With all the sleaziness on Wall Street these days, it's no wonder ETF investors are wondering if they're safe.

Rate-fixing. Fraud. Money-laundering. Today’s hottest growth niche seems to be white-collar crime by financial institutions. Can you trust your ETF to steer clear of these shenanigans?

Here’s a look at the parts of the ETF world that rely on trust—starting with those most frequently misunderstood—and their impact on risk to ETF owners.

ETF Short Sales

ETFs trade like stocks, not like mutual funds. This means ETFs can be shorted—borrowed, sold and repaid in kind—by those betting on a drop in price.

Short positions in certain ETFs can reach high levels, and for a handful of funds, will occasionally exceed the total amount of ETF shares outstanding. This apparent impossibility typically results from serial short-selling, where A lends shares to B, and—rather than selling the shares—lends them to C.

The bottom line here is that those who hold the ETF shares—and more importantly, the fund itself—bear extremely little risk from short-selling. Only those who hold the shares have any claim on fund assets, so massive shorts won’t lead the fund to ruin.

Securities Lending

The typical ETF holds a basket of stocks. Shareholders hold a proportional claim on that basket. But many issuers loan out these stocks and receive interest in return. This sounds risky and maybe a little bit fishy, too. (To be clear, this topic differs from short sales of ETF shares by market participants.)

The risk to the ETF shareholders associated with securities lending is quite small. Fund managers demand collateral when lending the stocks—typically extremely liquid and safe securities, such as Treasury bills.

This is not a margin account: ETF managers require the full value of the stocks they lend, plus a little more, typically described in the prospectus as 102 percent of the stocks’ value.

Derivatives

Most ETFs don’t hold derivatives. They hold baskets of actual stocks and bonds instead. But certain assets, like some commodities for example, are accessed by ETFs using derivatives. And even in plain-vanilla funds, the prospectus language may permit derivative use.

When ETFs do hold derivatives, the risk comes in two flavors: low and lower. This may sound odd, but it’s true.

The first variety includes derivative contracts between two parties, such as a swap agreement to deliver a particular pattern of returns.

The risk here is that the other side won’t pay what they owe. But counterparty risk here is low because each side starts out owing the other nothing, and, at regular intervals, the account gets trued up.

So if a counterparty blows up, the ETF’s likely exposure is only the performance gains over a short period—maybe a few weeks. Nothing else is at risk.

The second flavor of risk comes from listed derivatives—those that trade on an exchange, rather than over the counter. Here the counterparty risk is even lower, and would require the exchange itself to fail.

ETNs

I spoke about counterparty risk related to exchange traded notes in a recent blog. To be clear, July is not ETN-bashing month: ETNs offer distinct advantages over traditional ETFs in tracking, taxes and exposure.

But ETNs rise to the top of the heap when talking about risk in this context. ETNs are debt instruments, so if the issuing bank fails, ETN holders stand in line with the bank’s other debtholders to claim assets.

This means the entire value of your investment is at some risk—however small—if the counterparty fails.

Even here, however, the risk is mitigated. ETNs differ from other debt in important ways.

First, ETNs are publicly traded securities. That means you can sell them quickly if you feel the issuing bank is on the verge of a Lehman moment.

Second, ETNs can be sold back to the issuer at fair value, as long as the issuer is still afloat. But this can only occur in large share bundles, typically 50,000. And in both cases, a distressed environment will likely dry up liquidity with correspondingly higher transaction costs.

The structural risks discussed here are real, but they’re clearly defined, and most importantly, manageable.

So investors in exchange-traded products can exhale a bit.

While the wider world of finance is tainted by ethical lapses and worse, ETFs are designed to be transparent and, for the most part, that’s exactly what they are.

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