The Central Bank of Ireland (the “Central Bank”) has announced that it will release a feedback statement later this year in response to its 2017 Discussion Paper on ETFs (the “Discussion Paper”) and the general work it has performed related to ETFs in the last year. The Central Bank has outlined it primarily intends to use the feedback it has received to assist in contributing to the International Organization of Securities Commissions (“IOSCO”) review of the 2013 IOSCO ETF Principles and in general in contributing to the international debate that is ongoing with respect to ETFs.
However, importantly the Central Bank has also indicated that there are several matters raised within the Discussion Paper where it may look to take the initiative prior to any IOSCO or other international developments in the area. Accordingly, there may be potential developments for Irish authorised ETFs in the areas of (i) disclosure of portfolio holdings, (ii) ETF and non-ETF share classes and (iii) differing dealing deadlines for hedged and unhedged share classes. Further analysis of each point is outlined below.
Disclosure of Portfolio Holdings
Currently, the Central Bank expects an ETF’s portfolio to be disclosed on a daily basis. This expectation is outlined in the Central Bank’s UCITS Questions and Answers document and states: “The Central Bank will not authorise an ETF, including an active ETF, unless arrangements are put in place to ensure that information is provided on a daily basis regarding the identities and quantities of portfolio holdings. The arrangements must be disclosed in the prospectus.”
Within the Discussion Paper the Central Bank noted that it may be possible for an ETF which does not publicly disclose portfolio holdings to reach an operational solution which creates an incentive for traded prices to remain close to the ETF’s net asset value. Potential approaches cited by the Central Bank in the Discussion Paper which would allow this include (i) full portfolio disclosure to a single of limited number of Authorised Participants (“APs”) and (ii) use of an index or other proxy for the ETF’s portfolio. The Discussion Paper posed the question of whether portfolio transparency was fundamental to the nature of an ETF or whether there are other mechanisms which could achieve the same goal as transparency. In addition, and specifically in the context of active ETFs, the Discussion Paper queried if transparency was essential to achieve a liquid market and to facilitate efficiency in pricing.
While some responses to the Discussion Paper argued that investors have traditionally valued portfolio transparency as central to the ETF product and a key differentiator to mutual funds, the majority of responses were broadly supportive of the concept that it was not necessary for active ETFs to disclose portfolio details publicly on a daily basis. The Central Bank has taken on those responses and confirmed it is engaging in some further bilateral discussions with entities involved in this area in order to further understand the complexities. In particular the Central Bank has noted that investors cannot currently access certain strategies, which would be appropriate for ETFs, primarily because of the portfolio transparency requirements. On this basis the Central Bank is looking into a potential relaxation of the disclosure rules, possibly through an amended form of daily disclosure or some form of delayed disclosure, whilst always ensuring this does not harm investors.
Whilst amended disclosure rules with respect to the release of portfolio holdings would be a welcome development, it must be remembered that there are also individual stock exchange rules with respect to portfolio holdings which the ETF must comply with in order to meet listing requirements. Unless the stock exchange rules are amended in conjunction with any revised rules from the Central Bank, the benefits of the revised rules would be limited to only certain stock exchanges. By way of example, the Irish Stock Exchange and the London Stock Exchange do not currently require an ETF to disclose its portfolio holdings unless it is under a regulatory requirement to do so. Accordingly, any Irish ETFs that are listed on the Irish Stock Exchange and admitted to trading on the London Stock Exchange would benefit from a relaxation of the Central Bank rules. However, this should be contrasted with Borsa Italiana which currently requires full disclosure of the previous day’s portfolio prior to trading each day. Unless Borsa Italiana amends its disclosure rules in line with any amended rules released by the Central Bank, Irish ETFs will still need to disclose portfolio holdings on a daily basis in order to maintain a Borsa Italiana listing. Consideration would also need to be given to any shares of an Irish ETF which are cross-listed across exchanges and to the differing disclosure requirements.
