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SEC Expands Exchange-Traded Fund Investigation

According to a Reuters report on February 21, 2012, exchange-traded funds ("ETFs") are receiving more attention from the Securities and Exchange Commission ("SEC") after the delay of a big trade of an unnamed but popular ETF. ETFs, which are intended to provide investors access to highly liquid pools of securities, have been around since the mid-1990s. They also allow investors to take magnified short positions on indexes or industry sectors, which are known as "leveraged" ETFs. There is currently about $1 trillion invested in all ETFs, of which leveraged and inverse (or "short" and "ultrashort") ETFs make up 5%, according to one estimate. ETFs also account for almost 30% of the equities traded daily in the American markets, according to a Credit Suisse report.

ETFs are securities, so they are also subject to the same regulations that cover a standard equity share. Still, despite the fact that ETFs have been around for almost two decades, the SEC has largely left ETFs alone until fairly recently. This changed after the May 6, 2010 "Flash Crash," when the Dow Jones Industrial Average experienced a 1,000-point swing in less than half an hour. The SEC and the Commodity Futures Trading Commission issued a joint report later that September, explaining that the volatility was caused by a large fundamental trader's sell program. The sell program created a massive sell-off ripple effect after high-speed traders using algorithms reacted to that trade, which, in turn, caused other high-speed algorithms to react to those reactions, and so on. In September 2011, the Wall Street Journal reported that the SEC began investigating whether ETFs added to market volatility after the market's wide swings that August as part of its larger investigation into high-speed trading. Specifically, the SEC inquired into whether the extent of high-speed leverage ETF trading could amplify market swings as traders sought to unload their holdings during a particularly volatile day. But while industry insiders acknowledge that possibility, they largely dismiss the connection because of the relatively minimal trading volume of leverage ETFs.

The recent trading shortfall has now caused the SEC to widen its investigation to determine whether high-speed trading was a contributor to that failure and to explore the links between the ETF prices and the value of securities that make up the ETF. Though the impact of failed trade settlements is currently unknown, the potential to manipulate the market using leveraged and inverse ETFs is becoming more and more apparent-nimble short-sellers may be able to use the leveraged and inverse ETFs to either quickly drive up or drive down equity or futures prices in response to an expected large or institutional investor trade.

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