Principles for the Regulation of Exchange Traded Funds
On March 14, 2012, the Technical Committee of the International Organization of Securities Commissions (IOSCO) released a Consultation Report (the Consultation Report) entitled Principles for the Regulation of Exchange Traded Funds. The Consultation Report was prepared by the Technical Committee's Standing Committee on Investment Management (SC5) and highlights the committee members' experience and key regulatory issues regarding exchange traded funds, identifies common issues of concern and proposes a set of principles or best practices for ETF regulation. SC5, on which both the Ontario Securities Commission and Québec's Authorité des marchés financiers have staff members, acknowledges the variety of exchange-traded products available in the market, but explains that the Consultation Report is limited to exchange traded funds that are organized as collective investment schemes, commonly known as ETFs.
SC5 proposes 15 "investor protection" principles that broadly fall into four categories.
- ETF classification and disclosure
- Marketing and sale of ETF securities
- Structuring of ETFs
- Issues broader than only ETFs.
ETF CLASSIFICATION AND DISCLOSURE
The majority of SC5's proposed principles focus on ETF classification and disclosure. As ETF strategies have become more complex and innovative, SC5 suggests that steps must be taken to address possible investor confusion and to clearly identify possible investment risks. Generally, SC5 believes that ETF producers should focus on disclosure that properly identifies the risks and benefits of an investment in an ETF versus an investment in another type of collective investment product, the different strategies that may be used by ETFs (such as full replication, sampling, leveraged, inverse and other synthetic ETFs), the portfolio securities held by an ETF and the costs and expenses associated with investing in an ETF. To address these points, the Consultation Report suggests the following eight principles (we use the same numbering of the principles in this Bulletin as in the Consultation Report):
1. Regulators should encourage disclosure that helps retail investors to clearly differentiate ETFs from other ETPs (exchange traded products).
2. Regulators should seek to ensure a clear differentiation between ETFs and traditional CIS (collective investment schemes), as well as between index-based and non index-based ETFs through appropriate disclosure requirements.
3. Regulators should encourage all ETFs, 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 the index (or the asset basket or the reference portfolio) tracked and its composition; as well as 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 ETFs 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.
MARKETING AND SALE OF ETF SECURITIES
SC5 examined the role of intermediaries in the marketing and sale of ETFs and suggests that they have a role to play in addressing investor protection concerns related to ETFs. In particular, the Consultation Report emphasizes the importance of intermediaries assessing the suitability of ETFs for retail investors and the need for having and enforcing written strategies, processes and controls in order to ensure that a proper suitability review is undertaken. SC5 proposes the following four principles with respect to market intermediaries:
9. All sales materials and oral presentations used by intermediaries regarding ETFs 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.
STRUCTURING OF ETFs
The Consultation Report also addresses the conflicts of interest that may arise between an ETF manufacturer and an ETF investor. Possible conflict of interest situations include affiliated index providers, securities lending agents, designated brokers or authorized participants and derivative counterparties. SC5 focuses on synthetic ETFs and, in particular, the adequacy of risk disclosure with respect to counterparty exposure, collateral management and securities lending. SC5 proposes two principles to help address these issues:
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 ETFs.
14. Regulators should consider imposing requirements to ensure that ETFs appropriately address risks raised by counterparty exposure and collateral management.
BROADER ISSUES
In addition to the principles set out above that address many ETF-specific risks, SC5 examined some of the broader financial stability issues associated with entities and investment products. These broader issues include the risks arising on secondary markets (risk of shock transmission), the risk of abusive behaviour and the impact of that behaviour on market integrity and the risk to financial stability caused by securities lending, counterparty risks and the impact on underlying market price formation. The last principle proposed by SC5 focuses specifically on the risk of shock transmission in secondary markets, for example, the "flash crash" of May 6, 2010. In this regard, SC5 proposes the following:
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).
SC5 asks some specific questions and is soliciting public comments on the Consultation Report. Comments are due by June 27, 2012. A full copy of the Consultation Report is available on IOSCO's website [available here].
Given the involvement of staff of the OSC and the AMF on SC5, together with the Canadian Securities Administrators' overall commitment to supporting and fostering IOSCO principles in Canadian securities regulation, we expect that the CSA will evaluate and address the proposals set out in the Consultation Report as part of the CSA's ongoing modernization project on the rules relating to mutual funds and investment funds1. This Consultation Report can be viewed as a very timely addition to that regulatory discussion and initiative.
Footnotes
1 Please see Canadian Regulators Propose to Modernize Investment Fund Regulation Investment Management Bulletin June 2011 Borden Ladner Gervais LLP [available here].
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