INTERNATIONAL: IOSCO Consults on ETF Regulation

Wednesday March 14 2012

Fund-Axis would like to highlight the recent consultation report released by the Technical Committee of IOSCO entitled “Principles for the Regulation of Exchange Traded Funds” which examines the key regulatory issues regarding Exchange Traded Funds (ETF’s).

 A full copy of the report can be found at the following link;

 Principles for the Regulation of Exchange Traded Funds

 The consultation report also proposes 15 principles against which both the industry and regulators can assess the quality of regulation and industry practices relating to ETF’s regarding investor protection, sound functioning of markets and financial stability.

The genesis of the consultation report from IOSCO is that market interest in ETF’s has increased worldwide as evidenced by the significant amount of money currently invested in these types of products. This dynamic growth has in turn drawn the attention of regulators who are concerned about the potential impact of ETF’s on investors and the marketplace.

In order to address these concerns, the consultation report released by IOSCO proposes 15 principles that should permit a common and practical guide for both regulators and industry practitioners in relation to ETF’s.

Note: The proposed principles address ETFs that are organised as Collective Investment Schemes (CIS) and are not meant to encompass other Exchange-Traded Products (“ETP’s”) that are not organised as CISs.

Fourteen of the proposed principles are categorised under the following three headings:

• Principles related to ETF classification and disclosure;
• Principles related to Marketing and Sale of ETF shares; and
• Principles related to the structuring of ETF’s.

In addition to proposing the above principles, the IOSCO consultation report also considers the potential broader risks to financial stability arising from ETF’s and other ETP’s. The consultation report also suggests that regulators should bear in mind that recommendations made for the ETF industry may be applied elsewhere to other areas of financial services.

These potential broader risks include the following;

• Risks arising on secondary markets (the risk of shock transmission)
• ETFs and market integrity (risk of misconduct)
• Risks to financial stability

The 15th principle for the regulation of ETF’s relates to the broader risk of liquidity shocks and transmission across correlated markets.

Fund-Axis has outlined the 15 principles proposed in the IOSOC report Principles for the Regulation of Exchange Traded Funds below;

Principles

1.       Regulators should encourage disclosure that helps retail investors to clearly differentiate ETF’s from other ETP’s;

2.       Regulators should seek to ensure a clear differentiation between ETF’s and traditional CIS, as well as between index-based and non-index-based ETF’s through appropriate disclosure requirements;

3.       Regulators should encourage all ETF’s, in particular those that use or intend to use more complex strategies, or other complex techniques, to assess the accuracy and completeness of their disclosure, including whether the disclosure is presented in an understandable manner and whether it addresses the nature of risks associated with such strategies or techniques;

4.       Regulators should consider imposing disclosure requirements with respect to the way in which an ETF will replicate the index (or the asset basket or the reference portfolio) it tracks (e.g., physically holding a sample or full basket of the securities composing the index (or the asset basket or the reference portfolio) or synthetically);

5.       Regulators should consider imposing requirements regarding the transparency of an ETF’s portfolio or other appropriate measures in order to provide adequate information to investors concerning;

5.A. the index (or the asset basket or the reference portfolio) tracked and its composition; and

5.B. the operation of performance tracking in an understandable form.

6.       Regulators should consider imposing requirements regarding the transparency of an ETF’s portfolio or other appropriate measures in order to facilitate arbitrage activity in ETF shares;

7.       Regulators should encourage the disclosure of fees and expenses for investing in ETF’s in a way that allows investors to make informed decisions about whether they wish to invest in an ETF and thereby accept a particular level of costs;

8.       Regulators should encourage disclosure requirements that would enhance the transparency of information available with respect to the material lending and borrowing of securities;

9.       All sales materials and oral presentations used by intermediaries regarding ETF’s should present a fair and balanced picture of both the risks and benefits of such products, and should not omit any material fact or qualification that would cause such a communication to be misleading;

10.   In evaluating an intermediary’s disclosure obligations, regulators should consider who has control over the information that is to be disclosed;

11.   Before recommending the purchase, sale or exchange of an ETF, particularly a non-traditional ETF, an intermediary should be required to take reasonable steps to ensure that recommendation is based upon a reasonable assessment that the product is consistent with such customer’s experience, knowledge, investment objectives, risk appetite and capacity for loss;

12.   Intermediaries should establish a compliance function and develop appropriate internal policies and procedures that support compliance with suitability obligations when recommending any ETF;

13.   Regulators should assess whether the securities laws and applicable rules of securities exchanges within their jurisdiction appropriately address potential conflicts of interests raised by ETF’s;

14.   Regulators should consider imposing requirements to ensure that ETF’s appropriately address risks raised by counterparty exposure and collateral management;

15.   ETF exchanges should consider adopting rules to mitigate the occurrence of liquidity shocks and transmission across correlated markets (e.g. automatic trading interruption mechanisms)

In seeking this consultation, IOSCO invites comments from regulators, industry participants and other interested parties on the proposed principles, as well as on the other specific concerns e.g.,

•  Do the principles adequately address the regulatory issues raised by ETF’s?
• Are the potential financial stability issues raised by ETF’s appropriately addressed?
• Is there a need for further analysis of issues not exclusive to ETF’s, for instance, by the Financial Stability Board?

Fund-Axis would encourage Asset Managers, particularly those who manage ETF’s to consider these IOSCO proposed principles very carefully and submit a response to IOSCO should they feel a particular principle is not feasible or practical or that a particular risk within the industry is not being addressed. It is very likely that the outcome of the final IOSOC report following the consultation period will lead to a regulatory impact for ETF’s in the near future and as such if Asset Managers do have any concerns on relation to the proposed principles then now is the opportunity to address same. If you require any assistance in addressing your response to IOSOC or would like to explore the possible impact of the above proposed options, please don’t hesitate to contact Fund-Axis on info@fund-axis.com