On Thursday, September 26, the SEC passed perhaps one of the most anticipated ETF regulations to date: The so-called “ETF Rule.” The ETF Rule (formally known as Rule 6c-11) represents a seismic shift for both incumbent and prospective ETF issuers, with impacts spanning much of the ETF ecosystem. Most importantly, provisions under the new rule modernize how ETFs are regulated and may spur greater efficiency and potentially lower costs. The rule will now allow asset managers to bring certain types of ETFs to market without gaining exemptive relief, which could lower the barrier of entry by making ETF issuance less cost prohibitive. It’s important to note that the rule excludes: master-feeders, levered/inverse, unit investment trust (UIT) and ETFs as a mutual fund share class. Nor does the rule cover non-40 Act registered exchange-traded products (ETPs). In this edition of Exchange Thoughts, we discuss the features of the ETF Rule and highlight key considerations for managers.
Here are our key takeaways:
1. No More Exemptive Relief
This is perhaps the most important feature of the rule. Without having to request exemptions from the ’40 Act, the process for ETF issuers bringing new products to market will be far less complicated. Since exemptive relief applications typically take months to process, with filing costs that may exceed $25,000, the effects of the rule should increase simplicity, reduce overhead costs, and drastically shorten timelines to launch. It also frees up much needed capacity at the SEC to concentrate on items beyond exemptive relief submissions. Other notable rule details regarding exemptive relief include:
- The SEC will rescind exemptive relief orders previously granted to all ETFs that fall within 6c-11.
- ETFs structured as fund-of-funds (FoF) will maintain their existing exemptive relief, while new entrants can rely on the guidance of rule 6c-11, until the proposed SEC Fund of Fund Rule is passed.
- The rule does not set minimum or maximum creation-unit sizes.
2. Customs Baskets Allowed
Broadly speaking, the SEC will permit custom baskets for use by ETFs under 6c-11. As originally proposed, issuers must adopt written policies and procedures outlining the use of custom baskets, how they are calculated, and who within the issuer may approve their use. These policies must be included in the funds 38a-1 documents and reported to the ETF’s board of directors.
The SEC added clarity and a few changes to its final rule, based in part on the 85 comments it received since releasing the proposal in June of 2018:
- Cash-in lieu are custom: Orders that call for a cash substitute of securities (e.g. cash-in lieu) are considered custom.
- Disclosure of fund holdings: The rule requires that ETFs publish their holdings each day to the funds’ website prior to the market open. This would include the securities that form the basis of the next calculated NAV and any cash balancing amount. An important shift from the proposal is that the rule does not require that daily or custom baskets be published. As such, the SEC relieved much of the industry concern that T-1 orders would fall outside the rule. In fact, the regulator explicitly says T-1 orders will be permitted under 6c-11.
- Historic record keeping: Issuers need to maintain records of all baskets, including customs, for five years and match custom baskets to an AP and create or redeem order.
3. No IIV?
Funds no longer need to disclose or reference an intraday indicative valuation (IIV). IIV, however, is still required by the listing exchanges as part of their listing requirements. The industry will no doubt monitor this issue to see if any exchange listing rule changes follow the SEC’s ETF Rule.
4. Clarity on Website Data and Disclosures
The SEC maintained a focus on the need for an ETF to include greater details and disclosures on their website. As previously mentioned, the daily holdings disclosure is required, while the ETF’s basket is not. The fund’s website is the only place the holdings need to be disclosed, a change from the proposal that called for holdings to be updated in the SEC’s filing repository, EDGAR. In addition to the daily fund holdings, the funds’ website will need to disclose:
- Net asset value (NAV)
- Market price
- Premium or discount
- Number of days the ETF traded at a premium or discount over the last year and last quarter
- Description of why a premium or discount exceeds two percent for seven days
- Rolling 30-day lookback on bid/ask spreads
Importantly, the regulator did not include the proposed bid/ask examples and the interactive calculator, both points of contention from the original proposal.
5. ETF regulatory reporting will see some changes
The rule does call for several amendments to the fund’s regulatory documents, including the registration statement, N-CEN and N-PORT filings, based on the required disclosure and data requirements.
The rule as well as the form amendments will take effect 60 days following their publication in the public register. Firms’ existing exemptive relief will remain in effect for one year following the effective date, giving firms ample time to update their compliance and regulatory disclosures, websites, and implement processes for the use of custom baskets. It remains to be seen how the SEC will handle pending exemptive relief applications between now and the effective date.
The long-anticipated rule is expected to be welcomed by the US funds industry as it seeks to normalize ETFs and level the playing field in how ETFs operate. This regulatory effort highlights the importance of ETFs in the US and global financial markets.
Over the past 15 years, Brown Brothers Harriman (BBH) has partnered with more than 40 asset managers and sponsors to bring ETFs to market in the US, Europe, and Hong Kong. As the ETF Rule moves forward in its implementation, BBH welcomes the opportunities to discuss its impacts to current and prospective ETF issuers.