With assets in exchange traded funds (ETF) growing to over $6 trillion globally at the end of 2019, it might seem hard to imagine how ETFs have further room to grow. However, separate decisions by regulators to ease ETF registration and permit the issuance of several new fund breeds — ranging from so-called semi-transparent funds in the US to comingled listed and unlisted shares in an ETF structure in Ireland — are likely to keep the boom alive for years to come.
Beyond new ETF product types, global regulators continue to assess liquidity and counterparty risks relating to the ETF market and whether further mitigants are needed. So far, they've stopped short of proposing any additional limits. New European rules about settlement failure could prompt changes to market structure and product design. And in the Asia Pacific region, regulators are positioning ETFs for further growth and scale. Here, we break down key regulatory developments in the US, Europe, and Asia Pacific regions.
US leads the regulatory easing
In the US, we expect to see a new crop of managers enter the ETF space in 2020, thanks to two decisions handed down by the Securities and Exchange Commission (SEC).
- Adoption of Rule 6c-11 (dubbed the ETF rule) will have far-reaching implications. Ever since the first US ETF was born in 1993 (the S&P 500 SPDR), the SEC required ETF sponsors to go through a lengthy and costly process to obtain what it called “exemptive relief” from the 1940 Investment Company Act (’40 Act).
However, in 2019, the SEC publicly recognized the benefits of ETFs to US investors and sought to enshrine these products with their own regulatory framework, rather than continue to shoe-horn approvals under regulations intended for mutual funds. In 2020, ETFs that qualify for the rule (e.g., ‘40 Act open-ended RICs) can simply file a registration statement and comply with the applicable ETF regulations.
The adoption of the ETF rule helped to modernize ETFs and create a more even playing field for managers. A key element of the regulation permits and standardizes the use of custom baskets for all ETF issuers. ETFs publish a basket of securities each day, usually based on an index or a pro-rata slice of the fund’s holdings, to inform authorized participants (APs) what securities to deliver to the fund when creating ETF shares, or what securities they should expect to receive when redeeming. Custom baskets allow ETF managers to create baskets for specific create or redeem orders which can help improve the fund’s tax efficiency and liquidity. However, only a subset of managers had SEC approval to use these types of baskets. This provision in the ETF should allow for a more consistent approach and oversight in how custom baskets are used.
Additional provisions in the rule did away with the requirement of an intraday indicative valuation (IIV) and clarifies ETF disclosure policies of fund holdings and secondary market trading metrics.
- The second major development focused on active ETFs and gave a boost to a new class of ETF structures that will not have to disclose their current holdings to the public on a daily basis. This change had long been sought by active managers concerned about tipping off the market as to the implementation of their investment strategies.
A number of firms had proposed various approaches to changing the disclosure requirements of ETF holdings, including Precidian, the New York Stock Exchange (NYSE), Fidelity, Blue Tractor, and T. Rowe Price. Precidian's ActiveShares SM ETFs became the first to win SEC approval in late spring, followed by other so-called proxy-based, non-transparent active ETFs.
Following these moves by the SEC, the listing exchanges (NYSE, NASDAQ, and CBOE) all sought rule changes that would make listing ETFs more consistent with the new ETF rule. ETFs that qualify for 6c-11 will automatically fall under the exchanges' generic listing standards, remove the IIV from listing requirements, and reduce the necessary seed capital to list an ETF to $100,000.
With the new disclosure policies available and the ETF rule making it easier to launch products, managers will have more choices available to enter the ETF market. Active firms that have been on the sidelines now have a new path to protect their IP and take advantage of the lower cost and tax-efficient ETF wrapper.
Europe gauges the risks
Across the Atlantic, European regulators haven't yet accepted the SEC's liberal views on transparency. Instead, their focus has been on the upcoming implementation of the Central Securities Depository Regulation (CSDR). ETFs are likely to be heavily affected when the regulation starts imposing what is termed "settlement discipline" later this year, penalizing settlement failures with two types of fines.
The reason ETFs are likely to be the first to suffer is that ETFs often have a high rate of settlement failure. That's because of a structural mismatch between the ETF and the underlying securities: the ETF shares may settle in two days (T+2), while the investments underlying the ETF shares may require five or more days to deliver (T+5).
Two things may happen in 2020 as a result. Increased costs to ETFs for failures could be passed on to investors. Alternatively, the market may be prompted to change the way the system operates, particularly the way in which APs, who create and redeem shares. These impacts may be felt by an ETF holding European securities, regardless of the funds’ domicile.
