The International Organization of Securities Commissions (IOSCO) has published a report calling for financial regulators to encourage greater transparency on the differences between exchange traded funds (ETFs) and other exchange traded products (ETPs) and more uniform regulation.
IOSCO’s June 2013 report, "Principles for Regulation of Exchange Traded Funds," found that globally, ETFs amount to $1.9 trillion in assets, representing roughly 7 percent of the global mutual fund market, which, in turn, is estimated at approximately $26.8 trillion.
The report noted several global trends of which regulators should be mindful. Among other things, the report stated:
- The ETF industry is consolidated and dominated by a few large players;
- Investor appetite for exposure to equity indices has grown in light of the low interest rate environment;
- ETF providers in some jurisdictions have substantially enhanced their disclosures;
- Synthetic ETF providers have taken significant steps to increase transparency and minimize counterparty risk.
Overview of the Principles
The report enumerates nine principles, which fall primarily into two categories. The first section concerns ETF classification and disclosures, including principles intended to clearly differentiate ETFs from other types of investments. The second section concerns structuring issues, including management of inherent conflicts of interest and counterparty risk arising from the two main types of index replication methods: physical and synthetic.
Investors in the U.S. should not be surprised by the nature of the recommendations, which are consistent with U.S. regulation of ETFs. Similarly, it would come as no surprise if the SEC were to propose regulations or issue guidance that would enhance the existing regulatory scheme, particularly with respect to disclosures, conflicts of interest or securities lending, which have been popular areas of focus for the SEC’s enforcement division.
IOSCO accompanied each principle with recommended means of implementation.
The Nine Principles
The nine IOSCO principles for ETFs are:
Principle 1: Regulators should encourage disclosure that helps investors to clearly differentiate ETFs from other ETPs.
Principle 2: Regulators should seek to ensure a clear differentiation between ETFs and other collective investment schemes (CIS), as well as appropriate disclosure for index-based and non-index-based ETFs.
Principle 3: Regulators should require appropriate disclosure with respect to the manner in which an index-based ETF will track the index it references. (This approach is already typical in prospectuses for U.S. ETFs.)
Principle 4: Regulators should consider imposing requirements regarding the transparency of an ETF’s portfolio and/or other appropriate measures in order to provide adequate information concerning (i) any index referenced and its composition, and (ii) the operation of performance tracking.
Principle 5: Regulators should encourage the disclosure of fees and expenses for investing in ETFs in a way that allows investors to make informed decisions about whether they wish to invest in an ETF and thereby accept a particular level of costs.
Principle 6: Regulators should encourage disclosure requirements that would enhance the transparency of information available with respect to the material lending and borrowing of securities (e.g., on related costs).
Principal 7: Regulators should encourage all ETFs, in particular those that use or intend to use more complex investment strategies, to assess the accuracy and completeness of their disclosure, including whether the disclosure is presented in an understandable manner and whether it addresses the nature of risks associated with the ETF’s strategies.
Principle 8: Regulators should assess whether the securities laws and rules of securities exchanges within their jurisdiction appropriately address potential conflicts of interest raised by ETFs.
Principle 9: Regulators should consider imposing requirements to ensure that ETFs appropriately address risks raised by counterparty exposure and collateral management.
The SEC and IOSCO
IOSCO consists of 32 securities regulators of different countries, including the Securities and Exchange Commission. The SEC served as co-chair of the working group that authored the report. In the past, the SEC has disavowed reports when it found the recommendations inconsistent with its goals. For example, in 2012, the SEC publicly stated that it disagreed with IOSCO recommendations for regulation of money market funds. It appears, however, that the SEC would be amenable to the IOSCO recommendations, which it may incorporate into future rulemaking or regulatory guidance.