The rise of passive investment strategies and the growing momentum of investment in exchange-traded funds (ETFs) has not gone unnoticed by European regulators. The Central Bank of Ireland (Central Bank) recently released a fact-finding Discussion Paper on ETFs (Discussion Paper).1 It is expected other European regulators may follow a similar route, with the goal of ensuring that such regulators properly understand, and can efficiently regulate, ETFs.
Specific European ETF guidelines were most recently issued by the European Securities and Markets Association in 2014, and it is uncertain whether, and if so when, any further rules and regulatory guidance on European ETFs will follow. However, it is clear that as the focus on ETFs by investors continues, so too will the focus of regulators. Accordingly, the matters raised in the Discussion Paper may provide insight as to the regulatory thinking and priorities that may impact ETFs at both a European and global level in the future.
The current flows of investment into European ETFs can be attributed to a multitude of factors, including:
- Cost verses Performance: The general industry focus on and downward trend in fees is coupled with longer-term comparable performance data for active and passive strategies. In many instances, the data suggests that active strategies are being outperformed by passive, leading to increased flows of investment into passive ETFs.
- Rise of “Robo-advisors”: The trend towards automation and technology solutions in the investment management industry is demonstrated by the increased use of “robo-advisors” – automated digital platforms that process client data through a set algorithm to offer investment recommendations (or automatic investment). Despite its limitations, robo-advice is gaining significant traction due to the range of benefits offered to certain types of investors. Such benefits include: lower fees; greater portfolio transparency; the ability to control one’s own portfolio; and, crucially, the ability to do all of the above online. ETFs are often the financial products that sit beneath the algorithm and are used by robo-advisors primarily because they are low cost while providing access to a broad range of “market” strategies.
- Additional “Buy-side” Strategies: Investment funds have invested in ETFs for many years, as ETFs historically have been – and remain – an efficient and liquid method of investing cash balances. Presently, investment funds are making wider use of ETFs, as they may be used for a variety of investments (such as specific allocation to a strategy or market), as part of a hedging strategy, or as a method of gaining exposure to a specific index (and thereby avoiding the margin requirements of derivatives).
- Diverse Products: As the ETF market evolves, particularly in Europe, a diverse range of ETF products and strategies has become available to investors. New ETF products with strategies such as gender diversity or socially responsible investment have been launched. These new products are often developed by traditional ETF providers looking to expand their existing product range. Similarly, active managers are venturing into offering ETFs, either to provide their existing investors with the full suite of products (both active and passive) or as an opportunity for new capital flows. These active managers are bringing their strategies into the ETF arena and expanding the range of products available.
As investment flows into ETFs continue at a steady pace, and as more reasons to invest in ETFs become apparent, European regulators are carefully monitoring these developments.
The fact that the Central Bank is looking more closely at ETFs is no surprise. Ireland is one of the principal domiciles for European ETFs, with more than $287bn (nearly half of all investment in European ETFs) invested in approximately 688 Irish ETFs.2 On the release of the Discussion Paper, the Central Bank commented that “ETFs are the most important product development the investment funds industry has seen in the last 20 years – this is evident from their exponential growth…. We encourage both industry and investor representatives and other regulators to enter into dialogue with us.”
It is expected that other regulators will follow suit on seeking to obtain additional information on ETFs. It has been reported that the French regulator, the Autorité des marchés financiers, is examining ETFs and the market in general, while at a global level it is expected that the International Organisation of Securities Commissions (IOSCO) will undertake a review of the ETF industry.
The Discussion Paper provides valuable insight into the regulatory thinking and potential focus for any ETF regulation going forward, both at a European and global level. In the Discussion Paper, the Central Bank indicates it does not currently envisage the Discussion Paper will lead to new Irish ETF regulations – rather, the exercise is primarily intended to contribute to the international debate as well as the risk assessments that regulators continually undertake to supervise the market effectively. However, the Discussion Paper recognises that additional guidance (in consultation with the industry) may be warranted with respect to particular aspects of ETF practices, and that innovative investment products require close regulatory attention “to ensure that the benefits of innovation are delivered within a robust, but enabling, regulatory framework”.
The Discussion Paper offers the Central Bank’s understanding of a range of ETF-specific matters, including: dealing arrangements; risk factors; market liquidity; and particular types and features of ETFs. The Discussion Paper also raises various questions for response by industry stakeholders, in order to obtain further market insight. The Central Bank discusses these matters and raises questions against a background of what it identifies as “overarching” themes, including:
- Investor Expectation and Understanding: In light of the increased investment in ETFs, and corresponding broadening of the investor base, the Central Bank wants to ensure that investors understand, and can properly assess the risks of, their ETF investments. By way of example, European ETFs are predominantly authorised as undertakings for collective investment in transferable securities (UCITS), which are subject to a range of investor protection mechanisms. However, the Central Bank has queried whether investors in ETFs authorised as UCITS are aware that such investors do not directly benefit from those protection mechanisms (as they are not seen as the investors of record of the UCITS).
