Initial Steps Towards a Regulation of Exchange Traded Funds
Initial steps towards a regulation of Exchange Traded Funds
Laurent Grillet-Aubert, Senior Economist, AMF (France)
- Growth in the ETF market has come along with a structural change in their nature
Since their creation in Canada in 1990, ETFs have grown from a fairly niche product into a full-fledged asset class with assets under management (AuM) amounting (excluding ETPs) to some USD1.6tn worldwide at the end of September 2012, i.e. about 6.4% of the global AuM of mutual funds. As a matter of fact, the few incentives of fund distribution channels to promote them was an initial impediment to their marketing, but those specialized players who have promoted them have grown into global firms as ETFs have met significant demand, particularly since the advent of the financial crisis due to their specific features (low fees, transparency and liquidity). Throughout this period, ETFs were actually one of the few fund classes that kept recording positive net fund inflows. ETFs thereby reached out to an increasingly wider client base, extending from their traditional, institutional remit into the high-net worth and retail investor space.
In doing so, the use of ETFs evolved to an extent, from asset allocation and diversification tools to tactical instruments, used, for example, by investors to take leveraged or inverse positions on underlying asset classes. Accordingly, some ETFs use increasingly innovative indices as an underlying reference, either to replicate the performance of ever more illiquid asset classes. On the one hand, competitive pressures on management fees in a maturing and ever more global industry prompted a growing recourse to traditional “physical ETFs”, allowing managers to earn a portion of the foregone management fees by lending their securities, often to banking counterparties. On the other hand, innovative strategies and the search for better tracking performances (through lower tracking errors) led swap-based, so-called “synthetic ETF” structures to source their performance from the trading desks of investment banks. Both types of ETFs thereby strongly increased their exposure to banking counterparties.
- Regulatory challenges
These changes in the structure of ETFs and in that of their market have brought a number of regulatory challenges. Several international regulatory initiatives have been launched in the course of the last few years with the aim of discussing and consulting the industry and the broader public on the issues at stake, and to inform the regulatory decision-making process. Whereas some of these initiatives are still ongoing, it appears worthwhile at this stage to review some of the concerns they seek to address.
- Various regulatory initiatives on ETFs
Some initiatives have been conducted in the traditional remit of securities market regulation with the primary goal of addressing ETF investor protection issues. ETFs were however also seen as potentially impacting financial stability, in particular when their operations involved banks as counterparties, which prompted prudential regulators' investigations into the matters at stake.
At a global level, an initiative was led by the International Organization of Securities Commissions (IOSCO), which issued in March 2012 a consultation report on "Principles for the Regulation of Exchange Traded Funds". On top of addressing investor protection issues, this investigation pointed to issues pertaining to financial stability and market integrity and raised questions, in this regard, on the need for further joint investigation with prudential regulators, namely of the Financial Stability Board or of the Joint Forum on related topics. These questions actually came as a reply to interrogations raised in April 2011 by the Financial Stability Board and other prudential regulators on financial stability issues arising from recent trends in the ETF market.
Building on this global perspective, European authorities investigated the issue of ETFs further, as the European Securities Market Authority (ESMA) initiated a comprehensive review of UCITS ETFs which eventually led to the publication of “Guidelines on ETFs and other UCITS issues” on 25 July 2012. It is worthwhile noting here that, further to renewed financial stability concerns expressed by the European Systemic Risk Board (ESRB) on that occasion, the Standing Committee on Financial Innovation of the European Banking Authority (EBA) also initiated an analysis of ETF-related risks from a banking perspective.
- Those regulatory initiatives point to a range of issues
In this context, investor protection concerns were expressed and a potential for investors to misjudge some risk factors was recognized. Several types of issues or potential issues were identified in this respect.
Firstly, it appears that the labeling of exchange-traded products can be imprecise. This is typically the case where products such as Exchange-Traded Notes (ETNs), Exchange-Traded Commodities (ETCs), or Exchange-Traded Vehicles (ETVs) are subsumed under a broader understanding of the ETF denomination. The scope of the issue reflects the need for investors to distinguish between various legal structures, particularly when ETFs (strictly and rightly understood as fund products) possess different risk-return characteristics and provide more diversification and transparency than their close, non-fund, substitutes. More ambiguity arises where ETFs become actively managed, thus losing their characteristic index-tracking nature.
Secondly, the specific functioning of ETFs’ primary market and of their liquidity provision process on the secondary market was seen as bearing some potential for being misunderstood by investors. This was related in particular to the role of Authorized Participants, who intermediate such functions, and to the fact that investors usually do not redeem their shares directly from asset managers.
Thirdly, as exchange-listed products, ETFs were recognized as carrying the risk that investors might not receive appropriate disclosure when buying ETF shares in the secondary market.
Fourthly, the structures of both synthetic and physical ETF were identified as raising potential conflicts of interests between their operator, affiliated third-party service providers, and their shareholders, and as obscuring their impact on the ETFs’ risk-return profile. Whereas some of the above issues have a clear investor protection dimension, prudential regulators have been actively involved in reflecting on other topics relating to the ongoing investigations on "shadow banking", and more particularly, with regard to counterparty risk exposure resulting from the use of swaps and recourse to securities lending.
Lastly, to the extent they track the performance of an index, ETFs also raised questions with regard to the eligibility of underlying indices, particularly when strategy indices aim at replicating quantitative or trading strategies that may entail a degree of discretion, or where there is a risk that fund diversification rules are not complied with.
