Financial ETFs Feel Heat of Derivatives Crackdown

NEW YORK (TheStreet) -- Responding to the financial crisis which nearly crippled the U.S. economy and the questionable business practices at one of the world's most successful financial institutions, Goldman Sachs (GS), President Obama and his administration is determined to provide better financial regulation which will likely influence the financial industry.

The U.S. Senate has already passed two amendments which are aimed at setting up a new government protocol for seizing and dismantling large financial firms that are in distress, overcoming the "too big to fail" philosophy. In the proposed bills, which are expected to be enacted into law within the next few weeks, the Federal Deposit Insurance Corp. will be able to manage an "orderly liquidation" process for troubled firms that would pose a risk to the banking system if they were to collapse.

A second part of these amendments lessens risks by restructuring how major banks trade derivatives and by requiring most derivative contracts to be cleared by a clearinghouse, through the Wall Street Transparency and Accountability Act. This act may also require that derivatives be traded through public exchanges.

Some suggest that derivatives were the primary driver behind the financial meltdown. Derivatives are often used as hedging tools or a way to gained amplified exposure to certain equities, bonds or commodities, and hence carry more risk than traditional securities.

The financial legislation which would require banks to leave the lucrative business of derivatives trading and which has passed the House will have a significant impact on the following exchange-traded funds:

• Financial Select Sector SPDR (XLF), which boasts the nation's five largest banks that dominate trading in derivates -- Goldman Sachs, Bank Of America (BAC), JP Morgan Chase (JPM), Citigroup (C) and Wells Fargo (WFC). XLF closed at $15.09 on Friday.
• Vanguard Financials ETF (VFH), which too holds all five of the banks that dominate trading in derivates, as well as other firms involved in derivatives trading like Morgan Stanley (MS). VFH closed at $30.89 on Friday.
• iShares Dow Jones US Financial Sector (IYF), which too allocates a significant portion of its assets to the five largest banks mentioned. IYF closed at $54.21 on Friday.

Due to the impact that this legislation could have on these ETFs and their holdings, implementing an exit strategy is a good way to mitigate the risks involved.

According to the latest data at SmartStops.net an upward trend in the ETFs could come to an end at the following price points: XLF at $14.41, VFH at $28.13 and IYF at $51.83.

Written by Kevin Grewal in Laguna Niguel, Calif.

At the time of publication, Grewal had no positions in the securities mentioned.

Kevin Grewal serves as the editorial director and research analyst at The ETF Institute, which is the only independent organization providing financial professionals with certification, education, and training pertaining to exchange-traded funds (ETFs). Additionally, he serves as the editorial director at SmartStops.net where he focuses on mitigating risks and implementing exit strategies to preserve equity. Prior to this, Grewal was an analyst at a small hedge fund where he constructed portfolios dealing with stock lending, exchange-traded funds, arbitrage mechanisms and alternative investments. He is an expert at dealing with ETFs and holds a bachelor's degree from the University of California along with a MBA from the California State University, Fullerton.