ETF and Non-ETF Share Classes
The second area the Central Bank has confirmed it may look to introduce rules around relates to the possibility of establishing within a UCITS ETF both “listed” share classes (i.e. standard ETF share class listed and traded on a stock exchange) and “unlisted” share classes (i.e. non-ETF share class). Within the Discussion Paper the Central Bank noted that the current regulatory requirements would technically permit the creation of such share classes within the same UCITS ETF. It also noted that operationally it would be possible to do so. However, the Central Bank raised several concerns regarding the fair treatment of shareholders with the creation of “listed” and “unlisted” classes within the Discussion Paper. Firstly, the Central Bank was concerned that investors in the “listed” classes would not have access to the redemption facilities available to investors in the “unlisted” classes, primarily in times of market stress. Secondly, and notwithstanding that investors may choose to invest in either the “listed” or “unlisted” classes, the Central Bank queried whether it was fair that the investors in the “listed” class were able to redeem shares on an intra-day basis whilst investors in the “unlisted” classes could only redeem once daily.
A potential solution to the fairness issue was raised within the Discussion Paper. It was noted that a standard feature of a “listed” class was that the shares were freely transferable between investors intra-day. However, for “unlisted” classes a transfer of shares would typically require approval from the UCITS ETF itself. The Central Bank raised the possibility of the UCITS ETF allowing “unlisted” shares to be transferred without the need for approval from the UCITS ETF.
This particular proposal was not addressed by many respondents to the Discussion Paper with most arguing in general that there is no reason why a UCITS ETF could not offer both "listed" and "unlisted" share classes. It was pointed out that “fair” treatment does not equate to “equal” treatment and that adequate disclosure would resolve the Central Bank’s concerns.
We are aware that the possibility of creating both "listed" and "unlisted" classes within a UCITS ETF (or indeed the creation of an ETF class within a standard UCITS) would be of interest to many. The Central Bank’s proposals in this area are keenly awaited and if the proposals focus on the solution the Central Bank itself raised within the Discussion Paper (allowing “unlisted” shares to be transferred without the need for approval from the UCITS ETF) this would seem like a workable solution.
Dealing Deadlines for Hedged and Unhedged Share Classes
As standard the Central Bank requires investment funds to operate the same dealing deadline across all share classes in a UCITS (on a sub-fund by sub-fund basis). It has deviated from this requirement for UCITS ETFs in allowing different dealing deadlines for cash and in-kind subscriptions. In doing so the Central Bank has recognized that dealing with an ETF on a cash basis attracts different considerations to dealing on an in-kind basis. For cash subscriptions the UCITS ETF will need additional time to invest the cash in the market and hence the dealing deadline for cash is set earlier than for in-kind.
Within the Discussion Paper the Central Bank queried if there may be other circumstances which might necessitate consideration of different dealing deadlines within the same UCITS ETF. The example raised within the Discussion Paper related to a UCITS ETF with a hedged share class which implements currency hedging through a currency hedged index (a hedged version of the index the UCITS ETF is replicating). Within the example, the hedge trades are placed as close as possible to the time the foreign exchange rate is fixed within the index. The UCITS ETF will need sufficient time to place the trades and therefore will require an earlier dealing deadline. For unhedged classes this is not relevant and hence they could have a later dealing deadline.
The Central Bank did not raise any specific questions with regard to this matter within the Discussion Paper. However, it should be remembered that the Discussion Paper only formed part of the Central Bank’s review of ETFs - it has also conducted surveys, held a conference in November 2017 and engaged in bilateral discussions with ETF issuers. It would be a welcome development if the Central Bank was to allow differing dealing deadlines for hedged and unhedged share classes in the future. This would assist ETF issuers and demonstrate that the Central Bank is open to development of its rules.
Future IOSCO Work
As outlined above, the Central Bank intends to use the Discussion Paper and its work surrounding that as an educational tool in order to allow it to further participate in the international discussions taking place with respect to the ETF industry. IOSCO’s pending review of its 2013 ETF Principles will be an important part of the developments in the ETF area and the Central Bank has clearly outlined its intention to form a central part of that process. Indeed the Central Bank recently participated in an IOSCO round table event in Dublin.
Part of the IOSCO review is expected to include matters such as investor understanding of ETFs that are using more complex indices. Representatives of the Central Bank have also recently confirmed that one area it is expected IOSCO will look into is the potential introduction of a naming convention for ETFs. In the meantime the feedback statement from the Central Bank and the potential amendment to the rules outlined above is expected later this year.