On 14 September 2018, the Central Bank of Ireland (CBI) issued the eagerly awaited feedback statement on its Discussion Paper on exchange traded funds (ETFs).
Key Policy Statements
The feedback statement contains two welcome policy changes. The CBI will now permit:
- listed and unlisted share classes within the same fund; and
- different dealing cut-off times for hedged and unhedged share classes in an ETF.
The third key outcome of the feedback statement is that the CBI did not relax its requirement that ETFs must make full daily portfolio disclosure to the public. It was hoped that a middle-ground would be found that would ensure that the market price of an ETF is close to its net asset value while enabling managers seeking to launch active ETFs to protect their strategies from public disclosure. The CBI left the door open for a potential change to this policy indicating, however, that this would be on foot of a broader international consensus on the matter being reached.
This article examines these three key policy pronouncements as well as the other findings contained in the CBI's feedback statement.
Ireland is the largest European ETF domicile and the CBI has been leading the international regulatory discourse on ETFs since publishing the Discussion Paper in May 2017. The Discussion Paper, which sought to identify ETF-specific issues of key regulatory importance, received significant attention from across the globe and was contributed to by some twenty-six responses from a broad range of stakeholders. The CBI's feedback statement summarises the CBI's findings on the key themes identified in the Discussion Paper and, as well as making the policy pronouncements already referred to, provides a focus for future international regulatory engagement on these topics.
Listed and Unlisted Share Classes
Listed (i.e., exchange traded) and unlisted share classes will now be permitted within the same fund. This is welcome news for ETF providers who will now likely offer unlisted share classes within their ETFs. It is also an exciting opportunity for promoters of mutual funds wishing to enhance distribution opportunities by adding ETF share classes to their existing products.
The CBI noted that establishment of listed and unlisted share classes did not go against any of the principles set out in ESMA's opinion on UCITS share classes and that any potential concerns around investor confusion could be addressed by appropriate disclosure. As acknowledged by the CBI, the ESMA Guidelines on ETFs already contemplated listed and unlisted share classes in the same fund by providing that a UCITS which has a share class trading on an exchange is a UCITS ETF. As a UCITS ETF must contain the "UCITS ETF" identifier in its name, it follows that any UCITS mutual fund seeking to launch exchange traded classes will be required to change the name of the fund to include "UCITS ETF". The CBI indicated that it would issue guidance on disclosure requirements for both types of classes.
Share Class Dealing Arrangements
Hedged and unhedged share classes within an ETF may now have different dealing cut-off times. Earlier cut-off times are required for currency hedged share classes to allow time for ETFs to place hedges on the same day. Unhedged share classes in the same ETF can therefore have later dealing times and permitting this enables authorised participants to place trades in shares of unhedged ETF classes as closely as possible to the close of the underlying markets. This is therefore a sensible and welcome deviation from the general CBI rule that dealing deadlines must be the same for all share classes in a fund. The CBI has also previously permitted different dealing cut-off times in the same fund for cash and in-kind dealing.
It is not clear whether limiting the ability to have different cut-off times for hedged and unhedged classes is limited to ETFs simply because the question arose in an ETF forum or whether the CBI only sees merit in permitting different cut-off times for hedged and unhedged classes for ETFs alone. While some of the reasoning for allowing different cut-off times would equally apply to mutual funds, it remains to be tested with the CBI whether it would adopt the same approach for mutual funds.
Portfolio Disclosure and Active Investment Strategies
Disappointingly for active managers, the CBI has not relaxed its requirements on full portfolio disclosure. While acknowledging the arguments made by the majority of the respondents in favour of more limited portfolio disclosure as well as solutions proposed that would facilitate that, the CBI reiterated its view that full daily portfolio disclosure must be made to the public. The CBI was not convinced that additional investor choice in the form of active ETFs (with limited public portfolio disclosure) justified a departure from what the CBI considers a fundamental principle that investors are assured that the exchange price of ETF shares is close to the ETF net asset value. In the CBI's opinion, this can only be ensured by full portfolio transparency. The CBI observed that the balance of the protection of intellectual property within the investment strategy that may be revealed by granular portfolio disclosure therefore became a commercial question for managers who are considering the establishment of active ETFs.
While the CBI did not change its policy on this occasion, it indicated that it would continue to consider the matter at European and international regulatory forums. One might speculate that should a more limited portfolio disclosure be acceptable in future, the alternatives to full disclosure set out in the CBI's feedback statement might be used to formulate future policy. The alternative forms of portfolio disclosure considered by the CBI seek to balance the protection of intellectual property rights and the prevention of front-running of active ETFs against the desirability for transparency and effectiveness of keeping the exchange traded price close to the ETF's net asset value. These included the provision of a full portfolio to a limited number of authorised participants and official liquidity providers, calculation of the indicative net asset value (iNAV) and provision of information on a proxy portfolio which closely resembles the actual portfolio of the ETF.
Authorised Participants (APs) and Official Liquidity Providers (OLPs)
Disclosure of information in relation to entities acting as APs and OLPs is seen by the CBI to be desirable from a regulatory perspective, particularly to enable the CBI to assess potential risks from the concentration of AP and OLP activity in a limited number of market participants.
