The problem centers around shorting ETFs which may explain why 70% of the cancelled trades in last May’s Flash Crash were in ETFs when ETFs represent only 11% of the securities in issue in the US.
From the article:
"In an ordinary equity, the short-selling is limited by the ability of the short sellers to borrow the stock so that they can deliver it to complete their sell bargains.
In an ETF a short seller can always rely on the process of creating shares in the ETF to ensure he can deliver. This leads to the possibility that a buyer of an ETF share is buying for a short seller and that no new share has yet been created.
The investors who buy from the short sellers don’t own a claim on the underlying basket of securities or swap in the ETF, they own a promise to deliver the ETF share given by the short-seller. The problem this causes is that as no new shares are created in the ETF by this process, the assets of the ETF may become significantly less than the outstanding cumulative buy orders would suggest."
http://ftalphaville.ft.com/blog/2011/05/24/576351/terry-smith-doesnt-like-etfs/
Comments
Unless the short seller is selling naked shorts, he still have to locate shares from someone else (only Authorized Participant can create more shares). In this respect, shorting ETFs is no different than shorting stocks and if the shares were all recalled nobody would be left without shares. Now, naked shorts are a problem but it is not different than stocks either.
However, while the total shares of a stock is relatively fixed, ETF dynamic share creating process allows for higher levels of short interest than stocks.
http://seekingalpha.com/article/226380-shorts-running-amok