A Discussion on the Regulatory Scrutiny Facing ETFs
Other than GDPR, exchange traded funds (ETFs) has been the buzzword for the first half of 2018. The year-on-year increased inflows into European ETFs is something which is being discussed at every conference or seminar where product development is on the agenda and; given I am not a statistician, I will not spend any more time on this aspect.
However, an area which continues to generate interest is the increased level of scrutiny applied to ETFs by regulators across the globe.
Regulatory scrutiny of ETFs
I am sure by now we have all read the Central Bank of Ireland's (CBI) discussion paper on ETFs. For those of you who haven’t I suggest you do – it is an excellent way to get know (in only 100 pages) how an ETF operates. As any good regulator should, the CBI has set out its stall on what it considers are the key risk factors for ETFs that concern them the most. These include questions over:
- The design of ETFs.
- Their use of primary dealing and secondary trading.
- The impact of ETFs on market liquidity.
- Disclosure requirements surrounding ETFs.
At first glance, on their own, such remarks seem very valid and sincere questions that should be asked of a growing sector, but when put together with additional calls for "the assessment of the risks inherent in the ETF structure" and a reminder that national, international and supranational securities regulators have embarked on work that is focused on ETFs, it is certainly time for the industry to pay attention.
In recent months, discussions have taken place to explain how ETFs operate and to address the question regarding how the ETF sector faces up to challenges during periods of market stress, for instance in the aftermath of the financial crisis or after the sell-off of volatility ETFs.
In general, the ETF sector has come out strong, making its case for how individual ETFs and the ETF market deal with potential liquidity pinch-points. Linked to this discussion is the emphasis being placed on the role of the authorised participant (AP) and the perceived potential lack of accountability held between the ETF sponsor and an AP, other than through their terms of business. While I am generally skeptical of sweeping statements that infer that one must look at an entire sector just as they are increasing in popularity, I do understand why regulators may wish to see a more evolved process surrounding the appointment of APs. With this in mind, an increased level of consistency of AP terms across the industry and dare I say it, robustness, within AP documentation is likely to be a good starting point.
The risk of contagion is another factor where regulators have expressed their concern and the potential "ripple effect" of any liquidity crisis within the ETF sector. My observation is that ETF providers across the industry have been requesting additional methods to increase market transparency, including schemes such as the use of consolidated tape under the initial MiFID II proposals (that is, the MiFID II Directive (2014/65/EU) and the Markets in Financial Instruments Regulation (Regulation 600/2014) (MiFIR). However, as this is not the case, for now, regulators and the industry will need to keep a watchful eye over how the increased transparency requirements under MiFID II may assist in shedding light on trading patterns of ETFs within Europe.
Finally, no synopsis on increased regulatory scrutiny can be complete without the mention of increased transparency for investors. Now before you point out that MiFID II addresses this, it is clear that the regulators and the sector still feel there may be more to come within the ETF sector. Some of this relates to comments on the appropriate nomenclature used, something which was raised again in the United States earlier this year.
Those of us in Europe would argue that we already have the distinction between a UCITS ETF and products that do not fall within this category. Nonetheless, I would highlight that there is still a certain level of debate between the use of the label ETF versus exchanged traded certificate versus exchange traded product globally that means the conversation continues.
In addition to terminology, regulators are most concerned with ensuring that ETFs have appropriate descriptions and disclosures that explain the specific risk profile of an ETF. Again many would argue that we need to give time for MiFID II to demonstrate its effect before adding further requirements, but I would not be surprised if further globally based principles are released addressing some of these concerns. In fact, I note that the International Organization of Securities Commission (IOSCO), confirmed that it plans to look at ETFs in 2018, and has been reaching out to the ETF sector since then, with a report (draft or otherwise) rumoured likely to be produced before the end of the year.
The potential for ETFs in Europe
Reading the above, one realises the upcoming challenges the ETF sector has in getting its voice heard, but I am confident that this process is underway. This leads us to why ETFs still appear to be a buzzword this year and a possible source of growth. Some of this potential can be attributed to a "push" effect emanating from unintended consequences of the application of EU legislation to global products, such as the potential application of the Regulation on key information documents (or KIDs) for packaged retail and insurance-based investment products (PRIIPs) (Regulation 1286/2014) to non-EU ETFs. It may also be due to the appearance of a more level playing field with traditional mutual funds as a result of MiFID II’s rules (and in the UK, the retail distribution review (RDR)) on payment of commission. While it is too early to tell where this all leads, it is clear that the trend towards (at the very least) understanding how an ETF operates and is constructed remains.
On the "pull" side, we are now in an environment where value for money is being discussed heavily (see Practice note, Hot topics: Implementing the FCA asset management market study (AMMS)) and an additional level of scrutiny is being applied to fees. Again, ETF sponsors will need to be wary of the rhetoric behind this and ensure that when claiming such benefits, these are indeed reflective of the actual structure of a particular ETF.
Collaboration within the ETF sector
A number of us in the ETF sector, often talk about the "ETF ecosystem" and for those who are new to it, I imagine it can seem impenetrable. From a personal perspective, I would add that I was in that place not that long ago (if you count in decades!) and, in general, I have found the ETF ecosystem to be one of the most open out there, with very senior individuals taking the time to explain how an ETF works, the ways in which liquidity is generated, and how cross border AP systems may work in practice. It is, with few exceptions, generally a very transparent sector. It will be interesting to see how this reputation for transparency continues, particularly as firms design products that are more "active" in nature. But, one may also argue that the same level of transparency and openness should apply across the spectrum of investment products irrespective of their wrapper? That is at least how the most recent EU product legislation and investment services regulation has been drafted.
Now, of course, a collaborative environment does not mean that there is not healthy dose of competition in the sector whether it be for "best of class" status, or being the first out of the blocks to launch the newest and most innovative (and, for some, bespoke) product range. But, surely, that is to some extent the case for any potentially successful growth story.
This article was originally published by the Practical Law Company in May 2018.