Esma group paper gives clue to rule changes

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In 2011 regulators in many countries expressed concerns that exchange traded funds were becoming too complex, and raised issues relating to investor protection and systemic risk. The European Securities and Markets Authority (Esma) is expected to announce new rules soon. One of the catalysts for these concerns among regulators and investors has been the finger pointing and bickering between physical ETF providers (mostly asset managers) and synthetic ETF providers (mostly banks and brokers) highlighting risks to investors making use of the rival products.

Many Ucits funds employ the same practices as ETFs in terms of using derivatives, synthetic replication and securities lending. While ETFs offer daily transparency on their underlying investments and management processes, most Ucits funds provide less frequent information. To the extent there is a concern about synthetic replication, the use of derivatives and securities lending it should not be approached as an ETF specific issue but rather as a Ucits issue. 

ETFs were first introduced in Europe in April 2000. Most ETFs in Europe are Ucits funds, and although these ETFs account for only 3.5 per cent of all Ucits funds, they have been growing at a much faster rate than other Ucits funds (asset growth of 47 per cent a year over the past 10 years for ETFs, versus 5 per cent pa for other Ucits funds).

The feuding among ETF providers has created uncertainty for investors trying to determine if, when and what type of ETF they should consider using. As most ETFs (both physical and synthetic) in Europe are Ucits funds it has also created a quandary for regulators.

Esma’s Securities and Markets Stakeholder Group’s paper (Advice on Esma’s public consultation on Ucits exchange traded funds in the European Union ), published in November, provides insight into potential changes.

The Group says it views ETFs “as a low-cost and straightforward investment proposition for investors”, and says Esma “should investigate how to make indexed ETFs more offered to retail investors”. On the risks that may arise from ETFs, while there is unanimity that greater disclosures are required, most Group members believe regulators should additionally “adopt a more interventionist approach”.

Specifically, the paper recommends that the risks of conflicts of interest should be limited by prohibiting entities from the same group from acting as both ETF provider and the derivative counterparty (in line with current regulations for mutual funds and ETFs in the US, which is why the US does not have banks and brokers as ETF managers). The paper also states that “securities lending should be made more transparent to investors, should be forbidden in respect to the collateral received in exchange for the swap in the case of synthetic ETFs, and the lending agent must be required to indemnify the Ucits when a counterparty defaults for all types of ETFs (synthetic and physical).

“The Group also believes it necessary to avoid any type of regulatory arbitrage, by subjecting all Ucits products and exchange traded products to similar rules.”

Potential regulatory changes have caused many investors to state a preference for physically backed ETFs, as demonstrated by both the total assets and net new asset flows into synthetic ETFs, which have consistently lagged those of physical ETFs. At the end of 2011, the ETF industry in Europe had 1,231 ETFs, with assets of $268bn, from 39 providers. Physical ETFs accounted for $163bn, or 61 per cent, of ETF assets in Europe, but synthetic ETFs are more numerous, making up 775 or 63 per cent.

If the regulatory recommendations outlined above are implemented, the competitive landscape is likely to change significantly. Many banks and brokers are likely to find being a provider of ETFs without also being able to be a swap counterparty to their ETFs will reduce the profitability of their businesses, and destroy the synergies from managing and trading the ETF and earning commission and financing on the swap. That would likely cause them to sell or exit their ETF businesses as most could not easily convert to physical ETFs.