- Liquidity: The Central Bank looks at an ETF’s liquidity risk from two different angles: (i) in relation to the ETF’s underlying assets (similar to any other investment fund); and (ii) the liquidity of the ETF’s shares as affected by the ETF creation/redemption mechanism and dependence on the role of Authorised Participants (APs).
- Growth of ETFs and Market Impact: The Discussion Paper recognises that the regulatory assessments of ETFs focused on the structure of ETFs at a time when ETFs had a much smaller market share. With the increased investment in ETFs, the Discussion Paper queries whether the original benefits of ETFs remain as the product gains market share, and whether the current regulatory framework can continue to bear the weight of further ETF growth.
The Discussion Paper also has several micro themes as to which the Central Bank is seeking specific information. These include:
- Unique Role of the Authorised Participant: The Discussion Paper recognises the unique “link” that APs play in the markets through which ETF shares are traded. APs are not service providers to the ETF – they are commercial market participants with no obligation to create or redeem shares or to provide liquidity. As a result, and given the central role APs play in the operation of an ETF (as the primary channel through which shares are bought from and redeemed by the ETF), the Discussion Paper considers whether it would be beneficial to investors and regulators to require public disclosure of the identity and remuneration models of APs. Similarly, the Central Bank has raised concerns as to how secondary market investors might directly deal with an ETF in circumstances where the AP primary market arrangement has broken down. In light of specific operational issues with the “creation” of shares mechanism in the primary market, the Discussion Paper queries whether share classes should be permitted to be structured having regard to the operational concerns of APs (for example, with differing dealing deadlines). Further, the Discussion Paper queries whether regulators should consider a “scenario analysis” relating to the role of the AP in overseeing the risk management activities of the ETF.
- Impact of “Stressed Market Conditions”: A recurring theme throughout the Discussion Paper is the impact that extreme or stressed market conditions may have on the operations of an ETF and, in particular, on secondary market investors. For example, the Central Bank notes that ETFs are typically sold as liquid, open-ended funds that trade intra-day with the perception that their open-ended nature is essentially guaranteed. However, in practice, ETFs (similar to other open-ended products) generally do not offer a guarantee of liquidity in all circumstances, but rather have a range of liquidity tools at their disposal in the event of stressed market conditions. As a result of the unique primary and secondary dealing arrangements for ETFs and the role of APs, in stressed conditions investors in the secondary market may face impaired liquidity without having any access to primary dealing with the ETF itself. The Central Bank has expressed concern that secondary market investors could be left “stranded” in the event of stressed market conditions.The Central Bank has also raised questions with regard to whether institutional investors have undertaken a realistic assessment within their own liquidity planning as to how ETFs in which they have invested would perform in stressed market conditions.
- Risk Management Policies of Investment Managers: Linked to the increased focus on the role of the APs and, in particular, on “stressed market conditions” as outlined above, the Discussion Paper raises several risk-planning and management considerations for investment managers. For example, the Central Bank queries whether investment managers should have contingency plans in place for instances where an ETF initiates a liquidity management tool (during stressed market conditions) and the AP withdraws from active trading of the ETF shares as a result. The Central Bank’s concern is that this could lead to a scenario where the market price of the ETF shares significantly moves away from the value of the underlying assets of the ETF. Similarly, the impact of an AP stepping away from an ETF, even outside of stressed market conditions, may need to be assessed. The Central Bank would like to understand in greater detail how ETF providers view these risks and how they would prepare for such a breakdown of the AP creation/redemption mechanism as part of their risk management policies.
- Interconnectedness of Parties to the ETF: The Central Bank conducted a survey of Irish ETFs in 2016. Certain results of that survey led the Central Bank to query in the Discussion Paper as to the general interconnectedness of parties to an ETF structure. The Discussion Paper notes that, although for the majority of Irish ETFs the APs are independent of the ETF provider, there are instances where the AP is a “connected person” (e.g., a management company, investment manager, or a delegate or group company of such entities). Similarly, the Discussion Paper queries whether the connectedness between APs and collateral counterparties, in particular for synthetic ETFs, impacts the overall risk profile of the ETF.In addition to the above, the Discussion Paper looks broadly at new and innovative ETF structures being launched in Europe, such as active and inverse ETFs. It also looks at the general concept of establishing ETF share classes within a standard non-ETF investment fund, as well as specific issues this may raise from a regulatory perspective, such as the fair treatment of all investors.
For the moment, the European ETF industry should take comfort that the Central Bank has no current plans for new ETF regulations, and that the purpose of the Discussion Paper is essentially a “fact-finding mission”. However, it is clear that European regulators are looking at ETFs in greater depth and are following market developments closely. Should any regulation, reform or guidance follow at some point in the future, it is likely to involve some of the macro and micro themes identified above.