ETF regulatory update
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With the phenomenal interest and growth in exchange-traded funds (ETFs), this article focuses on some impending European Union (EU) legislation and explores the impact such legislation may have on EU ETFs.
The EU Packaged Retail and Insurance-based Investment Products (PRIIPs) Regulation, which comes into effect from 1 January 2018, lays down uniform rules on the format and content of the Key Information Document (KID) to be drawn up by the manufacturers of PRIIPS; and on the provision of the KID to retail investors by PRIIP manufacturers and those selling, or advising on, those products.
The obligation to prepare a KID arises where the relevant PRIIP is offered or sold within the European Economic Area (EEA) to any ‘retail investor’, as defined under MiFID II. Therefore, the PRIIPs Regulation has implications for EU ETFs where their shares are offered or sold to retail investors within the EEA.
The PRIIPs Regulation does not distinguish between PRIIPs sold with or without advice provided to the retail investor, or acquired by the retail investor on its own initiative or otherwise. For any PRIIP made available to retail investors, a PRIIP manufacturer (ie, the fund manager or ETF if internally managed) must draw up and publish for that product a KID on its website. Further, any person advising on, or selling, that PRIIP must provide the retail investors with the KID. The KID must be provided in a language prescribed by the Member State where the PRIIP is distributed in order to ensure that retail investors can understand it.
UCITS (Undertakings for Collective Investment in Transferable Securities) and AIFs (Alternative Investment Funds) also fall within the definition of PRIIPs. However, UCITS are exempt from the requirement to produce a PRIIPs KID until 31 December 2019, due to the existing UCITS (KIID) regime.
While the UCITS KIID shares similar goals as the PRIIPs KID, there are significant differences between the two, as outlined in figure 1.
Whilst a UCITS ETF is exempt from the PRIIPs KID regime until 31 December 2019, there may be situations where a UCITS ETF could be required to produce the data required for a KID before 31 December 2019. This could be the case, for example, where the UCITS ETF is sold via unit-linked insurance products. In this case there would be an obligation on the life insurer (as the PRIIP manufacturer) to produce a KID for the underlying UCITS ETF. This will necessitate data exchange between the ETF investment manager and the life insurer.
The EU Benchmarks Regulation (the BMR) regulates the provision and use of benchmarks within the EU and will, subject to transitional arrangements, come into effect from 1 January 2018.
The rules governing the use of a benchmark apply principally to ‘supervised entities’ which are defined in BMR as including a UCITS, a UCITS management company and an Alternative Investment Fund Manager (AIFM) in respect of AIFs under management. Therefore, such rules are applicable to any ETF “using a benchmark”.
Although the “use of a benchmark” is defined broadly within BMR by reference to a number of scenarios, passive ETFs replicating or tracking an index or a combination of indices will come within the definition. An active ETF may also come within the definition if, for example, it is measuring its performance through an index or a combination of indices for the purpose of defining the asset allocation of its portfolio or for computing performance fees.
Subject to transitional arrangements, a benchmark can only be ‘used’ within the meaning of BMR by an ETF if:
(i) in the case of an EU index provider, that index provider is authorised or registered with the European Securities and Markets Authority (ESMA) as a benchmark administrator; or
(ii) in the case of a non-EU index provider,
(a) the provider is located in a jurisdiction which has implemented rules which are deemed to be equivalent to those introduced under BMR and the entity is authorised and subject to supervision and enforcement under such rules, or the specific provider or benchmark being used has been deemed subject to equivalent requirements; or
(b) the provider is recognised by a ‘member state of reference’ within the EU; or
(c) the relevant benchmark has been endorsed by an EU benchmark provider for use in the EU.
The transitional arrangements depend on whether the index provider is located in the EU or in a third country and also depend on when the index provider first began providing an index within the EU.
EU Index Providers
If an EU index provider first started providing benchmarks in the EU before 30 June 2016, an ETF can continue to use any of the provider’s benchmarks (including any new benchmark established after 1 January 2018) without the index provider being authorised under BMR until 1 January 2020 (unless the index provider has had its application for authorisation refused in the interim).
If the EU index provider only started to provide benchmarks in the EU after 30 June 2016 and the benchmark being used by the ETF is in existence as at 31 December 2017, that benchmark can continue to be used until 1 January 2020 without the benchmark provider being authorised (unless the index provider has had its application for authorisation refused in the interim). However, if the index is only created after 1 January 2018, an ETF will not be able to use that benchmark until such time as its provider is authorised under BMR.
Non-EU index providers
ESMA has called on the European Commission to provide further clarification on the final transitional arrangements applicable to non-EU benchmark providers. No clarification has yet been provided but it would appear from Article 51(5) of BMR that where the benchmark is already in use within the EU as at 1 January 2018, it can only be used by an ETF before 1 January 2020. Subject to any clarification from the European Commission, it would appear that a non-EU index provider of any benchmark used for the first time in the EU after 1 January 2018 must be recognised or deemed equivalent under BMR or alternatively the benchmark itself must be endorsed or deemed equivalent in accordance with the BMR regime.
