ETF Short Interest and Failures-to-Deliver: Naked Short-Selling or Operational Shorting?

92 Pages Posted: 3 May 2017 Last revised: 10 Mar 2021

See all articles by Richard B. Evans

Richard B. Evans

University of Virginia - Darden School of Business

Rabih Moussawi

Villanova University - Department of Finance; University of Pennsylvania

Michael S. Pagano

Villanova University - Villanova School of Business

John Sedunov

Villanova University - Department of Finance

Date Written: March 3, 2021

Abstract

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

Evans, Richard B. and Moussawi, Rabih and Pagano, Michael S. and Sedunov, John, ETF Short Interest and Failures-to-Deliver: Naked Short-Selling or Operational Shorting? (March 3, 2021). Darden Business School Working Paper No. 2961954, 2019 Academic Research Colloquium for Financial Planning and Related Disciplines, Available at SSRN: https://ssrn.com/abstract=2961954 or http://dx.doi.org/10.2139/ssrn.2961954

Richard B. Evans

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4030 (Phone)
434-243-7680 (Fax)

HOME PAGE: http://faculty.darden.virginia.edu/evansr/

Rabih Moussawi (Contact Author)

Villanova University - Department of Finance ( email )

800 E Lancaster Ave
Bartley Hall, 2051
Villanova, PA 19085
United States

HOME PAGE: http://www.homepage.villanova.edu/rabih.moussawi

University of Pennsylvania ( email )

3733 Spruce Street
216 Vance Hall
Philadelphia, PA 19104-6301
United States

HOME PAGE: http://www.rabihmoussawi.com/

Michael S. Pagano

Villanova University - Villanova School of Business ( email )

800 Lancaster Avenue
Villanova, PA 19085-1678
United States
(610) 519-4389 (Phone)

HOME PAGE: http://www90.homepage.villanova.edu/michael.pagano

John Sedunov

Villanova University - Department of Finance ( email )

800 Lancaster Ave.
Villanova, PA 19085
United States
610-519-4374 (Phone)

HOME PAGE: http://homepage.villanova.edu/john.sedunov/

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