On 22 July 2011, the European Securities and Markets Authority (“ESMA”) issued a discussion paper setting out policy orientations on guidelines for UCITS exchange-traded funds (“ETFs”) and structured UCITS. Following the entry into force of the broader investment freedoms for UCITS under UCITS III and their further extension in the Eligible Assets Directive (2007/16/EC), UCITS have been used as vehicles to implement a variety of strategies previously unavailable to them. ESMA is examining the impact that such innovation may have on investor protection and market integrity, particularly as UCITS products are not intended to be complex. ESMA is of the view that the current regulatory regime does not take sufficient account of the specific features and risks associated with UCITS which are ETFs or structured funds and is concerned that particularly complex products, which may be difficult for retail investors to understand and evaluate, may be made available to them. ESMA is therefore considering introducing measures which would mitigate these perceived risks.
ESMA raises a number of questions in the discussion paper in relation to whether there ought to be limitations on the distribution of exchange traded and structured UCITS to retail investors, or whether warnings ought to be issued to investors in respect of such products. ESMA has identified the following topics in respect of which it believes that guidelines should be developed and on which feedback is sought:
Use of an Identifier
ETFs should use an identifier, in their name and in their fund rules, prospectus and marketing material, which identifies them as an ETF.
The prospectus of ETFs which track the performance of an index or other assets should contain a clear and comprehensive description of the underlying asset which it proposes to track and the mechanism by which it will gain exposure to the it, ie whether the asset will be tracked synthetically or physically.
The prospectus of ETFs which track underlying assets synthetically should at a minimum include information on the underlying asset, the type of collateral which may be received from counterparties, the risk of counterparty default and the effect of such an eventuality on investors’ returns.
Securities Lending Activities
ESMA suggests that collateral received by ETFs in respect of securities lending activities, should comply with the criteria for OTC transactions set out in CESR’s Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS, which were built into the Irish UCITS framework as an addition to the implementation of UCITS IV in Ireland on 1 July 2011. The prospectus should clearly inform investors about the policy in relation to collateral, eg permitted types of collateral and the level of collateral required by the UCITS.
Disclosure of Main Risks of Actively Managed ETFs
Where an ETF is actively managed, investors should be clearly informed of this fact and of the main sources of risk arising from this choice of investment strategy.
Disclosure of Leverage Policy
The prospectus of leveraged ETFs should disclose their leverage policy and the risks associated with it, as well as including a description of how the daily leverage impacts on investors’ returns over the medium to long term.
Secondary Market Investors
ESMA is considering whether ETFs ought to be required to give all investors, including those who acquire units in the secondary market, the right to redeem their units directly from the UCITS.
ESMA describes structured UCITS as using financial derivatives, typically total return swaps, to provide investors with a predefined payout at the end of a specific period based on the return on underlying assets. ESMA considers that guidelines should be developed with regards to total return swaps and strategy indices. For structured UCITS gaining exposure to complicated investment strategies, ESMA believes that both the UCITS’ investment portfolio, which is swapped out, and the underlying of the swap to which the UCITS is exposed, should comply with the relevant UCITS diversification rules. Also, ESMA is of the view that the role of the counterparty of the total return swap should be subject to specific safeguards. ESMA proposes policy orientations concerning strategy indices on, inter alia, the appropriate frequency with which indices should be rebalanced and how their composition should be disclosed.
Matheson Ormsby Prentice, who have advised many of the leading ETF providers in the European market on the establishment of Irish domiciled ETFs, believes that the ETF market in Europe in particular is likely to experience significant growth in the coming years and that regulatory focus on it is understandable. The challenge for ESMA in considering the issues outlined above is to promote appropriate regulation of this market which safeguards investors without disadvantaging fund product providers by imposing unnecessarily burdensome or inefficient procedural requirements. For example, we believe that Irish domiciled funds may already comply with many of the proposals made by ESMA which further demonstrates Ireland’s position as a market leading domicile for ETFs in Europe.
ESMA will use the feedback received to the discussion paper to develop draft guidelines for ETFs and structured UCITS. Responses are due by 16 September 2011 and, as we currently anticipate that Matheson Ormsby Prentice will submit a response, we welcome and encourage any suggestions or opinions that you may have. The draft guidelines prepared by ESMA following review of the responses received will be subject to a further public consultation in due course.
ESMA’s discussion paper can be accessed through the following link: ESMA Discussion Paper.