ETF Short Interest and Failures-to-Deliver : Naked Short-Selling or Operational Shorting?

We identify an alternative source of ETF shorting related to the market maker liquidity provision and creation/redemption activities. This “operational shorting” arises due to a regulatory exemption, allowing ETF market makers to satisfy excess demand in secondary markets by selling ETF shares that have not yet been created. We find that operational shorting is associated with improved liquidity and greater price efficiency in the underlying securities held by an ETF, and with short-term return reversals consistent with liquidity supplying motives rather than informed trading. Delayed ETF creation to cover operational shorts results in failures to deliver and is found to be a valuable option in the presence of a liquidity mismatch between the ETF and the underlying securities. Operational shorting can lead, however, to increased counterparty risk and trading linkages between liquidity providers. We document a commonality in operational shorting across ETFs that share the same lead market maker and find that financial leverage can amplify this commonality