Q+A-SEC's widened probe of ETFs: What you need to know

NEW YORK Fri Feb 17, 2012 6:48pm EST

NEW YORK Feb 17 (Reuters) - The SEC has widened its examination of the trillion-dollar exchange-traded funds industry. ETFs are baskets of stocks, commodities or other securities that trade like stocks on an exchange. There is concern in the industry about instances where trades in ETFs fail to settle on time.

Here is quick look at what the SEC examination means.

- What exactly is the U.S. Securities and Exchange Commission examining?

The SEC is looking at whether there is a connection between how hedge funds and high-frequency traders use popular exchange-traded funds and the fact that some of them are failing to settle their trades within the standard four-day window.

- How do hedge funds and high-frequency traders use ETFs?

Retail investors, institutions and hedge funds like ETFs because they are an easy way to get exposure to a sector or an index. They are traded throughout the day on exchanges.

A hedge fund, for example, can make a big bet on a single stock, and then hedge its trade by short-selling an ETF, thus shorting the entire sector in one swoop.

Often there can be a chain of investors lending ETF shares to other investors, who are then also lending out the shares, which has resulted in cases where there are ETFs that have up to 200 percent short interest.

The SEC wants to determine whether that could be resulting in ETFs failing to settle their trades in time.

- What does the industry say about this?

ETF providers and traders say this is not an issue for investors because they are guaranteed to receive their ETF shares at the price quoted when they placed their order, no matter how long it takes for the trade to settle. Market makers, which are the companies that do the bulk of the ETF trading, have seven days to settle ETF trades. However, any ETF that takes more than four days to settle is labeled a "fail," despite the seven-day rule. And if for some reason an ETF trade did not settle at all, it would be up to the entity that clears all of these trades, to guarantee those trades.

- What does this mean for retail investors?

It is not yet clear how this affects retail investors. The concern is that the web of IOUs going on behind the scenes could affect how companies process the trades or put pressure on the underlying stocks, particularly in less-liquid ETFs.

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