Exchange-Traded Funds, Fails-to-Deliver, and Market Volatility

Abstract

Exchange-traded fund (ETF) trading volumes have increased over the last decade and so have ETF settlement failures at the clearing corporation. We test the hypothesis that ETF short selling, high stock borrow prices, and options contract expiration contribute to ETF fails-to-deliver (FTDs). We document a positive relationship between net daily ETF settlement failures and daily ETF short sale volume, the cost to borrow ETFs, and quarterly index options expiration dates (so-called “triple witching” dates). These findings are not consistent with the claim that fails are random. Rather, these findings are consistent with the hypothesis that market makers fail to deliver to avoid paying borrowing costs associated with their short sales. Further support for this hypothesis comes from a positive correlation between ETF FTDs and ETF put option open interest. Finally, we show that ETF settlement failures are important for the functioning of markets because they impact market index volatility. We find that positive changes in aggregate ETF FTDs Granger-cause higher market index volatility. We attribute this causality to buying and borrowing of common stock shares by market makers in order to close-out ETF FTD positions by trade date plus six days (“T 6”). We conclude that ETF FTDs are not inconsequential for market stability.

Keywords: exchange-traded funds, short selling, fails-to-deliver, volatility

JEL Classification: G14, G18, G28