Exchange traded products – the need for classification – June 2012.

It is arguable that the genesis of the concern around ETFs lies both in their rapid growth and more significantly the concerns that first emerged around the security of uncollateralized exchange traded notes at the height of the credit crisis when the issuers and backers of these notes, principally investment banks and insurance giants, wobbled in the aftermath of the Lehman collapse.

The irony remains that in the EU the bulk of regulation attaches to the already highly regulated funds sector with the various participants arguing, over the past 4 years, the incremental levels of excellence in investor protection above an already high mark of regulation, while the effectively unregulated market will recover the ground it lost at the then height of the crisis without really participating in this debate. As memories of counterparty exposure fade, investors will one day return to quick to market investments where neither the exposure nor the protections in its delivery might be considered suitable for the unadvised retail investor. The continuing uncertainty in the Eurozone, with the attendant contagion risk for those issuer banks, means that it is likely that counterparty risk for private issuers – let alone public ones – will remain a real and present concern for some time.

Notwithstanding that focus, the regulators are mindful that something clearly needs to be done in this area as a long term solution. From the initial report of the Financial Stability Board to the European Securities and Market Authorities Consultation Paper on ETFs they have opined that some level of regulation or distinction around non fund exchange traded structures will be required. It is simply not enough, as some providers have done, to suggest it is sufficient that the investor has access to the prospectus or offering document of the note or debt security structure when the current level of regulation allows the retail investor to access these often complex, high risk or low safeguard products without either seeing that prospectus or being advised as to the nature and risk of their investment. This situation is not optimal, but perhaps acceptable, with regard to funds and some of the exposures they offer, but is clearly undesirable with respect to non fund structures.

In our view the progress in MiFID and PRIPS may – and hopefully will – ultimately level the playing field so that investors in funds and notes will at a minimum understand better the distinction and/or have restricted product offerings and/or ( and as a probability likely)  have the suitability concerns addressed at the point of distribution through prohibition on access or access on the foot of expert advice only – the free for all through the unadvised brokerage account may end.

European Directives and their transposition into Member State laws take time and a quick win might be to address the labeling confusion around the offerings within the exchange traded universe so that the investor at least knows what he needs to think about. This is a point it might be imagined – wrongly as it happens – that promoters of funds might be in agreement on as clearly the promoters of the non fund offerings will benefit from investors thinking their products are on the same level as funds.

Broadly, it could be proposed that an investor might be advised to think about all exchange traded offerings under the generic term exchange traded exposures. The benefit of such a term is that it does not, unlike some terms in loose usage, imply the nature of the product and more particularly its regulation. It is a term more akin to the nature of the investment risk assumed – a concept which is generally easily understood.

The second limb then is to consider how that investment risk is delivered to you as the investor and what additional risks you assume. Clearly then there is a need to distinguish between ETFs and all other exchange traded exposures – be it a generic term such as Exchange Traded Products or a labeling of the individual product types – ETNs, ETCs, ETVs etc. For the investor however, the point is that once they are made aware that their exposure is outside the highly regulated world of both their investment and their structural protections in the funds world they can understand the effectively unregulated nature of their investment and proceed with caution. Non fund products should never use or be loosely associated with the term “ETF”.

The loosely defined nature of what an exchange traded exposure can be means there is no right answer here but there are wrong intentions that muddy the waters as to the risks undertaken. The industry could do well to seek an agreed solution in advance of a necessarily imposed one.

 

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