BACKGROUND

The global market for Exchange Traded Funds (ETFs) has continued to grow and evolve significantly in recent years. This has seen the emergence of ETFs with novel asset classes and more complex strategies. Following a detailed review of the global ETF market, the International Organisation of Securities Commissions (IOSCO) issued its long-anticipated consultation report in respect of ETFs on 6 April 2022 (the Consultation Report).

The overall sentiment of the Consultation Report is that the ETF structure has generally proven resilient during historical stress events (which is consistent with IOSCO's report of August 2021 titled ETFs Thematic Note - Findings and observations during COVID-19 induced market stresses) and that IOSCO's 2013 Report on the Principles for the Regulation of ETFs (the 2013 ETF Principles) remains relevant and appropriate. The Consultation Report does not therefore propose the replacement of the 2013 ETF Principles, but rather to build upon and supplement them. However, the Consultation Report suggests a number of additional good practices for ETFs, which are outlined below.

PROPOSED GOOD PRACTICES

Suggested Measure

Good Practice

Comment

 

Effective Product Structuring

  
Measure 1 Regulators and responsible entities are encouraged to consider the range of asset classes and investment strategies that may be appropriate for the ETF structure, taking into account their nature, novelty, and complexity, the effectiveness of the arbitrage mechanism for such assets and strategies and local circumstances. IOSCO acknowledges that in Europe the UCITS regime already imposes rules in relation to eligible assets and the use of leverage and that the MiFID regime imposes requirements in relation to product suitability.
Measure 2 Regulators are encouraged to consider requirements regarding the transparency of an ETF's portfolio and/or other appropriate information provided to market participants so as to facilitate effective arbitrage. IOSCO notes that the arbitrage mechanism is a key feature of the ETF structure and that it is important that there is sufficient transparency in respect of the valuation of ETFs for this mechanism to work efficiently. However, IOSCO also recognises that this may be achieved in different ways.
Measure 3 For jurisdictions that mandate the provision of an iNAV, regulators and/or trading venues are encouraged to consider means to enhance the accuracy and usefulness of the iNAV. IOSCO notes that jurisdictions and trading venues vary in their approach to whether and how frequently an indicative net asset value (iNAV) is required to be issued. Where an iNAV is required, IOSCO would like to explore if it can be made more accurate and useful, for example by using real-time fair value for the inputs that are used to calculate the iNAV; increasing the frequency of dissemination of iNAV information; and verifying the iNAV calculation against live quotations on secondary markets.
Measure 4 Responsible entities are encouraged to:

(i) conduct due diligence on Authorised Participants (APs) and Market Makers (MMs) when on boarding them to the ETF, with a view towards having those that are capable of facilitating an effective arbitrage mechanism and providing liquidity.

(ii) conduct ongoing monitoring on APs and MMs for the ETF regarding, amongst others, the functioning of the arbitrage mechanism and liquidity provision; and

(iii) avoid exclusive arrangements with APs and MMs if they may unduly affect the effectiveness of the arbitrage mechanism.

 Given the effectiveness of the arbitrage mechanism and that liquidity in the secondary market is largely dependent upon the active participation of APs, IOSCO emphasises the importance of carrying out due diligence before appointing an AP and also on an ongoing basis.
Measure 5 Responsible entities are encouraged to put in place appropriate arrangements to facilitate an effective arbitrage mechanism, including contingency plans to address the circumstances where the arbitrage mechanism of the ETF is impaired. IOSCO suggests that effective arbitrage may be facilitated by a number of means, including operational mechanisms such as smaller minimum creation/redemption basket size where possible and also through encouraging competition between APs.

It is also interesting to note that IOSCO appears to query the effectiveness of the "direct redemption" facility that UCITS are required to arrange in the event of significant price dislocation between the NAV and the secondary market trading price.
Measure 6 Regulators are encouraged to consider whether the securities laws and applicable rules of securities exchanges within their remit and jurisdictions appropriately address potential conflicts of interests raised by ETFs. IOSCO notes that there are certain potential structural conflicts of interest, for example where an AP or an index provider is affiliated with the ETF manager. IOSCO has queried whether existing laws and regulations are sufficiently robust to provide for such circumstances.
 

Disclosure

  
Measure 7 For ETFs, in particular those that invest in more complex or novel asset classes, or use more complex investment strategies, regulators are encouraged to consider appropriate requirements for the adequacy and appropriateness of the disclosures regarding ETF-specific aspects, including whether certain disclosures are presented in an understandable manner and whether they address the nature of risks associated with the ETFs' strategies. IOSCO suggests that there should be greater disclosure on (a) risks arising from the distinctive features of the ETF structure (such as trading on a secondary market at a discount/premium to net asset value); and (b) for more complex strategies - the Consultation Report references some strategies which may warrant additional disclosure, including crypto-asset ETFs.
Measure 8 Regulators are encouraged to consider appropriate requirements for the disclosures of fees and expenses for investing in ETFs (including secondary market trading costs) 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. While IOSCO acknowledges that most jurisdictions already have requirements regarding the disclosure of fees and expenses, it is suggesting that there could be more detailed disclosure regarding ETF-specific fees.
Measure 9 Regulators and responsible entities are encouraged to consider appropriate disclosure requirements or disclosures to help investors to clearly differentiate ETFs from other ETPs / CIS, as well as appropriate disclosure for index-based and non-index-based ETFs. IOSCO notes that most jurisdictions already contain some level of disclosure (such as the UCITS naming convention/identifier) but suggests that there is room for improvement in this area.
 

