ESMA Guidelines on ETFs

The latest ETF news sees the eagerly anticipated Guideline on ETFs and other UCITS issues being published by ESMA.


The guidelines represent classic regulatory progress in that they may be considered move evolutionary than revolutionary. While in many parts more principles based the guidelines – which under the regulation establishing ESMA itself Member States must make “every effort” to comply with – do contain some areas of considerable detail which will serve ETF investors and ultimately the ETF industry well and require changes in the operating models of promoters as well as some revenue impact.


In line with the spirit of transparency that underlines the traditional model of ETFs this is now partly codified in the Guidelines starting with the requirement that the identifier “UCITS ETF” must be in the title of the fund. This move, while welcome in that it is a clear distinction from non fund products which benefit by association with their well regulated exchange traded exposure stablemates, will not please those providers of ETFs that argued strongly that the label “physical” or “synthetic” should also be in the title. ESMA were convinced that this would raise more problems than in it would solve accepting, amongst other reasons,  the case that there would be difficulties for hybrid products were such a binary option put forward.


Of course in last year’s promoter battle between synthetic and physical providers the synthetic providers were quick to point out the counterparty risk introduced by securities lending and ESMA has duly included this activity within the guidelines with clear benefits to the end investor. The guidelines dictate that all revenues arising from efficient portfolio management techniques such as securities lending must be returned to the fund and it’s worth noting that this applies to all UCITS funds and not just the ETF segment. While the fee to be returned is net of any direct or indirect operational costs, ESMA is clear that “these cost and fees should not include hidden revenue” and hammer home the point with the requirement to disclose the recipients of fees and indicate their relationship to the UCITS Management Company or custodian.


The collateral arrangements relating to securities lending exposure are also brought within the guidelines and they and the collateral rules relating to swap counterparty exposure are harmonised with additional granularity added to the previous guidelines on risk measurement and counterparty risk for UCITS –another welcome development.


The KIIDs importance to investors is also underscored with the requirement to disclose the replication methodology and factors likely to affect the ability of the fund to track its reference benchmark required to be disclosed. While ESMA specifically name the effect of transaction costs, illiquid index components and dividend reinvestment, we can see from the ETF point of view this will require synthetic funds to disclose the impact of swap spread in the KIID while for physical funds they will have to disclose transaction and rebalancing costs and the impact of optimisation strategies. How exactly securities lending revenues and costs will be treated is not clear.


The ability of the secondary market investor to redeem directly at fund level is provided for and while on the face of it a good initiative, might be problematic in practice. The guidelines make it clear that direct redemption may occur where the market price and the NAV “significantly” vary. What might be considered “significant” is not quantified and while the absence of a market maker is the instance cited where this might be invoked, it is likely that a promoter would be more inclined to suspend the fund rather than allow direct redemption where it would have to bear any price differential. The additional complexity might also be in secondary investors proving title to their ETF as their brokerage accounts holdings may be through nominee arrangements. In general the position of secondary market investors still raises some concerns in that while some attempts are made to make inverse and leveraged exposures more transparent through naming conventions the fact remains that an investor may buy exchange traded funds without first having sight of the KIID or prospectus. ESMA also correctly highlight that something must also be done about non fund exchange traded structures which use the ETF moniker and we would add also the concern for the secondary market investor  is compounded for these structures given neither the exposure nor the mechanism by which it is delivered – with or without fund equivalent safeguards – are regulated.


The ESMA Guidelines represent a positive step in addressing the concerns identified around aspects of ETFS which have now correctly been addressed in relation to ETFs and where appropriate the broader UCITS universe. The regulation of exchange traded exposures in general remains an ongoing project and we are likely to see some further changes through regulation of distribution – for now though the challenge for promoters is to understand the detail and implications of the latest round of oversight and adapt accordingly in the transition periods allowed.


July 2012


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