Canada: IOSCO Proposes 15 Regulatory Principles For ETFs


  • The International Organization of Securities Commissions (IOSCO) publishes 15 high-level principles against which both the industry and regulators can assess the quality of regulation and industry practices concerning ETFs
  • IOSCO confirms that interest in ETFs has increased worldwide as evidenced by the significant amount of money invested in these types of products over the years
  • The proposed principles relate to ETF classification and disclosure, marketing and sale of ETF securities, and structuring of ETFs
  • The proposed principles have been designed to help ensure investor protection, sound functioning of financial and capital markets, and financial stability

On March 14, 2012, the Technical Committee of the International Organization of Securities Commissions (IOSCO) published a consultation report (the Report) which examines several key regulatory issues that have arisen in connection with concerns raised by the rise in popularity of exchange-traded funds (ETFs). In the Report, IOSCO sets out 15 high-level principles against which both the industry and regulators can assess the quality of regulation and industry practices concerning ETFs, with a focus on achieving investor protection, the sound functioning of markets and financial stability. The Report is only intended to address ETFs that are organized as collective investment schemes. A complete copy of the Report is available at Principles for the Regulation of Exchange Traded Funds.

IOSCO is a leading international policy forum for securities regulators and widely recognized as a global standard setter for securities regulation. IOSCO aims to, among other things, co-operate in developing and implementing adherence to internationally recognized and consistent standards of regulation, enhance investor protection and promote investor confidence in the integrity of securities markets and to exchange information at both global and regional levels on their respective experiences in order to assist the development of markets and implement appropriate regulation.

The proposed principles are intended to be a practical guide for regulators and industry practitioners and can be categorized under three general headings: (i) ETF Classification and Disclosure; (ii) Marketing and Sale of ETF Securities; and (iii) Structuring of ETFs. There is also a principle concerning the potential broader risks relating to financial stability. According to the Report, some of these principles may be better addressed through industry best practice rather than regulatory intervention.

Classification and Disclosure

Historically, ETFs replicated the performance of a broad-based market index by purchasing the constituent securities directly. The Report recognizes that the objectives and strategies employed by ETF providers have become more innovative and complex, as demonstrated by the leveraged ETFs, inverse ETFs, volatility-linked ETFs and other non-traditional ETFs which utilize futures contracts and other types of derivative instruments. The Report sets out the following principles that are intended to alleviate investor confusion and to raise investor awareness of potential ETF risks (such as risks relating to synthetic replication, counterparty risk, sampling strategies, index calculation and investor fees and expenses):

  1. Regulators should encourage disclosure that helps retail investors clearly differentiate ETFs from other exchange-traded products (such as exchange-traded commodities and exchange-traded notes).
  2. Regulators should seek to ensure a clear differentiation between ETFs and traditional mutual funds, as well as between index-based and non-index-based ETFs (such as actively managed 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.
  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.
  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 (i) the index (or the asset basket or the reference portfolio) tracked and its composition; and (ii) 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 securities.
  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 Sales

The Report addresses the role of intermediaries that market and sell ETF securities to the public and suggests that proper regulation of their activities can help to encourage investor protection. The Report recommends that intermediaries should assess whether or not ETFs are suitable investments for retail investors, while giving due consideration to each retail investor's objectives, financial situation and particular needs. Moreover, as non-traditional ETFs are introduced to the marketplace, intermediaries are encouraged to familiarize themselves with each investor's financial situation, trading experience and ability to meet the risks associated with such innovative products. The proposed principles relating to sales and marketing are:

  1. 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.
  2. In evaluating an intermediary's disclosure obligations, regulators should consider who has control over the information that is to be disclosed.
  3. 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.
  4. Intermediaries should establish a compliance function and develop appropriate internal policies and procedures that support compliance with suitability obligations when recommending any ETF.

Structuring ETFs

In addition to the traditional types of conflicts of interest that may exist between investment funds and their security holders, the Report acknowledges that unique conflicts of interest may also arise due to the manner in which ETFs are structured. In general, the Report recognizes that various potential conflicts of interest may arise where the index providers, securities lending agents or authorized dealers are affiliated with the sponsor of the ETFs. There is a concern that certain conflicts between affiliated entities may lead to the risk of the communication of material non-public information between parties or the provision of unfair pricing or services. The proposed principles relating to the structuring of ETFs are:

  1. 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.
  2. Regulators should consider imposing requirements to ensure that ETFs appropriately address risks raised by counterparty exposure and collateral management.

Broader Risks to Financial Stability

The Report acknowledges the potential broader risks to financial stability that may arise from ETFs and other exchange-traded products. The Report reminds regulators that recommendations made for the ETF industry may also be applied to other areas of financial services. These broader risks include risks relating to the secondary markets (shock transmission), risks relating to misconduct in the markets, and risks relating to financial stability. The final proposed principle is as follows:

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

IOSCO is welcoming comments on the proposed principles and other areas of concern. Comments are requested to be submitted on or before June 27, 2012.

* * * * * * * * * *

Since the world's first ETF (Toronto 35 Index Participation Units) was launched on the Toronto Stock Exchange (TSX) in 1989, ETFs have soared in popularity. In Canada, according to the Canadian ETF Association, despite difficult market conditions in 2011, strong sales helped Canadian ETF assets grow by nearly 13% to approximately C$43-billion. As at February 29, 2012, there were 254 ETFs listed on the TSX. The dramatic growth of the ETF industry has drawn the attention of regulators concerned about the impact of ETFs on investors and the marketplace. The industry's willingness to focus on the growth and modernization of the ETF regulatory landscape should be a welcomed dialogue to industry participants. We anticipate that these principles will also inform the regulators' approach to regulating other forms of listed investment funds.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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