Trading Restrictions, Exchange Traded Funds, and Regulatory Arbitrage

Abstract

As of January 2012, there were 1,155 Exchange Traded Funds (ETFs) with $1.134 trillion in assets and daily dollar trading volume exceeding 35% of total exchange trading. Academics and regulatory agencies are increasingly beginning to investigate the market impacts of traditional, leveraged, and inverse ETFs. The extraordinary growth and innovation in ETFs and a recent spike ETF delistings and liquidations should be of concern to financial market participants. This paper studies the current market for ETFs and specifically examines whether investors substitute ETFs and inverse ETFs for short positions in individual financial securities while short sale trading restrictions are in place. Even though ETFs are the preferred vehicle among short sellers, no studies are known to have examined whether ETF’s are a viable substitute. I find large declines in ETF trading volume (-51%) and large declines in ETF short interest (-46%) suggesting there are impediments to circumventing the ban with ETFs. This suggests trading restrictions in conventional securities had negative spillover effects to ETF markets and adds further evidence in support of constrained short selling, limits to arbitrage, and overvaluation.