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ETFs Under Fire as Senate Probes the Need for More Regulation

Breakout

After mushrooming from essentially zero to more than a trillion dollars in assets in the U.S., exchange traded funds, or ETFs, have gone from obscurity to being a household name in little over a decade. With over 1,000 different products to choose from, and new ones frequently hitting the marketplace, it comes as no surprise that these cheaper and tradeable alternatives to mutual and index funds now account for a third of daily U.S. trading volume.

It's also not surprising that such a hot growth industry is undergoing unprecedented scrutiny from the Securities and Exchange Commission, Congress, the academic world, as well as from traders and the financial services sector itself. It's a polarizing debate that so far has not slowed the meteoric rise of ETFs, but testimony given Wednesday before a Senate subcommittee seems to have at least nudged the needle towards the side of the regulators.

Even Blackrock (BLK), the world's biggest seller of ETFs, has called upon lawmakers to pursue a re-labeling rule that would redefine leveraged and inverse ETFs, likening them to derivatives for their ability to offer 2 to 3 times the move of a particular index on a given day, as well as the ability to move in the opposite direction.

Testimony was given by Harold Bradley, the chief investment officer of the Kaufman Foundation, that linked leveraged ETFs to distorted market returns and suggested that this was also curtailing IPO activity, thus hampering economic growth. In the attached video clip, Bradley outlines some of the rules he believes must be implemented to ensure the stability of what insiders call market microstructure; but what you and I might call the "plumbing" that keeps our trading systems flowing.

From Flash Crash to "Flash Up"

"We just had another flash up," Bradley says, coining a term that denotes the inverse of a flash crash, yet carries none of the negative connotations. "Two weeks ago, the Russell 2000 ETF (IWM) in the last 20 minutes of the trading day, went up 7%," he says. "I've been trading for 30 years and I've never seen anything like it."

Other regulatory tweaks that Bradley is calling for include a ban on plain, old fashioned, open market orders entered without a price, the adoption of an "opt-in" rule that would allow smaller thinly traded companies to say whether or not they wanted to be included in a particular ETF, and the immediate inclusion of ETFs in the "post-Flash Crash liquidity timeouts" that were devised by the SEC in the aftermath of the now legendary one-day market plunge in May 2010.

ETF Impact on Market Volatility

Naturally, there is anything but consensus over the impact ETFs have on the market. Earlier in the month, a professor from East Tennessee State University gained notoriety when his research showed no link between ETFs and volatility, as did Proshares when it blasted Blackrock's labeling idea as "arbitrary, anticompetitive, and unworkable."

Clearly the debate and probing of ETFs is far from over. In fact, Reuters reports that SEC Investment Management Director Eileen Rominger says the agency is also looking into "investor disclosures, liquidity levels, fair valuations" as well as the impact ETFs have on volatility.

For now, investors can expect to see additional, increasingly specialized products coming to market, such as the ETRACS 2x Long Leveraged ISE Cloud Computing Fund (LSKY) which began trading two weeks ago. Honestly.

Do you want to see increased regulations over the ETF industry? Let us know in the comment section below.