ETF Short Interest and Failures-to-Deliver: Naked Short-Selling or Operational Shorting?
92 Pages Posted: 3 May 2017 Last revised: 10 Mar 2021
Date Written: March 3, 2021
We identify an alternative source of ETF shorting related to the market maker liquidity provision and creation/redemption activities. Unlike “directional shorting” used for informational or hedging purposes, liquidity-driven “operational shorting” arises due to a regulatory exemption which allows ETF market makers to satisfy excess demand in secondary markets by selling ETF shares that have not yet been created. We find that operational shorting is associated with improved liquidity and greater price efficiency in the underlying securities held by an ETF. Higher retail trading activity and short-term ETF return reversals are also consistent with liquidity-supplying motives rather than informed trading. Consequently, delayed ETF creation to cover operational shorts results in failures to deliver and is found to be a valuable option in the presence of retail trading and liquidity mismatches between the ETF and its underlying securities. Commonality in operational shorting across lead market makers can lead to increased counterparty risk and we find that financial leverage can amplify these inter-dealer relationships.
Keywords: Exchange-Traded Funds, Short-Selling, Failure to Deliver, Retail Trading, Market Making, Authorized Participants, Liquidity, Security Settlement, Counterparty Risk
JEL Classification: G1, G12, G14, G23
Suggested Citation: Suggested Citation