ESMA Cracks Down on Disclosure for ETFs
The European Securities and Markets Authority, the pan-European regulator, wants exchange-traded funds to disclose a lot more information on their lending activities and collateral used as part of an overall attempt to provide greater transparency to regulators and investors.
The proposals, issued in a 77-page consultation paper Monday morning, apply to physical ETFs and synthetic ETFs. Comments are due by March 30 and the final guidelines could be published as early as mid- 2012.
The document follows the publication of a discussion paper in July 2011 which reflected market concerns that the growing structural complexity of some ETFs may not be clear to end investors and therefore are not appropriate for the retail market. However, ESMA fell short of requiring that synthetic ETFs be classified as complex products. Such an approach, viewed as draconian by some ETF providers, could have restricted their ability to sell the products to retail investors. The regulatory body says that it will tackle the issue of how complex ETFs should be sold to retail investors after the European Commission makes final revisions to the Markets in Financial Instruments Directive. The revisions would introduce a new classification of "complex" funds which fall under the Undertakings for Collective Investment in Transferable Securities (UCITS) pan-European directive. That directive allows investment funds to be marketed more easily across the European Union after approval from their home market.
Physical ETFs invest in the underlying asset being tracked, while synthetic ETFs use a derivative or swap to guarantee the return on the same underlying product, without owning it. Both products can carry additional counterparty risk. Providers of physical ETFs often lend out underlying securities to generate additional income while synthetic ETFs are exposed to the institution on the other side of the derivative trade.
ESMA is asking exchange-traded funds to explain in their prospectuses whether or not they lend out securities, the risks involved and provide more detail about the collateral they accept. Collateral pledged in return for securities must meet certain standards outlined under UCITS. The regulator suggests that cash used as collateral should not be reinvested into "risky assets." Cash is not typically used as collateral in European securities lending transactions but some U.S. funds have encountered some mega financial losses in their cash reinvestment programs administered by custodian banks.
"In outlining the draft future rules for investment funds today, ESMA is proposing to reinforce the legal framework applicable to ETFs and other types of UCITS," says Steven Maijoor, chairman of ESMA in a statement. "The aim of these guidelines is to enhance investor protection and limit the risk of certain practices by strengthening in particular the standards applicable to collateral received in the context of activities such as securities lending."
Among other recommendations: all ETFs which fall under the category of UCITS-compliant funds must be identified using the code ETF; provide more detail on when those UCITS funds do not actively track an index; and are actively managed. ESMA says that an ETF fund can be defined as a UCITS if "at least one unit or share class of which is continuously tradeable on at least one regulated market or multilateral trading facility with at least one market maker, which takes action to ensure that the stock exchange value of its units or shares does not significantly vary from their net asset value."
ETFs -- funds tracking baskets of shares, bonds or commodities that are traded like stocks -- have become popular among retail investors who want the same returns without buying underlying securities. By 2010's third quarter, the global ETF market managed $12 trillion of assets, according to figures provided by the Financial Stability Board. Synthetic ETFs are more common in Europe than the U.S.
What the Prospectus of an Index-Tracking UCITS ETF Should Include:
1- A clear description of the index including details of the underlying components
2- Data on how the index will be tracked and how a chosen method will affect exposure to the underlying index and counterparty risk
3- A description of factors which are likely to affect the ETF's ability to track the performance of the index.
4- Details on whether the index tracking UCITS will follow a full replication model or a sampling policy
What the Financial Reports of an Index-Tracking UCITS ETF Should Include:
1- The semi-annual and annual reports of an index tracking UCITS should include the size of the tracking error at the end of the period under review
2- The annual report should explain any difference between the target and actual tracking error for the relevant period under review
Written by Chris Kentouris, Editor-in-chief (Chris can be contacted through Chris.Kentouris@hotmail.com)
