The controversial study from the Kauffman Report on systemic risks posed by exchange traded funds (ETFs) was roundly criticized by the industry when it was released last year. The foundation followed up with another report in March about ETFs and settlement fails, which has also been criticized. The problem, according to the authors, is that the ETF settlement process is not nearly as refined and reliable as the settlement process for stocks and bonds. The result is added systemic risk that could weigh on the entire financial ecosystem.

To be sure, settlement fails among ETFs are high. Currently, ETF fails account for approximately 60 percent of the nearly $2 billion of daily equity trading fails reported to the SEC, and on some days they account for 90 percent of all exchange traded fails. There are many reasons for this. One could cite the fact that, unlike stocks and bonds, there are no penalties for ETF fails. MBS settlement fails are also high.

But what really is the risk of this? After all, whether an ETF trade settles T+4 or even T+6, the trade is ultimately completed. The non-timely settlement is likely never even noticed by the customer, as trades are often considered settled when the trade is made.

But given fast moving events and lightning fast trading, the period during which a settlement is underway must be considered in a systemic light. If the trades pile up--and let's face it, one of the touted benefits of ETFs is that they can be bought and sold like stocks--and settlements get completely backlogged, chaos and confusion could easily set in. This has been a huge issue in the past. Recall the 1960s, when back office issues forced Wall Street to shut down once a week to process paper. More recently, regulators forced the derivatives industry to shore up its clearing processes as paper was still used to record trades. 

It would be wrong to sensationalize this, but one could argue that we're going in the wrong direction when it comes to ETF settlements. We need to be aiming for T+1 settlements, even though we going in the opposite direction. Given the speed at which a trader can respond to economic and other events, we're now in uncharted territory. May 2010 was just a taste. A massive dislocation might just wreak havoc on the market, with some ETF trades essentially lost in the mix. Better to solve these issues now than suffer the consequences, whatever they might be. 

But solving the issues will not be easy. It appears that some entities enjoy benefits from long settlement times, as they might want to delay settlement to allow for time to make trades in the secondary market, which may be cheaper. There could also be some arbitrage opportunities and chances to earn fees from delayed short sales.

So perhaps it's time for penalties on delayed short sales along the lines of the penalties imposed for failed stock and bond trades. - Jim