“ETFs are choking the recovery and may pose unrecognized risks to the financial markets.” These claims are part of a scathing 88-page ETF report recently authored by the Ewing Marion Kauffman Foundation, a Missouri-based organization that promotes economic education. Needless to say, it’s drawn its fair share of controversy.

Among the report’s chief gripes are that ETFs have overconcentrated positions in thinly traded stocks and could cause another “Flash Crash” type of event that occurred on May 6, 2010. 

As such, the report outlines a series of regulatory suggestions to the Securities and Exchange Commission, which include:

  • The Commission should require far more transparency about the liquidity of the underlying securities or instruments represented by an ETF. It may be a good idea for the Commission to ban ETFs whose holdings are not easily traded. One simple way of doing this is to preclude small capitalization companies from inclusion in any ETF.
  • The Commission should require ETFs to obtain opt-in consent from smaller cap companies (or from the exchanges where they are listed) whose stocks are relatively thinly traded.
  • The Commission should consider, for both stocks and ETFs, prohibiting plain market orders and instead require all market and algorithmic orders to have a minimum price of sale This would also help mitigate the kind of free fall in prices we saw during the flash crash, which could be repeated even with liquidity “time-outs” in place.

“ETFs are radically changing the markets, to the point where they, and not the trading of the underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future,” said Harold Bradley, the foundation’s chief investment officer.

In a rebuttal to the Kauffman report, BlackRock (sponsor of the iShares ETFs) noted the authors released a revised version of their original report, and thus backed away from their initial argument that proliferation of ETFs has contributed to a declining number of initial public offerings.

BlackRock also defended against the claim about dire consequences of a short squeeze on ETFs A short squeeze refers to a steep rise in ETF price triggered by the urgent need of many borrowers to purchase a borrowed ETF and return the ETF to the lender.

The firm’s rebuttal stated: “ETF sponsors aren’t vulnerable to a short squeeze. In order to create new shares of an ETF, an authorized participant (“AP,” the firm responsible for bringing ETF shares into and out of the market) in almost every case, does not deliver cash as the authors suggest. Rather, the AP delivers the relevant basket of securities comprising the fund and in return the sponsor gives the authorized participant ETF shares of equivalent value.”

BlackRock concluded: “ETFs have a structure that actually anticipates and defuses the very problem the Kauffman report warns about.”