Assets continue to flow into exchange traded funds (ETFs) at an astonishing rate. Assets in ETFs and other exchange-traded products increased by over $1 trillion in the first 10 months of 2017, bringing the global total to $4.60 trillion.1 As the momentum for esoteric ETF strategies grows, regulators are taking a closer look at the appropriateness of such strategies for all investors, and whether they may pose systemic risks to the global financial markets. Regulators will focus more attention on ETFs in 2018 with a view toward adopting either voluntary guidelines or mandatory regulations.
European ETF Regulations
From 2016 to 2017, the European market grew by an impressive 40%.2 This encouraged many asset managers to enter the ETF space, which is governed by the same UCITS rules that apply to mutual funds. Over the years, Ireland has established itself as the European ETF domicile of choice with a market share of almost 56%.3
Last year, the Central Bank of Ireland (CBI) issued an industry consultation paper aimed at fostering an international discussion from global ETF practitioners. The paper and subsequent conference in November 2017 helped advance the debate around several key points that will shape the future of ETFs which include investor expectation, liquidity, and the potential need for additional regulation.
US ETF Regulations
In the US, there are no specific regulations covering ETF issuance. Instead, ETFs are generally covered by the broad umbrella of the Investment Act of 1940. Issuers must seek exemptive relief from the rules from the Securities and Exchange Commission (SEC) on a case-by-case basis. However, the SEC is considering adopting specific rules for ETFs, which would save asset managers money and time in getting their ETFs to market.
In fact, the recent introduction of novel strategies that attempt to mimic hedge fund strategies, such as inverse benchmarks or leveraged funds, may give the SEC an incentive to adopt more concrete ETF regulation. In its July 2017 report on the core principles in the asset management industry, the Treasury Department urged the SEC to adopt a “plain vanilla" ETF rule that would ease market access without the cost and delay of obtaining exemptions.
Global ETF Regulations
The International Organization of Securities Commission (IOSCO), which brings together the world's securities regulators, confirmed that it plans to look specifically at ETFs in early 2018. This work centers on whether ETFs can be the subject of market manipulation. IOSCO will issue a series of recommendations on how to improve the current guiding principles that regulate ETFs. The IOSCO review will likely leverage the work and feedback garnered from the CBI review.
ETFs and Liquidity Risks
Liquidity of ETF's is a point of interest to regulators looking at investor protection. Of particular interest is the relationship between the underlying assets held and the ability of the ETF to meet redemption requirements.
In the US, ETFs will be impacted by the revision of Rule 22e-4, more commonly referred to as the SEC Liquidity Rule. Originally issued in October 2016, it requires asset managers to adopt a liquidity risk management program beginning in December 2018. Under these new rules, each fund sponsor must assess liquidity risk and classify assets into one of four buckets: highly liquid, moderately liquid, less liquid, and illiquid. The aim of the new classification rule is to provide transparency to investors of the ability of a fund to liquidate its assets in order to fulfil its ongoing redemption obligations.
Liquidity was also a key part of the CBI’s consultation paper. Their primary interests stem from ETFs with strategies involving investments in less liquid assets, such as high-yield bonds, and the ability of the ETF to meet redemption requests. The CBI also asked: if there is a period of market stress, as in 2008, what would happen if Authorized Participants (APs) stepped away from the market? What would be the downstream impact to ETF shareholders? Global regulators are also reviewing the role of APs in ensuring investor liquidity – another focal point of the planned IOSCO review.
Regulators are increasingly interested in the level and frequency of ETF portfolio disclosures. While most ETFs publicly disclose holdings quarterly, the CBI has expressed a desire for daily disclosure, a topic discussed extensively in their consultation paper.
Disclosure is particularly relevant in the context of holdings for active ETFs, where many ETF providers feel that disclosure of what they consider proprietary information could allow others to “front run” their portfolio.
In the US, ETF sponsors have submitted several SEC exemptive relief applications to allow for non-transparent or semitransparent ETF portfolio usage. These have been pending with the SEC for a long time, with NextShares being the only approved non-transparent structure. The SEC may use feedback from the IOSCO review to frame their own views on this critical ETF issue.
Regulators Keep Pace with ETF Innovation
An increasing area of focus is the speed and complexity of ETF innovation. ETFs are an excellent delivery mechanism for complex investment strategies, such as inverse and leveraged exposure, mortgage backed securities, and liquid alternatives. Regulators seek to weigh in on the appropriateness of these new ETFs and question their ability to align investor liquidity requirements with those of an ETF’s underlying assets.
The “interconnectedness" of the ETF industry is another source of potential regulatory scrutiny. In some instances, APs are connected to the ETF issuer and the AP is acting as market maker. In such a structure, the overall risk profile of the ETF is amplified. Regulators want to determine whether ETFs using the same counterparty to conduct all or some functions, will heighten systemic risk in the overall market.
With growth in global ETFs showing no signs of slowing, the regulatory spotlight on this critically important fund type will only grow stronger in 2018. While recent regulatory shifts such as increased cost transparency and sales commission bans have favored ETFs, regulators will likely add in additional safeguards specific to ETFs. It is important for global ETF providers to proactively work with policymakers to help shape the future.
3 French Autorité des Marchés Financiers (2017), ETFs: Characteristics, Overview and Risk Analysis – The Case of the French Market
This article was originally published in the 2018 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 – and beyond. Visit bbh.com/regulatoryfieldguide to explore the guide.
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