ETFs arent derivatives

Herb Greenberg misreads the SEC flash-crash report. in an attempt to justify his silly claim that ETFs are derivatives.

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Herb Greenberg misreads the SEC flash-crash report. in an attempt to justify his silly claim that ETFs are derivatives. I agree with Herb that there are serious questions which should be asked about ETFs, especially ones which include small-cap stocks. You cant turn an illiquid stock into a liquid stock just by throwing it into an ETF, and illiquidity is one of those things which goes hand-in-hand with volatility and attempts at price manipulation.

But that doesnt mean that ETFs are derivatives. Theyre not.

Herb quotes this bit of the SEC report:

The E-Mini and SPY are the two most active stock index instruments traded in the electronic futures and equity markets. Both are derivative products designed to track stocks in the S&P 500 Index, which in turn represents approximately 75% of the market capitalization of U.S.-listed equities.

There is a way in which this is true, but its best read as a slightly clumsy attempt to lump the E-Mini and the SPY together with some inartful phrasing.

The E-Mini is a derivative product by dint of being a derivative. Its a futures contract, a zero-sum game, an instrument whose value at expiry is a wholly transparent function of the value of some other financial instrument.

The SPY, by contrast, is a derivative product only by dint of the fact that its a product a security, not a derivative which is derived from aggregating 500 different stocks. You couldnt have the SPY without the S&P 500, so in that sense the SPY is derived from the S&P 500. But if you own shares of SPY, you have real wealth: real claims on real assets of 500 real companies in the real world.

Think about it this way. If all of the shares of SPY were to become vaporized tomorrow, then the S&P 500 itself would rise, since the total number of shares outstanding in the stock market would have fallen. Since the value of those 500 companies wouldnt have changed, the value per share would be higher.

If all of the worlds E-Mini contracts were to become vaporized tomorrow, by contrast, then the effect on the S&P 500 would be de minimis. E-Mini contracts are side bets on the S&P 500: theyre not real-world claims on it.

What the E-Mini and the SPY have in common is that theyre both trading vehicles: both of them are used to make bets on the short-term direction of the S&P 500. Thats why, pace Greenberg, theres so much short interest in SPY. If I want to short the S&P 500, Ill borrow a few shares of SPY and then sell them in the market. Those shares will be bought by my counterparty, who will then turn around and lend them to someone else who wants to short the S&P. And so on and so forth: the same shares can end up being shorted many times by many different people.

But that doesnt make them derivatives.

The distinction between securities and derivatives is a useful one. Its always possible to argue that the value of any financial instrument is ultimately derived from the value of some other financial instrument: if you wanted to, you could probably come up with a colorable argument that senior unsecured bonds are derivatives of stock options. But in the real world, stocks arent derivatives, and ETFs are stocks. Derivatives, meanwhile, are something you call financial instruments you dont like. Which is why occasionally people will erroneously say that CDOs, say, are derivatives. Theyre not, any more than ETFs are.