The CBI acknowledged that the majority of ETFs apply an "all in" fee structure whereby a single fee is paid by the ETF to the management company. As the management company then discharges the fees of other service providers, it is typical that service provider fees would not be individually disclosed in the ETF's prospectus. In considering the disclosure of remuneration of APs and OLPs, the CBI stated that it viewed transparency of remuneration structures as best practice and suggested that a future regulatory move (likely to be at a European level) to impose more granular remuneration disclosure requirements was possible.
The CBI considered the question of providing direct redemption facilities for secondary market investors where liquidity on exchange was impaired. It was observed that direct redemption from an investor who is not a participant in a central securities depositary was unlikely to be operationally possible and would in any event be extremely complex and burdensome. As against this, the CBI noted the investor expectation likely to have been created by the ESMA requirement that redemptions to secondary market investors could, where exchange liquidity was impaired, be made directly by the ETF. In view of these findings, the CBI suggested scrutinising this issue further at the European level.
ETF Dealing Arrangements
In considering a scenario of liquidity constraints in underlying markets which results in dealings being suspended at the ETF level while ETF shares continued to trade on exchange, the CBI observed that access to liquidity on the exchange would likely come at a cost to the investor. In this context, the CBI identified a risk that higher prices of ETF shares on an exchange might be misinterpreted by investors to represent value rather than a reflection of increased spreads. The CBI suggested that action might be required from the ETF provider in these circumstances to suspend trading on the exchange also. This suggestion may be the subject of further study that the CBI indicated is merited on this topic.
On the question of whether an ETF should remain "open-ended" in stressed market conditions, the CBI concluded that an ETF should not be prevented from the ability to suspend primary market dealing. The CBI noted that such a prohibition would unlikely achieve the aim of creating liquidity in circumstances where liquidity is lacking in stressed market conditions.
Conflicts of Interest
The potential for conflicts of interest to arise in an ETF context were noted in particular where APs or counterparties to swap transactions or transactions entered into by ETFs for the purposes of efficient portfolio management were part of the same economic group as the ETF manager. The CBI acknowledged the strict and extensive conflicts of interest rules that apply to ETFs under various European directives and the CBI rules. Of interest is the CBI's observation that it did not perceive ETFs pursuing synthetic strategies using swaps to be more exposed to conflicts of interest than physical ETFs as they were subject to the same rigorous approach to identification, disclosure and management of conflicts of interest.
Noting that intuitively a multi-counterparty model was associated with risk diversification, the CBI did not consider that it was desirable to impose a minimum or maximum number of APs or counterparties to swap transactions or transactions entered into by ETFs for the purposes of efficient portfolio management. The CBI observed that risk management techniques in respect of counterparty exposure were mandated under the existing regulatory framework and acknowledged that there may be circumstances where a single counterparty model may be the only workable or most efficient model.
It was acknowledged that ESMA Guidelines on ETFs focused on the liquidity and quality of the collateral provided to ETFs and that the industry continued to see introduction of any requirements on correlation of collateral delivered to a synthetic ETF to the index it tracks as inappropriate for economic, structuring and regulatory reasons. The CBI concluded that it did not see merit in further considering collateral correlation from an ETF-specific perspective given that collateral requirements have implications for all UCITS.
The CBI indicated that the issue of ETF liquidity will be a likely focus of ongoing European and international work streams relating to ETFs. The CBI commented on the expectation of inherent liquidity of ETFs at a reasonable cost. The continued regulatory focus on liquidity will therefore come as little surprise in light of the expansion of the types of exposures provided by ETFs to less liquid markets. It was acknowledged that the assessment of the robustness of ETF liquidity was complex given that visible on-exchange trading of ETF shares does not always give the complete picture. MiFID II trade transparency requirements were cited as potentially improving visibility of off-exchange trading of ETFs (noting the limitations in view of absence of consolidated data at a European level). The requirement under the UCITS rules to invest in liquid assets was recalled as something that should work to alleviate concerns with regard to potential illiquidity of underlying investments. While it was acknowledged that ETFs were subject to market forces and were not providers of "liquidity at all costs", it was observed that ETFs nevertheless continued to trade during a number of crises over the past ten years in circumstances where there was an absence or a reduction of liquidity in the underlying markets.
Informational Efficiency of Underlying Securities
The CBI considered that the extent to which increased investment in index-tracking ETFs could potentially result in the price of underlying securities not reflecting their true value (i.e., increased investment in ETFs being detrimental to informational efficiency) required further research and analysis on a supranational regulatory level. The effect of the inclusion or exclusion of a security from an index on its price appears to be an area of research of particular interest to the CBI.
ETF Provider Support
The CBI was clear that it was not in favour of creating an impression that investment in ETFs was not subject to market risk. Nevertheless, the question of the scope of support that ETF providers may be incentivised to provide (for instance, from a reputational risk perspective) where ETF liquidity is affected remains of interest to the CBI.
The CBI acknowledged the fragmentation of operations of European ETFs due to the variety of listing rules on multiple European exchanges. The CBI also noted discrepancies in the processes of communicating with end-investors. The CBI commented on the desirability of the harmonisation of rules on listing and trading of ETFs as well as on the investor communication process. An introduction of a single set of European rules on these matters would be a welcome enhancement of the ETF ecosystem and the indication that the CBI would support these initiatives at the European level is encouraging.