A new Kauffman Foundation report says yes. Does their logic hold up?

http://www.kauffman.org/newsroom/new...-recovery.aspx

New Report Outlines Causes of Market Distortions Choking Recovery and Preventing New Growth Companies from Going Public


Derivatives known as "ETFs" are the true culprits in artificially setting stock prices and posing threats to market stability

Report provides recommendations for SEC to mitigate ETF dangers
(KANSAS CITY, Mo.) November 8, 2010 – A form of indexed securities known as “exchange traded funds”—or ETFs—are distorting the markets to such an extent that they are threatening the growth of new companies by effectively curtailing their access to capital, according to a provocative new report issued today by Harold Bradley and Robert Litan of the Kauffman Foundation. Moreover, it is these derivatives and not the phenomenon known as high-frequency trading (HFT)—commonly critiqued as contributing to the “flash crash” of May 6, 2010—that pose serious threats to market stability in the future.
Numerous factors have been pointed to as contributing to the significant downward trend in IPOs over the past decade, some of which, like the higher regulatory costs of going and remaining public under the Sarbanes Oxley Act of 2002, are widely agreed to as one of the main culprits.
But, as Bradley, Kauffman’s chief investment officer, and Litan, Kauffman’s vice president of research and policy, argue, ETFs represent a far more important and heretofore unrecognized deterrent to companies going public because they are artificially distorting stock prices and thereby dissuading new growth companies – on which the growth of our economy depends – from going public.
“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,” says Bradley.
Adds Litan, “In the process, ETFs that once were an important low-cost way for investors to assemble diversified stock holdings are now undermining the traditional price discovery role of exchanges, and in turn, discouraging new companies from wanting to be listed on U.S. exchanges.”
The report further documents that the proliferation of ETFs also poses systemic risks similar to those that were briefly manifested during the “flash crash” of May 6, 2010. Without significant ETF-related reforms, the authors contend, more flash crashes and market instability are highly likely.
The report suggests that dangers posed by ETFs can be mitigated with the following remedies, all of which fall under the purview of the U.S. Securities and Exchange Commission (SEC).
Specifically, say Bradley and Litan, the SEC should:

  • require far more transparency about the liquidity of the underlying securities or instruments represented by an ETF;
  • compel ETF sponsors to explicitly describe ETF creation and destruction processes in product registration and disclosure documents, including hard rules that govern creation processes based on short interest as a percent of shares outstanding, with hard caps (e.g. 5%) on short interest;
  • immediately subject ETFs to the post-flash crash liquidity “time-outs”;
  • 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;
  • require securities holders to specifically “opt in” to securities lending agreements rather than the current “opt out” agreement in most account documents;
  • 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; and
  • seek assistance from the Federal Reserve in requiring custodial banks to report each week their fails-to-receive and fails-to-deliver of equity and ETF securities, in an analogous fashion to the requirements imposed by the Fed on U.S. primary dealers for debt securities.

The report offers a number of additional prescriptions aimed at improving the functioning of U.S. capital markets. The report, which includes an executive summary, is available for download at www.kauffman.org/etf.
About the Authors
Harold Bradley, chief investment officer of the Kauffman Foundation, has over 28 years of trading and portfolio management experience. He has written widely on financial issues, especially those relating to the U.S. equities markets and is a retained speaker by the CFA Institute. Bradley was appointed by SEC Chairman Arthur Levitt to the Federal Advisory Committee on Market Data. He has testified before Congress on market structure issues, was a member of the NASDAQ Quality of Markets Committee and the Investment Company Institute Market Structure committee. He was a member of the board for Archipelago Holdings, LLC and now serves on the NYSE Pension Managers Advisory Committee.
Robert Litan, vice president of research and policy at the Kauffman Foundation, also has written widely on financial policy issues, both at Kauffman and at the Brookings Institution. Litan is a long-time member of the Shadow Financial Regulatory Committee. He has consulted for government agencies and private sector institutions on financial matters, was a member of the Congressional Commission on the Causes of Savings and Loan Crisis and most recently served on the Pew Task Force on Financial Reform.