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The original was posted on /r/Superstonk by /u/OneSpeedyBoiii on 2023-10-06 18:30:33.

Hey all,

Like many of you, I saw the XRT jump in short interest and shares this week. This got me thinking, about XRT and then ETFs in general. I did some digging, please bear with me, I am closer to a smooth brain than a wrinkle brain on the spectrum. I am also on the spectrum. XRT is the most shorted ETF in the world. By approximately 4.5x.

I am sure we are all wondering, where are the shares available to borrow coming from? I hope to give some semblance of an answer below.

The first external source I want to call attention to is this peer-reviewed published paper about ETF Short Interest, FTDs, and Naked Short Selling. It calls into question the sources of FTDs in ETFs, whether they result from "Operational Shorting" or Naked Shorting. I haven't read the full 70-page paper, but I have gone through the PPT which summarizes it.

Here is the TLDR of the PPT:

1. Opening quote from SEC (2015) “Short selling is extreme in many ETFs. The lending markets are not being properly utilized to accommodate the selling, causing systemic risk from undisclosed leverage in the financial system (more shares sold than exist) for the benefit of very few while creating risks for all stakeholders, including taxpayers.”
2. Why Study FTDs in ETFs
   1. $2.5T in AUM in ETFs as of the time of writing. (Estimated to be closer to $10T as of December 2022)
   2. FTDs on ETFs have a "greater potential to induce contagion (vs) a single stock"
3. What is driving ETF FTDs?
4. "Prior literature shows Stock FTDs driven by naked short selling" However, "Operational Shorting" is a more contemporary alternative reason.
5. "Operational Shorting acts as a “buffer” and improves the basket’s liquidity"
6. Operational Shorting is identified to be the primary driver of ETF FTDs , and ETF Short Interest contains operational shorting.
7. Market Maker (Authorized Participants) Choices
   1. Sell shares from its inventory or locate the shares in the secondary market (and deliver at T+3).
      1. Locks in a market-making profit but requires higher upfront capital outlays (safer but lower return).
   2. Sell shares “naked” and then locate or create the shares at a later time (up to T+6 for “bona fide” market making).
      1. Can also lock in a profit (if a futures/options hedge is used) but with less capital outlay (safe and higher return).
8. Conclusions from PPT
   1. SEC rules have reduced overall FTDs but are growing for ETFs since 2009 (counter to trends in Stock FTDs)
   2. We propose a new possible source of ETF FTDs, Operational Shorting
   3. We also propose a novel measure of operational shorting and show that it is positively related to FTDs (but different than “directional” shorts)
   4. Operational shorting can act as a buffer and improve the basket’s liquidity

Here is the article:

https://jacobslevycenter.wharton.upenn.edu/wp-content/uploads/2018/08/ETF-Short-Interest-and-Failures-to-Deliver.pdf

Here is a PowerPoint Summary which is much easier to digest:

https://business.depaul.edu/about/centers-institutes/financial-services/events/Documents/CFIC%20Presentations%20Day%202%202018/5_Pagano.pdf

So, the main takeaway is Operational Shorting is a contributing factor to SI of ETFs (and results in FTDs). Operational Shorting is legal Naked Short Selling and occurs to meet excess buy orders by creating liquidity in the ETF. r/Superstonk knows that privileges like this are often abused. But let’s just explore this through the lens that true operational shorting is the driving factor behind the extreme SI observed in XRT. This viewpoint is corroborated by XRTs shares outstanding jumping 1.1mm shares since yesterday’s 5mm jump in shares short.

(Source: https://www.etfchannel.com/symbol/gme/ )

So, XRT was legally naked shorted in the name of operational shorting to provide liquidity. Why? Well, if we take a look at the companies publicly reporting their XRT positions (Source: https://www.holdingschannel.com/bystock/?symbol=XRT ) We see a who’s who of many of the protagonists in this Saga. Kenneth Cordele Griffin and Citadel Advisors LLC have the second largest net short position in XRT, behind Herr Investment Group LLC (someone give them a look?) The data is not updated frequently, but I would wager a bet that we will see increases in net short positions when an update comes down the pipeline.

Now, where the rubber meets the road here is admittedly hard to say. In terms of free, publicly reported data, there is no direct causation between GME’s recent increase in borrowable shares and the subsequent price action. Yes, there is both correlation and causation between the jump in borrowable shares for shorting and the price action. However, in terms of openly available data, there is only an observable correlation between XRTs jump in SI and GMEs jump in borrowable shares.

Given the understanding of operational shorting of ETFs, it can be inferred that there is some degree of causation. Namely, operational shorting provided liquidity to the ETF which increased the short interest of XRT and provided more shares outstanding to said ETF. I do think it is curious that the increase in shares short, less the increase in shares outstanding equals the increase in shares available to borrow and short on GME. 6.13mm – 1.10mm = 5.03mm.

I’d like to pivot to another external source. This 65-page PDF explores “Synthetic shorting with ETFs”

A key quote, “Our empirical analysis suggests that the ETF short ratio is high when the demand for shorting the underlying stocks is high, when the lending supply of underlying shares is low, and when the cost of shorting the underlying stocks is high.” Given that GME is not a terribly liquid stock, and CTB is high, it is easier to proxy-short via an ETF. ETFs tend to be more liquid than the underlying stocks. And, through operational shorting, it is “easy” for a market maker to create artificial liquidity for ETFs if there isn’t sufficient liquidity in the ETF because of increased interest in said ETF because they want to proxy-short it because the desired stock to short in the basket is illiquid.

Furthermore, in shorting an ETF (a la Citadel Advisors LLC) there is less of a chance for a catalyst for a short squeeze on the ETF, given that a short squeeze in one stock in the basket shouldn’t cause the ETF to squeeze as well.

Another important note, because XRT has 78 securities in it, the shorting of GME (which is only reported to be 1.15% of XRT’s holdings) via XRT is not super-efficient. So, how can you efficiently proxy short GME through an ETF?

I hypothesize that going long on every other stock in the basket beside the one you wish to short (GME) could isolate GME, directly applying ETF short pressure to a single security. I don’t even know if this would work. I don’t have a conclusive answer on how shorting an ETF can directly translate to shorting an individual stock in the basket. I also don’t have a conclusive answer as to how an increase in short volume in XRT can directly translate to an increase in borrowable shares of GME to short. If anyone knows, please comment!

Another interesting ETF I found is the “REX Short GME ETF” The most recent SEC filings I found are from 09/21. REX is actively pursuing a single-stock ETF that exists as a direct proxy-short to GME. I know this is a way to gain exposure to shorting GME, but again, I am unsure how this ETF will directly impact the stock itself and borrowable shares to short. I think if some wrinkle brains did some digging into how this ETF will capture and inverse of GME there may be an answer.

I think there is a lot of hidden and unknown backdoors to manipulation in the ETF market. I think ETFs give market makers an excuse to make fake shares to fill these ETFs. I think the “operational shorting” of ETFs gives MMs a further excuse to increase liquidity via naked shorting.

Some action items for the community:

· Look into how to isolate securities within an ETF by going short (or long) on the ETF.

· Look into the structure of ETFs, how shares for ETF shares are located (or created) and the impact that has on underlying securities within the ETF.

· Dig into REX Short GME ETF, how it will capture an inverse of GME, how that may impact GME.

· Dig into whether there is actual causation between XRTs short interest increase and shares borrowable for shorting of GME.

Cheers!