Liquidity Provisions

  
Measure 10 Regulators and/or trading venues, where applicable, are encouraged to monitor secondary market trading and market making activities of ETFs and have rules governing the orderly trading of ETF shares. IOSCO notes that depending on the local circumstances of an ETF market, the secondary market liquidity of certain ETFs may heavily depend on MMs fulfilling their functions and accordingly the monitoring of trading/ market making activity by such MMs is considered important in order that steps can be taken where MMs' performance falls short of obligations/ expectations.
 

Volatility control mechanisms

  
Measure 11 Regulators and/or trading venues, where applicable, are encouraged to appropriately calibrate volatility control mechanisms (VCMs) applicable to ETFs, considering factors including their liquidity profile and volatility profile. Where an ETF is listed or traded on a number of trading venues, those trading venues are encouraged to consider communicating with one another as appropriate when VCMs are triggered. Regulators and/or trading venues are encouraged to evaluate whether the existing VCMs applicable to ETFs (i.e. trading halts based on historical secondary market price and those based on divergence between the ETF share price and the iNAV) are appropriately calibrated and review the merits of different approaches to enhance their existing approach.

ANALYSIS AGAINST THE CENTRAL BANK OF IRELAND'S FEEDBACK STATEMENT ON DISCUSSION PAPER 6 ON ETFS

In September 2018, the Central Bank of Ireland (Central Bank) issued its eagerly awaited 'Feedback Statement' on Discussion Paper 6 - Exchange Traded Funds ("Discussion Paper") which indicated a willingness to consider matters such as portfolio disclosure, disclosure of costs incurred by investors and ETF liquidity in line with international best practice. IOSCO builds on much of the research undertaken by the Central Bank and echoes in many areas the findings of the Discussion Paper.

The Central Bank noted that a key element of ETFs is transparency and portfolio disclosure which seeks to ensure effective arbitrage and is seen as being integral to pricing. The Central Bank considered the point of restricting the provision of full portfolio information to a limited number of market participants in its Discussion Paper and the strong arguments proffered for moving from the Central Bank's current position of requiring full daily portfolio disclosure. Measure 2 of IOSCO's Proposed Good Practices echoes the Central Bank's view on the importance of the arbitrage mechanism but introduces the potential for further consideration on the manner in which information is provided to the relevant parties, noting that certain information may be less useful to certain cohorts of investors. Experiences in different markets since 2018, such as the United States of America, will have fed into the deliberations of IOSCO and would appear now to provide stronger evidence of the benefits of less than fully transparent disclosure, be it on a delayed basis, proxy basket or full disclosure of the constituents with different weightings.

The Central Bank noted the importance of the AP community, the arbitrage mechanism of the ETF and the liquidity of an ETF in the secondary market. The Central Bank also noted the operational risks which arise with having a limited number of APs active in the market and engaged with each ETF product. Measure 8 of IOSCO's Proposed Good Practices seeks to encourage ETF issuers to put in place appropriate arrangements to facilitate an effective arbitrage mechanism including increasing competition amongst the number of appointed APs to each ETF product. Both the Central Bank and IOSCO appear to be aligned in considering the issues which may arise in a European context relating to the potential for investors in the secondary market to effect direct redemptions against the ETF in certain market conditions. IOSCO has gone further in its consideration by suggesting that the merits of a contingency plan permitting direct redemptions of secondary market investors should be assessed in light of the effectiveness and operational challenges which may arise given the characteristics of the ETF ecosystem and the manner in which ETF shares are recorded through the ICSD settlement system.

A key element of the Discussion Paper was consideration of the role played by APs and Official Liquidity Providers (OLPs) in the ETF ecosystem. The Central Bank made particular reference to the disclosure of costs which are borne on behalf of the relevant ETF where an OLP obtains remuneration for its services noting that such costs should be sufficiently clear and should indicate the basis on which all costs including OLP remuneration (either monetary or otherwise) is calculated. Measure 8 of IOSCO's Proposed Good Practices echoes the Central Bank's position that clear disclosure of fees and expenses which are borne by investors in an ETF should be made available.

NEXT STEPS

IOSCO will accept responses to the Consultation Report until 6 July 2022. It is anticipated that it will then take a period to review these responses before IOSCO issues a final good practices report, which will supplement its 2013 Principles.

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.