On Thursday, June 28, the US funds industry welcomed the SEC’s proposed ETF regulation, representing a seismic positive shift for both incumbent and prospective ETF issuers. If the proposal becomes the rule, asset managers will be able to bring to market certain types of ETFs without first gaining the SEC’s explicit approval. In amending Rule 6c-11, the SEC will now “permit exchange-traded funds that satisfy certain conditions to operate without first obtaining an exemptive order from the Commission.”
The industry predicted this possibility for some time now but the debate on whether to grant US ETFs their own ruleset began back in 2008 when the SEC first proposed an ETF rule. Market events at the time meant it never came to fruition. The second time around, the SEC’s Dalia Blass looked pleased to address the issue again. “Continuing exemptive orders for all ETFs no longer suits the size and maturity of this market,” she said.
Under current rules, prospective ETF issuers must first get permission from the SEC on a case by case basis, a process known as “exemptive relief.” It requests exemptions from parts of the Investment Company Act of 1940 (or the ‘40 Act). Many, including the commissioners within the meeting, suggested this system is confusing, inequitable, inefficient, and has ultimately led to additional costs and an unequal playing field across the US ETF industry. Currently, US ETF issuers operate under different rulesets that have inadvertently given some firms a competitive advantage over others. The proposal has the potential to add momentum to the already blistering pace of US ETF growth within the $3.6 trillion US ETF market1 and remove cost barriers to entry for prospective ETF issuers.
Five key initial takeaways from this proposal are:
1. Removal of Exemptive Relief Regime
Many agree this is the most important feature of the proposal. For years, the industry has wished to allow ETF issuers to skip the exemptive relief application. This change would increase simplicity, reduce cost, and shorten the timeline to a launch. It frees up much needed capacity at the SEC and within asset managers to concentrate on items beyond exemptive relief submissions.
2. Level Playing Field for Basket Design
The proposal tackles “custom baskets” head on. Some ETF sponsors are required to create baskets of securities that are a pro rata slice of the ETF’s holdings while others can create a “custom basket” (not pro rata) of securities that differ from the underlying portfolio. Under the proposal, ETFs operating under Rule 6c-11 may use custom baskets across the board, once they adhere to the new written policies and procedures and always act in the best interest of the ETF and its shareholders. Also, the proposal requires a list of authorized people who can approve such custom basket orders. All details of custom basket orders must be recorded and be made available to the SEC to ensure fairness and mitigate against what Commissioner Kara Stein referred to as “dumping” and “cherry picking” of securities.
3. Impact to Existing ETFs
In a surprising move, the proposal suggests the SEC rescind all prior exemptions for current ETF sponsors who can now rely on the new ETF rule instead. The SEC suggesting that it would “do so without placing a significant burden on existing ETFs to comply,” however, reconciling granted relief against the proposed rule set is no small matter for ETF issuers. It imposes several additional transparency reporting requirements including:
- Requirement for all ETFs to disclose holdings on a website daily
- Requirement to include a website disclosure relating to bid-ask spreads thus giving investors a better view into the efficiency of the arbitrage process
4. Not all ETFs will benefit
It’s important to note not all ETF types will be eligible for the proposed Rule 6c-11. ETFs organized as unit investment trusts (UITs), those structured as share classes of mutual funds, and all leveraged and inverse ETFs must still apply for exemptive relief on a case by case basis.
In the commissioner comments, Stein stressed there is still further work to be done to differentiate between types of products stating that “ETFs are not a monolith.” She said retail investors don’t necessarily understand the differences between ’40 Act ETFs and other products such as Exchange Traded Notes (ETNs).
5. Sensitivity over Piwowar departure
The ETF proposal was voted through unanimously by the five commissioners. Since Michael Piwowar is due to step down next week, the timing of this meeting and vote on this proposal is important. Large scale regulations will be harder to pass with just 4 commissioners sitting and Piwowar’s successor has not yet been chosen. This could cause regulatory gridlock for the foreseeable future.
The long-anticipated proposal looks largely as the industry anticipated and will be broadly welcomed by the US funds industry. The proposal will normalize ETFs and recognize them as the sizeable and significant aspect of the US funds industry that they are. It provides greater certainty around the rules of engagement for all ETF applications going forward and will free up capacity at sponsors and at the SEC.
Now begins a 60-day public comment period on the proposal. Click here for the SEC’s “fact sheet” or the proposing release. While the proposal is overall a welcome one, we expect that both ETF and mutual fund sponsors will have strong opinions on some of the proposed elements – particularly in relation to impacts to existing funds. There will also be much discourse around the cost impacts of the new disclosure and reporting regimes. This process will result in a fit for purpose ruleset for a key constituent of the US fund industry. And other regions may follow close behind…
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1 ETFGI to May 2018