In addition to investor protection risks, ETFs were found, more tentatively, to raise potential issues with regard to market integrity, in particular when a large part of ETF trading does not occur on an exchange, but OTC, or when algorithmic and high-frequency trading (AT/HFT) raise the complexity and size of order flow, thereby increasing the difficulty of detecting abusive and manipulative behavior. With regard to financial stability, analogous concerns have been raised with respect to situations where counterparty, funding or liquidity risk are induced by securities lending and swap operations, but also where the dynamics of AT/HFT would heighten the vulnerability of market liquidity to shocks.
- Preliminary regulatory orientations
ETFs’ regulatory framework is still to an extent in a state of flux. Indeed, although ESMA Guidelines have given an impetus in this regard in Europe, further to an extensive consultation on its report, IOSCO is expected to formulate final recommendations in the first part of 2013.
Against this background, the FSB, which had announced that “its member authorities and standard setting bodies are continuing to monitor developments in the ETF market closely, and will use the feedback received as an input for [its] work”, is thus expected to build upon IOSCO’s input with a view to address ETF-related issues, particularly in the context of its investigations on shadow banking, which both designate certain ETF categories as shadow banking entities and devise recommendations to address risks in securities lending and repos, with potential impacts on ETFs.
At this stage, however, a number of observations may be worth making.
Firstly, some of the issues considered still face a number of analytical limitations. This results from several factors. On the one hand, using relevant data for solving with some degree of accuracy a number of questions – e.g. measuring the impact of various types of trading strategies on the stability of secondary markets, or assessing even basic metrics of the securities lending market ‑ remains challenging. This is both because gaining access to the data is difficult, and because of the complexity – and, in some cases, the amount – of data to be processed. On the other hand, the analysis of ETFs’ market structure entails per se factors of difficulty. Those relate in part to the hybrid nature of ETFs, which are both (index-tracking) funds and (often multi-)listed shares, the liquidity of which can often be arbitraged with that of correlated products. Analyzing related risks will require developing analytical tools. This bears implications, for example, for the analysis of some of the above-mentioned financial stability issues, for which a number of questions remain to be addressed by researchers and academics, leaving some scope for regulatory thinking to develop in the medium-term.
Secondly, ETF investigations by regulators have stressed that many regulatory issues raised by ETFs are actually not exclusive to them, and are, for example, often also raised by other kinds of mutual funds. This was clearly evidenced by ESMA, the guidelines of which apply to “certain types of UCITS, including UCITS ETFs, and particular activities such as Efficient Portfolio Management techniques” (such "EPM" techniques designate securities lending and repo operations). Indeed, many of the guidelines are applicable also to other non-listed, index tracking UCITS ‑ typically UCITS taking counterparty risk (i.e. using total return swaps or EPM techniques), or relying on leverage and/or on complex indices as an underlying reference. Thus, a number of regulatory provisions governing ETFs are not specific to ETFs only.
Thirdly, harmonizing terminologies of ETFs and other, non-fund, ETPs might contribute to level the level playing field between these product categories. Hence, more work will remain to be done in the future in this respect.
In spite of all these challenges and limitations, authorities have taken clear steps, both at a European and international level, to adopt investor protection measures that are specific to ETFs. These relate mainly to the ETF denomination (as mutual funds), to some features of their primary and secondary markets (typically their redemption process), to their sales process and to some specific types of complex ETFs (typically leveraged and inverse). Looking forward, and reaching out of the traditional investor protection remit of securities regulators, important issues will also be addressed by the upcoming recommendations of the Financial Stability Board on shadow banking.
ETFs have attracted a strong focus of regulators in recent years. This appears largely due to their dual nature of listed products and funds, and to the increasing use of sophisticated and often automated techniques to optimize their management ‑ both with regard to their structuring and to their trading. Thus this attention appears to reflect a logical attempt by financial regulators to cope with these innovations. It matters in this respect to note that the regulatory thinking has considerably evolved, and now tends increasingly to focus on issues that are not specific to ETFs, leaving some scope however for a set of specific rules to be tailored to their particular risks. Hopefully, this will benefit the ETF asset class, which had, and keeps, the potential to continue attracting investor confidence in times of unprecedented uncertainty.
 This article expresses the personal views of its author, which are not necessarily those of the AMF (France).
 The Joint Forum was established in 1996 under the aegis of the Basel Committee on Banking Supervision (BCBS), the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) to deal with issues common to the banking, securities and insurance sectors, including the regulation of financial conglomerates. The Joint Forum is comprised of an equal number of senior bank, insurance and securities supervisors representing each supervisory constituency.
 See FSB (2011) “Potential financial stability issues arising from recent trends in ETFs”, 12 April 2011 (http://www.financialstabilityboard.org/publications/r_110412b.pdf); Ramaswamy (2011) “Market structures and systemic risks of ETFs, BIS Working Paper n°343, April (http://www.bis.org/publ/work343.pdf); and Annex 1.7. on “ETFs: Mechanics and Risks” in the Global Financial Stability Report of the IMF dated of April 2011 (http://www http://www.imf.org/external/pubs/ft/gfsr/2011/01/pdf/text.pdf).
 ESRB response to the ESMA Discussion paper on “Policy orientations and guidelines for UCITS ETFs and structured UCITS”, Sep. 2011 (http://www.esrb.europa.eu/pub/pdf/ESRB_response_to_ESMA_consultation _exchange_traded_funds.pdf).
 See “An overview of the objectives and work of the EBA’s SCFI in 2011-2012 dated 1 February 2012 (under http://www.eba.europa.eu/cebs/media/Publications/Consumer%20Protection/E...).
 This point was also made by ICMA’s Asset Management and Investors Council in its 26/09/11 report (http://www.icmagroup.org/regulatory-policy-and-market-practice/asset-man...)