Short-Selling Restrictions

With regulators worldwide introducing new and further restrictions on short sales (and President Bush threatening to "persecute" those involved), it is open season on those who believe that stocks might go down rather than up. The implications for the ETF market are several.

First, we saw an immediate impact on the US-based ProShares Short Financials (AMEX: SEF) and Ultrashort Financials (AMEX: SKF), which halted trading last Friday. While it has now resumed, and other inverse ETFs continue to operate, the environment is becoming tougher for short-biased funds, and at some point the increased difficulty of hedging short exposures is undoubtedly going to result in higher trading costs and reduced liquidity. While it is not (yet) illegal to take a short position on the S&P 500 or EURO STOXX 50, ETFs offering inverse exposure to narrower areas of the market may indeed find it difficult to function. Inverse ETFs have been a huge success story since their introduction, enabling investors to hedge existing exposures or take a negative view on stocks very easily, often within long-term savings plans that typically do not allow short exposure. Suddenly the landscape has changed, and investors face a much tougher time.

There are other, more indirect knock-on effects for the ETF market as well. Securities lending has generated significant revenues for ETF providers (stock-lending income has typically been split 50:50 between the fund manager and the investors, although some funds give all of the proceeds to the investor). A decline in the demand to borrow because of short-selling restrictions, then, may reduce these earnings. Total expense ratios have fallen during recent years for many ETFs, partly as a result of this extra income stream, and if the income slows down, then managers are likely to resist further reductions in fees. This is not good news for investors either.

Roy Zimmerhansl's recently launched blog gives an excellent overview of the latest short-selling restrictions, for those wanting to keep in touch with the constantly changing regulatory framework.

ETF Market Consolidation

While the ETF market remains one of the few relative success stories in a financial market beset by problems, and new funds continue to be launched (this week has seen a variety of interesting releases in Europe, including a significant expansion of CASAM's range; a new hedge fund replicator from SGAM; ETF Securities' first equity ETFs, based on commodity-related themes; plus launches from SPA and Lyxor), it is impossible to ignore the problems that financial institutions in general are confronting.

2008 has seen a stagnant European ETF market in terms of assets under management, as equity market falls counterbalance cash inflows. With banks incurring huge losses and savage cost-cutting under way at many institutions, it is surely only a matter of time before some of the more marginal players exit the ETF market. While the big three—iShares, Lyxor and db x-trackers—at the latest count** control 75% of European ETF assets between them, there are many institutions with a percent or two in market share, whose viability is probably open to question.

Equally, the heyday of product launches has probably passed and there are many tiny funds that are overdue for closure or consolidation. Will 2009 be a year of "spring cleaning" in the European ETF market?

*The CDR Counterparty Risk Index is the property of Credit Derivatives Research LLC

**Deutsche Bank - ETF liquidity trends, 23 September 2008

Paul Amery is the European correspondent for IndexUniverse.com. He can be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .

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