Another regulation that is likely to impact the European market is the Central Bank of Ireland’s (CBI) decision to allow sponsors to comingle ETFs and unlisted (mutual fund) share classes in the same UCITS structure. With comingled assets, the ruling promotes economies of scale, attracts investors who prefer investing via the mutual fund wrapper, and may succeed in attracting new institutional investors that have minimum fund size thresholds for investment. A similar rule exists in Luxembourg, which is the second largest ETF domicile in Europe market. In the US, funds with comingled mutual fund and ETF share classes are only offered by Vanguard as they have a business method patent on this structure. [Notably, the SEC did not include this type of ETF in rule 6c-11 and will still require these structures to seek exemptive relief. In Asia, Hong Kong’s funds regulator added this share class structure in early 2019.]
Finally, European regulators continue to assess ETF liquidity and interconnectivity of the market participants. Key themes within this area are the risk of contagion, how much attention should regulators pay to the interconnectivity of the ETF eco-system, and the ability for investors to redeem if there is an event which impacts the secondary market. ETFs are already regulated by a triumvirate of EU legislation: UCITS, MiFID II, and EMIR to some extent. The question now is: are more ETF specific rules needed?
Asia Pacific looks to standardize
Regulators in Asia Pacific are focused on positioning the ETF industry in their respective markets for further growth and scalability. Many of the new enhancements have emphasized the importance of standardization in the market and aligning the region with international best practices.
Since the middle of 2018, the onshore ETF market in China has grown rapidly to exceed $70 billion in assets as of the end of November 2019.1 Even with the recent outsized growth, ETFs are still a nascent industry in China and only accounts for approximately seven percent of total investment fund AUM. But a number of reforms are likely to bring about a shift in assets from the traditional wealth management channels into public funds, with ETFs particularly well positioned to capitalize on this reallocation of assets because of their flexible, transparent, and low-cost structure.
Hong Kong is also spearheading several initiatives focused on enhancing liquidity for ETFs listed in the territory, including launching the Designated Specialist program, which allowed a broader group of global market makers access to provide liquidity for Hong Kong ETFs.
In July, the Hong Kong Exchange (HKEX) launched a pilot program to provide an ETF buy-in exemption for market makers. This program provides these institutions one extra day on top of the standard settlement cycle to cover any short positions resulting from their market making activities. In December, the Hong Kong exchange announced a new ETF-specific spread table, which is scheduled to be introduced in late February 2020. The new spread table, as well as a new set of market making obligations, will align Hong Kong with international standards.
In Hong Kong, expect to see the first ETF issuers take advantage of the Hong Kong Exchange being added to the international central securities depository (ICSD) ETF settlement model. This enhancement allows a streamlined settlement process for UCITS ETFs that are cross-listed into Hong Kong, while significantly reducing the risk of settlement failure of the ETF shares.
Issuers are planning to bring a wide range of new products to the market. Supporting product design, the Securities & Futures Commission (SFC) recently announced streamlined eligibility requirements for ETFs adopting a master-feeder structure. This structure allows Hong Kong domiciled ETFs to invest into a single master fund, which would need to be regulated in a recognized jurisdiction, have a minimum asset size of $1 billion, a track record of more than five years, along with other requirements.
Global ETF issuers should watch this development as it could provide an efficient and cost-effective way to enable distribution into Hong Kong and the broader Asian market.
Transparency is also under the microscope with the funds regulator in Australia (ASIC) pausing approvals of new actively managed ETFs in July 2019 due to concerns related to market making. The review was focused on the internal market making function where the ETF issuer acts in this capacity in Australia. ASIC published their findings in December 2019, including recommendations for compliance, oversight, and ensuring information barriers are in place and functioning properly. ASIC will continue to monitor international ETF developments in these areas and they have re-opened the door for new actively managed ETF listings.
2019 was a momentous year for ETF regulation. Rule makers across the globe acknowledged the importance of ETFs to retail and institutional investors alike and brought standardization to much of the global market. 2020 will see many of these rules take effect, with impacts across product development, regulatory compliance, and operations. Further rules may be coming as analysis of liquidity, product structures, and transparency all remain at the forefront of the regulatory agenda.
This article was originally published in the 2020 Regulatory Field Guide. The guide features insights from a number of our experts on key regulatory developments that will have the greatest impact for asset managers in the year ahead. Visit bbh.com/regulatoryfieldguide to explore the guide.
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