ETF Whistleblowers Make Explosive Allegation

“The vast majority of ETPs have very low levels of assets under management and illiquid trading volumes. Many of these have illiquid underlying assets and a large group of ETPs are based on derivatives that are not backed by physical assets such as stocks, bonds or commodities, but rather swaps or other types of complex contracts. Many of these products may have been designed to take what were originally illiquid assets from the books of operators, bundle them into an ETP to make them appear liquid and sell them off to unsuspecting investors. The data suggests this is evidenced by ETPs that are formed, have enough volume in the early stage of their existence to sell shares, but then barely trade again while still remaining listed for sale. This is reminiscent of the mortgage-backed securities bundles sold previous to the last financial crisis in 2008.”

The above quote comes from a series of letters being written by a pair of anonymous whisleblowers to securities regulators and members of congress with financial sector oversight responsibility.

Their argument is that because legitimate exchanges like the NYSE list these products, they have an imprimatur of legitimacy conferred upon them that lures unsuspecting investors.

The only problem with the argument is that if the case is being made that the exchange traded products in question are small by both AUM and volume, then how big of a problem could this be? Also, the “subprime” reference might be far-fetched – housing is a lot more systemic to the financial system than a few hundred tiny ETFs. There aren’t any gigantic ETFs that use complex contracts – at least none that I’ve ever heard about.

But still, this is an issue worth considering. One of the major potential problems is that there are only a handful of authorized participants, like KCG, handling the bulk of the trading. Authorized participants are the firms that handle creation / redemption and build the baskets of securities to order when an investor or institution buys or sells an ETF in their brokerage account.

I send you now to Wall Street on Parade to read the full explanation of what these whistleblowers are alleging.


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