Manooj Mistry, head of db x-trackers in London, explained that his company's request for an exemption from two-way market-making obligations for the DJ STOXX 600 bank ETF was a precautionary move, taken in response to the new regulations. In effect, with Deutsche Bank quoting bid prices only, investors can redeem existing holdings in the ETF, but no further shares can be created.

This is very similar to what we have seen happen with the ProShares and Rydex inverse financials ETFs in the US market, even though the latter funds use different replication methods. For the time being, Mistry added, broader ETFs, such as those on country indexes, and the other sector ETFs, remain unaffected, although it is necessary to keep a close eye on the ever-changing regulations.

Francois Millet, head of ETF & Index Funds for SGAM in Paris, stressed the difference between one type of inverse ETFs, where it is necessary to borrow and sell the underlying stocks to create new ETF units, and other ETFs on indexes where a liquid futures market exists. In the former case, if the stocks are on a restricted list, new creations will be effectively impossible, whereas in the latter case, it still remains relatively easy for a market-maker to hedge its positions by selling futures, and therefore to create new ETF units.

Underlying Liquidity

I asked Millet what would happen if a substantial proportion of the equities in a broad market index, even one with a related futures contract, became subject to short-selling restrictions. He explained that one of the groups underlying futures liquidity, the arbitrageurs, could in theory be affected, as they are typically the ones at the end of the "chain" who exchange futures and the underlying index components to keep prices in line. The deterioration of liquidity in futures would, of course, have much broader and potentially damaging knock-on effects for the financial markets than just for ETFs.

For the time being, Millet added, bid/offer spreads on the SGAM inverse ETFs have not been adversely affected. The SGAM XBear CAC 40 ETF (Paris: BX4.PA), their most heavily traded fund—which offers leveraged inverse exposure—has an average bid/offer spread of 15 basis points; the unleveraged, delta-one inverse ETF on the CAC 40 has an average bid/offer spread of 6 basis points. This is in line, he explained, with what one should expect, with the structured product (two-times leveraged) version being slightly more expensive to trade.

Henrik Norén, managing director of XACT in Sweden, which manages the most highly traded inverse ETF in Europe—the (150% leveraged) XACT Bear fund (Stockholm: XACT-BEAR.ST) on the Swedish large-cap index—made similar points, stressing that the fund's operations depend on the liquidity in the underlying futures market, and had so far not been affected. However, he added, XACT's two Norwegian funds—the Derivative Bear and Derivative Bull, which are both 200% leveraged—are already running into some capacity constraints, as the underlying Norwegian futures markets are not that large or liquid.

Diversified Indexes 

Claus Hein, executive director of Lyxor in London, told me that the short-selling restrictions have caused confusion, with some investors unsure as to whether it is still permissible to sell short an ETF. He explained that broad-based indexes are considered to be diversified enough (i.e., without too heavy a weighting in the stocks on the restricted list) that short sales of the ETFs tracking these benchmarks would be permitted.

By implication, an ETF consisting largely of restricted stocks may not be sold short, except if this were being done to hedge an existing long position. In other words, someone wanting to borrow (for example) the Lyxor ETF DJ STOXX 600 Banks (Paris:BNK.PA) in order to sell it short would have to provide evidence that they owned a long position in the relevant stocks and that the trade was being put on as a hedge only.

So, in summary, the short-selling restrictions have so far affected only a relatively small part of the European inverse ETF sector. But with the rules fluid and subject to further change, any potential extension of the restrictions could easily remove more inverse ETFs from investors' toolbox. And while ETF liquidity hasn't yet suffered, more short-selling constraints could affect the ability of market makers to arbitrage between stocks and futures, potentially raising costs for all market participants.

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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