The second Markets in Financial Instruments Directive (MiFID II), which comes into effect on 3 January 2018, applies to EU investment firms such as portfolio managers, investment advisers, distributors, brokers, etc, and to credit institutions when performing MiFID II investment services. It also applies to UCITS management companies and AIFMs who have extended their authorisations to include MiFID investment services, but only in respect of those extended services.
MiFID II does not apply directly to ETFs, but will impact ETFs who have, directly or indirectly through UCITS management companies or AIFMs, delegated portfolio management or distribution services to EU MiFID investment firms.
MiFID II introduces a number of changes applicable to MiFID investment firms that will have an impact on their ETF clients. In particular, these include new and amended rules relating to inducements, investment research and product governance.
Inducements received by a MiFID firm in providing investment services to an ETF cannot be retained by it unless they are designed to enhance the quality of the service to the ETF and do not impair compliance with the MiFID firm’s overriding duty to act honestly, fairly and professionally in accordance with the best interests of the ETF.
Notwithstanding the above general rule, MiFID firms providing investment advice on an independent basis or portfolio management services to an ETF are prohibited from accepting and retaining inducements from third parties in relation to the services provided to the ETF. Certain minor non-monetary benefits can be retained, where disclosed to the ETF.
Similarly, where a MiFID firm provides investment advice on an independent basis or portfolio management services to an investor, it is prohibited from receiving any inducement from third parties. Importantly, this will remove the incentive for intermediaries to choose a fund product that pays commission and is expected to enhance the size of the EU ETF market considerably.
Investment research will not constitute an inducement where it is paid for by the MiFID firm itself out of its own resources, or out of a research payment account (RPA) funded by a specific research charge to the ETF client. Significant compliance obligations apply to the operation of a RPA including rules on what can be paid for, agreeing a research budget with the ETF client, reviewing and assessing the purchased research and periodic disclosure to the ETF client. Where research charges are to be borne by an ETF, these will need to be taken into account in calculating the ongoing charges figure for the purpose of the ETF’s KIID.
The MiFID II product governance rules apply to MiFID firms that manufacture for sale, or offer or recommend, ETFs (the shares of which constitute financial instruments under MiFID II). Consequently, although such rules will not apply to ETFs or to UCITS management companies and AIFMs where they are only engaged in managing UCITS or AIFs, those entities are likely in practice to have to deal with the product governance rules and to do all that is required of ‘product manufacturers’. Otherwise, ETF distributors (ie, MiFID firms that offer, recommend or sell ETFs) are unlikely to offer or recommend those ETFs.
Among other things, the rules require the manufacturer to make available to distributors all appropriate information on the investment product and the product approval process, including the identified target market and one-off and ongoing charges (which, in the context of an ETF, will also include portfolio transaction costs).
The rules require the distributor to:
(i) determine the actual target market for the product;
(ii) have product governance controls in place to ensure that products and services it offers or recommends are compatible with the needs, characteristics and objectives of the identified target market and that its distribution strategy is consistent with the identified target market;
(iii) ensure it can obtain all required information from the product manufacturers; and
(iv) comply with the normal MiFID disclosure, suitability/appropriateness assessment, inducements and conflicts of interest rules.
The EU General Data Protection Regulation (GDPR), which comes into effect from 25 May 2018, aims to make businesses more accountable for data privacy compliance and offers data subjects extra rights and more control over their personal data.
(i) enhances existing rights of data subjects whilst also introducing new rights relating to (a) data portability, (b) restricting processing and (c) the right to be forgotten;
(ii) expands the list of provisions data controllers must include in their contracts with data processers;
(iii) expands the territorial scope of EU data protection law;
(iv) provides for the appointment of a Data Protection Officer in certain circumstances;
(v) requires a data controller to notify the applicable supervisory authority without undue delay, and where feasible, not later than 72 hours after having become aware of a personal data breach unless the breach is unlikely to result in a risk to the rights and freedoms of natural persons;
(vi) requires a data controller to communicate a personal data breach to the data subject without undue delay when it is likely to result in a high risk to the rights and freedoms of natural persons; and
(vii) requires a data processor to notify the data controller without undue delay after becoming aware of a personal data breach.
However, given the shareholding structure of ETFs (typically, ETF shares are issued directly into a central securities depositary (CSD), in which case only CSD participants will be shareholders of the ETF, or they are issued through a global share certificate in the name of a common depositary, being the applicable CSD’s nominee), the applicability of the GDPR to ETFs is limited. This is because shareholders’ data will not ordinarily include personal data. Therefore an assessment should be carried out on a case–by-case basis to determine what personal data if any is held and/or processed by or on behalf of an ETF.
Brian Kelliher is a partner at Dillon Eustace