On 15 May 2017 the Central Bank issued a discussion paper on Exchange Traded Funds ("ETFs"). The consultation is directed at "stakeholders" in the ETF industry which include:
- authorised participants;
- ETF promoters;
- market makers / liquidity providers; And
- end users.
The discussion paper has three key themes:
- investor expectations;
- liquidity; and
- the increasing popularity of ETFs.
The purpose of the discussion paper, which runs to 100 pages, is for the Central Bank to seek the views of ETF stakeholders on the key themes and the Central Bank anticipates that the feedback on the discussion paper will assist the Central Bank in influencing international discussions on ETFs. The focus of the Central Bank on ETFs reflects the fact that Ireland is the major location within the EU single market for the authorisation of ETFs.
The Central Bank has identified the following five sections for discussion:
- ETF dealing;
- distinctive ETF risk factors;
- particular types and features of ETFs;
- ETFs and market liquidity; and
- other considerations.
Throughout the paper the Central Bank poses questions (which are collated into a consolidated schedule) but also invites comment and observations on all aspects of the discussion paper. It is not envisaged that specific rule changes will follow from the consultation.
SECTION I: ETF DEALING
The discussion paper explores in some detail the operation of authorised participants ("APs") and the role of market makers and official liquidity providers ("OLPs"). One aspect the Central Bank draws attention to is the nature of the relationships between APs and OLPs. In particular, the question is asked as to whether an AP and a connected OLP could behave in ways which would have a sudden and damaging impact on the liquidity of the ETF. Again, when looking at the secondary market, the APs and OLPs are a key focus in understanding the liquidity picture and the impact on investors. The issue of the appropriateness or otherwise of investor warnings regarding liquidity is also referenced.
ETF Share Classes
The section on ETF share classes will be of great interest to ETF promoters. While the Central Bank notes that unlisted ETF share classes are operationally possible, it does question whether this type of share class enables investors to be treated fairly. The primary concern is whether unlisted share classes which can be redeemed directly from the ETF are insulated against any price divergence which may impact the "listed" share classes in times of market stress (as only an AP can access the ETF directly for these classes). The second issue is a slight reversal of the above where the Central Bank queries whether, in times of market stress, it is fair that the unlisted class does not have access to the intra-day trading. Separate from the debate on listed and unlisted classes, the discussion paper also discusses hedged classes and the impact of the cash drag on any cash which is not invested.
SECTION II: DISTINCTIVE ETF RISK FACTORS
Interestingly, the discussion paper considers how AP risk can interact with other types of risk assumed by an ETF. In particular, it revisits ESMA's 2011 ETF consultation with another look at the risks associated with synthetic ETFs, focusing on counterparty and collateral risk. The Central Bank queries whether conflict of interest rules are effective for dealing with concentrations of activities within an ETF provider's financial group, whether multiple counterparties expose ETFs to unintended risks and consequences and whether collateral should better correlate to the index.
SECTION III: PARTICULAR TYPES AND FEATURES OF ETFS
The Central Bank acknowledges the variety of index exposures in ETFs within the UCITS framework. An analysis is carried out on rebalancing, volatility and leveraged or inverse ETFs. Perhaps of most interest is the section on active ETFs. The Central Bank is clear that they exclude factor indices (smart beta) from the analysis. The Central Bank identifies that portfolio transparency might be a reason why there is less demand for active ETFs. The Central Bank sets out a very balanced argument for and against greater transparency, including an interesting analysis on the impact of front running.
SECTION IV: ETFS AND MARKET LIQUIDITY
Section IV deals with the possibility of systemic risk in ETFs. In particular, the Central Bank considers:
- liquidity impact of ETFs as rule-based vehicles;
- the impact on informational efficiency;
- whether ETFs encourage nonfundamental volatility; and
- ETFs and the creation of fragile liquidity.
This is the most technical part of the discussion paper. The Central Bank questions when an ETF promoter "might step in to reinforce secondary market trading to prevent its breakdown." This highlights the Central Bank's focus on investor protection and will require considered responses from ETF providers.
SECTION V: OTHER CONSIDERATIONS
The Central Bank refers to the fact that much of the research on ETFs is based on US data and queries if this is applicable in the European context and whether the peculiarities of UCITS and MiFID require an alternative analysis of the issues as outlined.
As part of its work, the Central Bank had discussions with international regulatory colleagues, industry representative bodies, fund service providers and a number of investment managers who are involved in the ETF industry. The Central Bank's paper stimulates debate on a wide range of issues relating to ETFs and is an impressive addition to the ongoing international discussions on ETFs.
The Central Bank has asked for responses to the paper by 11 August 2017. We will be responding to the Central Bank directly and as part of the Irish Funds ETF working group. If you are considering a response please do not hesitate to contact us if we can be of assistance.
This article contains a general summary of developments and is not a complete or definitive statement of the law. Specific legal advice should be obtained where appropriate.