The industry needs regulatory certainty, not just guidelines

Deborah Fuhr

Regulation continues to exercise the minds of Europe’s exchange-traded industry and was the focus of recent conferences in London and Amsterdam. Most participants at both events agreed that the European Securities and Markets Authority’s guidelines and follow-up questions and answers on ETFs and other Ucits funds, which were published in March, are sensible and meaningful. The guidelines covered broad topics, including the Ucits ETF label, the secondary market, efficient portfolio management techniques, derivatives, indices and transitional provisions.

However, regulators, legal experts, providers and investors commented that the European Commission should be setting EU level 1 regulations rather than level 2 guidelines and level 3 Q&A, which Esma has issued. Member states can take or leave these guidelines, and simply need to explain their reasons when they fail to comply.

The ETF ecosystem, which includes investors and regulators in Asia and Latin America, wants stable, predictable and regulatory certainty for Ucits ETFs, which is only possible with level 1 regulation. Market participants argue that guidelines and Q&As with variability in the national implementation is confusing.

There are also unanswered questions, including when and how secondary market investors may redeem directly with an ETF manager. There are uncertainties too in the securities lending area, concerning the definition and appropriate level of direct and indirect operational costs and fees that may be deducted from the revenue delivered to the Ucits fund.

There are mixed views on whether there will eventually be a division between complex and non-complex ETFs, and whether it will be defined by how the product is structured or based on the return profile, and whether ETFs will be regulated at the product level or at the point of distribution by requiring advice or an appropriateness test. There is recognition by regulators that for many investors having a complex label would equate to “bad” or “dangerous”.

There is still a concern that there is not a level playing field when it comes to the regulation of ETFs and exchange-traded products. Ucits ETFs have a strong brand and are highly regulated but it is often not clear to investors that there are significant differences when considering other ETPs. ETPs are typically unsecured debt instruments or exchange-traded notes which, although trading and settling like ETFs, are not covered by similar regulations and prudential rules.

Index providers historically have not been regulated but they expect they soon will be. The Libor scandal, in which banks manipulated interest rates, has led to the regulatory review of all financial benchmarks.

Esma is requiring index providers to disclose their methodology and to fully disclose the index constituents at each rebalance. Providing historical constituents for an index at rebalance is fine – but what counts as a rebalance for an index? One-size-fits-all regulations are not appropriate for benchmarks as most financial benchmarks are different from Libor in the way they are created and used.

Many see the Retail Distribution Review in the UK and its Dutch equivalent, as well as similar reviews of distribution regulations across Europe, as helping to open a new and important distribution channel that was previously closed to ETFs.

Consultancy KPMG cautioned that although there is an exemption for publicly traded securities under the US Foreign Account Tax Compliance Act, ETF providers will be required to ensure intermediaries and beneficial owners of ETFs are Fatca-compliant.

The review of eligible assets for Ucits VI may mean that the scope may be broadened or narrowed. There will be a reform of Ucits although it may not happen until after June 2014, when there is a new European parliament.
The ETF industry is awaiting the publication of the International Organization of Securities Commission’s report on the principles for ETF regulation. It proposed 15 principles against which both the industry and regulators can assess the quality of regulation and industry practices relating to ETFs, relating to investor protection, sound functioning of markets and financial stability.

http://www.efinancialnews.com/story/2013-06-24/etf-industry-needs-regulatory-certainty-not-just-guidelines-comment