Epic Fail: An 'F' For Failure to Understand Failed ETF Trades

Exchange traded funds, in what has been a relatively short life span compared to other financial products, have erroneously been blamed for everything from increased market volatility to flash crashes.

Give it some time and some folks will probably find a way to blame ETFs for famine, war and Detroit's bankruptcy.

Kidding aside, an "oldie but goodie" of issues that ETF naysayers love crept back into the conversation earlier this week, that being failed trades. The simple way of explaining a failed trade to someone that has not worked in the back office of bank or brokerage firm is like this: A failed trade, or "settlement fail," occurs when one party fails to deliver securities or cash to the other party in the allotted time.

With most U.S. securities, including bonds and ETFs, settlement date is T+3. For example, shares are purchased on Tuesday and the transaction must be settled by Friday.

Although failed trades can occur with nearly any security and do occur with arguably alarmingly regularity in the multi-trillion dollar repo markets where U.S. government and mortgage backed securities change hands, ETFs have become the favored whipping boy for criticism of settlement failure.

Earlier this week, a major financial news organization reported that failed ETF trades increase in times of elevated market volatility and that a rising number of failed trades raises concerns about the structure of the ETF industry.

Worth noting is that last month, this same publication in another article on ETFs, cited the heavily dicredited three-year old Kauffman Foundation report on ETFs. That report broached the subject of failed ETF trades. What the Financial Times failed to mention is that the Kauffman Foundation's president and CEO, Tom McDonnell, used to run DST Systems (NYSE:DST), a company that gets its bills paid in part by the mutual fund industry. Simply put, the Kauffman Foundation report has no credibility.

How Bad Are ETF Fails, Really? An elementary way of explaining the creation process for ETF shares is large financial institutions exchange shares of underlying securities for new ETFs shares from the fund manager. However, some worry that this process does not always work within the T+3 time frame and that failures can lead to liquidity issues. Some folks forget authorized participants have more time to settle trades.

"Large financial firms called authorized participants' use the creation/redemption process to match ETF supply and demand and to maintain fair and efficient ETF markets," writes Joseph Cavatoni, managing director at iShares. "In the process, these authorized participants are allowed more time to settle trades three more days, in fact."

Another way of saying that is the Securities and Exchange posts list of failed trades that is usually chock full of ETF "offenders," but the list does not consider that authorized participants are allowed extra time to settle trades.

"As a result, ETFs are often cited on the fail list more frequently than other securities. It doesn't mean that ETF trades fail more frequently; it simply means they may settle outside of the traditional 3-day cycle," writes Cavatoni. "As a result, the higher instance of reported fails for ETFs may not reflect actual failures at all."

Still, criticism lingers. Three years ago, Kauffman said ETFs could create systemic risk in an intense market sell-off because "some creators of ETFs may not be able to honor their obligations." That assertion has been debated.

Due to the creation process, "an ETF would never need to sell securities in a falling market to provide a redeeming shareholder with cash. Rather, if an authorized participant wishes to redeem ETF shares, the fund takes in the shares and hands over a basket of securities. Because its obligations are limited to a proportional share of its securities, an ETF will always be able to meet them, even in a declining market," according to the Investment Company Institute.

Failures Not Really Failures Part of the reason failed trades is an ETF buzz phrase is that there is an overlooked distinction as part of the creation/redemption process. ETFs do trade like stocks, but there is a finite supply of share for any given stock. That is not the case with ETFs. ETF creation and redemption, when working efficiently, matches supply and demand.

"The ETF creation/redemption process, as well as the very high rate of many ETFs' share bases, explains why settlement failures are more frequent in ETFs than in common stocks and bonds. However, it is important to note that the majority of ETF trades settle as they are supposed to, with no negative impact to shareholders, despite the characterization that these trades have failed," according to State Street Global Advisors.

Perhaps the real failure is not realizing the integrity of the ETF structure is not threatened nor are investors exposed to excessive risk by trades that settle three days later than usual.