Did the Shorting Ban Affect SKF?

I recently wrote a post ("Who benefits from new short selling rules?") discussing the impact of the new rules that ban "naked" shorting. My position was that this would probably increase the trading volume in the ProShares ultra short ETFs.

Since then we have seen the imposition of yet another rule. In an attempt to protect financial stocks, the SEC has prohibited short sales of shares of certain financial companies. The list of protected financial companies has now expanded to over 900.

While many of the ProShares ultra short ETFs continued to trade in a manner that is decently tracking the action in the underlying index they are shorting, the Ultra Short Financial ETF (SKF) ran into huge problems.

After getting hammered on Thursday and Friday of last week, SKF barely opened on Monday. It was almost noon before it started trading in earnest. Remember, Monday was the day when the well-known Financial Select Sector SPDR ETF (XLF) fell over 8%. SKF should have jumped 16%. By the end of the day, though, SKF hadn't come anywhere near that gain.

What was going on? Did the shorting ban affect SKF?

ProShares does not actually short the market. Instead, they use multiple financial instruments, in an attempt to mimic the inverse performance of the underlying index. Per the prospectus, those instruments are:

• Futures contracts and options on futures contracts
• Swap agreements
• Forward contracts
• Options on securities and stock indexes and investments covering such positions

OK, that means they shouldn't be impacted by the shorting ban, right? Not so fast.

ProShares announced on Monday that

Short Financials ProShares (SEF) and UltraShort Financials ProShares (SKF) are not expected to accept orders from Authorized Participants to create shares until further notice.

In other words, shares would not be created for those who wished to buy the ETF.

The problem seems to have been hidden a layer deeper than the ProShares ETF itself. As stated above, ProShares enters into swap agreements. This means we need to consider the actions of the counterparties to those swaps. With the government instituting a ban on shorting financials, what happens when the counterparties suddenly find themselves unable to short the market? Everything grinds to a halt.

That's what we saw on Monday. It seems that by Tuesday, they sorted things out. There are numerous ways to institute a short position without actually breaking the no-shorting rule. It appears that ProShares may have shifted the mix of financial instruments they are using. It is also likely that their swap counterparties have also moved to what can be called "synthetic shorting" using a mix of options, for example. In any case, SKF did deliver about twice the inverse of the performance of XLF.

As one of the articles mentioned below says, the government's unpredictable actions are the ultimate counterparty risk. In the meantime, SKF seems to be soldiering on. Given the unfavorable reception the Paulson plan received in Congress, SKF will hopefully continue to do its job delivering solid upside as the financial sector weakens again.

Related articles:

I highly recommend the following excellent articles if you wish to go into further detail:

• Proshares and Rydex inverse funds supposedly unaffected
• Proshares biggest counterparty risk is US Government
• Ultra ETFs and Counterparty Risk
• The Synthetic Version of Shorting

Disclosure: Author is long SKF

Comments

[GKM:]

Why can't Proshares just do net trading of UYG against SKF? Why would they have to enter into any agreements unless there becomes a supply demand imbalance which they would then just manage by trading the market in those instruments? I would imagine that is exactly what's going on.

2008 Sep 24 12:53 PM

[E F Nuttin:]

I lost a lot of $ on Thursday and Friday and that was my fault for owning SKF. The problem I have is that it didn't move Monday 16% as it should have and I want my $ back from Proshares. They turned this into a closed end fund overnight and it cost me $ and it doesn't matter to me why it happened, the fact is it happened and Proshares owes me for my 200 shares that didn't move Monday. They need to sue the government and pass that along to the people who held that worthless fund on Monday.

2008 Sep 24 02:20 PM

[User 257960:]

Financial Long (XLF) and Short (SKF) ETFs has traded with a narrow range for the past 2+ days. As soon as it break out on the upside or downside, enter for a quick percent gain in a short time.

2008 Sep 24 02:37 PM

[Summer:]

SKF should be on fire, considering it's the only game in town. The precious few shares that investors own now are the last to be issued. These shares are more valuable now than before the ban. Get a grip.

2008 Sep 24 10:32 PM

[adan:]

great timely info; please keep updating on the issue of inverse etf's

ps - staying away from etn's :-)

2008 Sep 25 08:44 AM

[andyn:]

Get out of the SKF. The govts naked intervention in the market and the fact that most of the financials have already reached bottom means there is not much upside left in this. If you still think some specific financials are still too highly priced, just buy puts on those directly.
I will be buying the XLF now as the upside is more there.

2008 Sep 25 08:58 AM

[ferdi:]

The ban on shorting bank stocks may have a perverted effect on bank shares. The price of financial stocks are currently inflated as shorting cannot occur. When the banks will tank, as they certainly will, their fall would be more dramatic than in the past as the shorts will not cover.

2008 Sep 25 04:59 PM