, it's actually bad outcome for a company to have their stock jump up after the IPO : it means that the company missed the opportunity to raise even more money (for the same amount of dilution for existing holders).

http://www.fool.com/investing/general/2010/09/17/5-companies...

How's MSFT doing for you these days?

"In 2004, Microsoft earned $0.75 a share. Over the past year, it pulled down $2.10 per share. That's 18.7% earnings growth per year. Extraordinary. Yet Microsoft shares trade lower today than they did for all of 2004. Dividends provided some return, but shareholders have essentially been handed a donut for a company that's blown the lights out on earnings."

I can say Gold ETFs aren't going to crash anytime soon.

Seriously? I've been figuring that fictitious gold is the next bubble to pop. Physical gold is hard money; obligations to deliver gold are not.

99% of gold supplies are controlled outside stock markets

The blame may be pinned on ETFS if it happens, t the mechanism described in this article is really a regulatory construct that creates a type of short selling that is problematic. Maybe it might also exist in a free market, but it is protected by regulation now.

yeah, I don't think the blame actually lies with ETFs. It's naked short selling that is culprit again.

I would not theoreticize whether it should be allowed in free market, the fact is it's illegal. However it might not be practical to demand all shorts to deliver or cover now, but I think if they're not willing then each and every one's financial positions should be assessed so that they have enough liquid assets to do so later.

Well, the blame doesn't lie in ETFs per se. I mean, the people running the ETFs have done nothing dangerous or wrong.

But the way ETF shares can be created allows people to naked short a much larger number of shares safely. So this would not happen with, say, Microsoft stock, but may with a large index ETF.

Culprit of what? There's nothing wrong with the markets at the moment. They don't go straight up.

culprit that is the topic of this discussion which is "ETFs: The next crash?" as far as I can tell? Have you read the article?

Yeah, I read the article. Naked short selling would have nothing to do with this. The parent ruled out ETFs and substituted naked short selling for the cause. You could view my post as highly sarcastic.

EDIT: Maybe I should clarify further. The next crash will not be because of anything related to ETFs or any type of shorting. The next crash will be the result retail investors having unrealistic expectations about how fast the market will rise. The 1990s and mid 2000s set unrealistic expectations about how fast the market will rise. When retail investors are not pulling off double digit returns, they claim things are rigged and leave the market. This is what will drop the markets again. I say we're looking at another major downturn in about two years.

The article explicitly says that EFT's are a way to achieve naked shorts. Whatever you think will be the next crash, naked shorts are key topic in the article.

Naked short interest has nothing to do with naked short selling?

Would you then like to explain what has anything to do with this?

I find this issue highly important, so I wouldn't expect "highly sarcastic" comments of very high use.

EDIT: the article is not about "The Next Crash". It's about the hidden risks associated with ETFs.

I read the parent's comment differently.

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