Exchange-traded funds (ETFs) may represent a tiny speck on the overall investment landscape but they are one of the fastest-growing products in the investment industry. It is no wonder then that they have been thrust into the global, regional and national regulatory spotlight. There are different angles, but liquidity, transparency and viability are the main themes.
The past two years have been a hive of activity with the European Securities and Markets Authority, the Central Bank of Ireland, France’s Autorité des marchés financiers (AMF), the UK’s Financial Conduct Authority (FCA) and the US Securities and Exchange Commission (SEC) all launching their own probes. This is not even mentioning the guidelines being mulled over by the International Organisation of Securities Commissions (IOSCO), which are due to be published at some point later this year.
“The regulatory interest is pretty straightforward,” says Andrew Craswell, senior vice-president at Brown Brothers Harriman, the US private bank. “The industry has had rapid growth and the regulators want to ensure that they do not pose a threat if there is a market event. They are looking into whether they could create a bubble and what the systematic risks are, even though they account for a fraction of overall global AUM.”
A new milestone
Recent figures from data provider ETFGI show that global ETFs hit a milestone earlier this year, breaking through the $5trn (€4.3trn) mark in assets, a significant hike from the $774bn recorded at the end of 2008 but still a pin prick compared with the almost $80trn of assets currently managed worldwide. They are more established in the US, which accounts for approximately $3.5trn of assets and has a mainly retail following, although they have been steadily gaining traction in Europe where the investor base is predominately institutional. Both regions have benefited from the ongoing shift to passive from active investing which is encapsulated in MiFID II’s focus on the total cost of investment including fees and transaction costs.
Sander van Nugteren, managing director in the iShares EMEA team, also believes that the interest is part of the regulatory information gathering exercise that is typical of any investment product, particularly one with such exponential growth. He notes that regulators not only want a better understanding but also to ensure that the end users comprehend the investment strategies employed and that the product is well supported.
The industry view is that ETF prices can change constantly as the value of their underlying assets fluctuate, but any difference in price between the two in liquid markets is typically shortlived as traders take advantage of any gaps, which in turn helps to restore equilibrium. The problem, of course, is when markets are unsettled, although this has been more of an issue at the more complex exchange traded product end of the spectrum.
This was evident in February when the Vix index – which measures volatility – hit a two-and-a-half-year high of 115 while the S&P 500 suffered its biggest one-day decline since 2011. Inverse Vix ETF prices plummeted by more than 90% while the more mainstream vehicles weathered the storm with generally tight offer-bid spreads, heavy volumes and high liquidity, according to research from BlackRock.
As Vitali Kalesnik, a partner and senior member of Research Affiliates’ investment team, notes: “Liquidity is always part of the regulatory equation and a core focus. Most of the established ETFs have decent liquidity but more recently there has been white labelling of products and a proliferation of exotic products which has caught the regulators’ attention.”
Keshava Shastry, head of ETP Capital Markets at DWS, the recently listed fund management arm of Deutsche Bank, agrees, adding “around 95% of the assets under management in the product range are in the easy-to-understand plain vanilla ETF range, but there have been concerns noted in relation to retail investors and inverse and leveraged products, which are in the exchange-traded product universe. Investors here need to have a thorough understanding of these types of products and how they behave.”
Not surprisingly, February’s episode triggered calls from the fund management community for a clearer delineation between the complex ETPs and the more traditional products that are registered investment companies under the Investment Company Act of 1940 and other regulatory regimes, such as UCITS.
Risk of market distortion
At the global level, there is IOSCO, which plans to build upon its Principles for the Regulation of Exchange Traded Funds published in 2013 as well as the more recent investigation into the liquidity risks of mutual funds and ETFs. The umbrella organisation of regulators, which works closely with the Financial Stability Board, is currently looking at whether serious market distortions might occur as a result of the growth of ETFs as well as liquidity and valuation matters.
“IOSCO provides a forum for the different voices around the table and it will incorporate industry best practices,” says Axel Lomholt, head of ETFs, international at Vanguard. “It will feed down to the local jurisdictions but they will have their own nuances and tweaks according to their own regulatory regime. However, there will be the common threads of investor protection, transparency across the entire value chain and the need for education at all levels.”
Industry participants also expect that the Iosco review will leverage the work and feedback garnered from a recent Confederation of British Industry (CBI) discussion paper. For many, this 100-page tome is a must-read because of the in-depth and insightful nature of the analysis of trading arrangements, liquidity, transparency and the various players in the so-called ETF eco-system. The UK is well placed to comment because it has a 56% stake of the European ETF market.
“The CBI issued a very detailed discussion paper that not only poses questions at the European level but also at the global level,” says Lisa Kealy, partner and European ETF leader at EY. “The drivers behind the scrutiny are the increased media attention that the ETF flows have gathered and to ensure that problems such as mis-selling, which we have seen before with other products that have grown so fast, do not happen again. It’s not about hampering innovation, but ensuring there is an appropriate framework for products such as active ETFs.”
A list of recommendations was supposed to be published this summer but it has been pushed to the end of the year due to further consultations that the CBI is holding with ETF participants. One example is the part played by the authorised participants (APs) who are mainly responsible for the creation/redemption mechanism. The main concerns are around overall price manipulation and more specifically the impact on smaller investors if APs stop trading ETFs during periods of market stress.
“The ‘interconnectedness’ of the ETF industry is another source of potential regulatory scrutiny,” according to Craswell. In some instances, APs are connected to the ETF issuer and they are also acting as market maker. “In such a structure, the overall risk profile of the ETF may be amplified and regulators want to determine whether ETFs using the same counterparty to conduct all or some functions, will heighten systemic risk in the overall market,” he adds.
Portfolio transparency is also in the spotlight. Currently, there are no uniform European regulations for the disclosure of active ETF portfolios and some exchanges, such as the London Stock Exchange, do not require portfolio holdings to be divulged. As Craswell notes, most ETFs publicly disclose their holdings daily, which is prohibitive to some active asset managers entering the ETF market. As part of its 2017 discussion paper, the CBI has requested industry feedback around portfolio transparency rules.
Van Nugteren adds there is a high level of information in Europe because most ETFs are sold under the UCITS wrapper which requires a Key Investor Information Document (KIID). “Also under MiFID II, there are post-trade reporting requirements and more emphasis on the view of liquidity, but the situation would greatly be improved if there was a consolidated tape for ETFs,” he adds.
As for the US, the regulators will heed the IOSCO dictates but the SEC is moving forward with reforms to create a more uniform ETF regulatory framework. The proposals, which are subject to industry feedback, will allow ETF issuers to launch plain vanilla versions without first seeking the often time-consuming and expensive exemptive relief under Investment Act 40.
The rule change would apply to open-ended ETFs, a type of mutual fund that does not have restrictions on the amount of shares it can issue, which covers the vast majority of ETFs. Currently, the industry’s 80-plus issuers all operate under different requirements in a complex system which many believe inadvertently has allowed some firms to gain a competitive advantage. The US regulator says it hopes the changes will boost competition and innovation by lowering the barriers to entry. TF
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