Impact on European ETFs
Asset Management Regulation
Last year Exchange Traded Funds (“ETFs”) and products listed in Europe hit a record high. In 2017 assets invested in European-listed ETFs and products reached $802bn (*ETFGI; 2017). In this article we will explore, what we believe could be the impact of some of the current asset management regulation on the growing European ETF industry.
- ETF Asset Management industry and regulation
- Regulation in Ireland and Luxembourg
- European Standards and Best Practice for ETFs
- The road ahead for ETF regulation
ETF Asset Management industry and regulation
Looking at the asset management industry as a whole the discussions about the need for more intensive regulation of asset managers due to residual systemic risk concerns will not go away. We believe regulatory interest in the sector will be heightened by asset managers increasing their risk-taking activities in response to the retrenchment of banks, and market instability that could arise from the ever growing proportion of global capital flows represented by passive investment and ETFs. However we do not expect individual firms to be designated as globally systemically important in the same manner as in the case of banking and insurance.
Last year the FSB published policy recommendations to address structural vulnerabilities in the asset management industry, and IOSCO is reviewing how national authorities have implemented the recommendations. Asset managers will need to develop strategic stress testing plans and the focus is likely to be on fund leverage monitoring and control requirements. The ECB has commented on the risks associated with the growing asset management sector and the recent ESRB recommendation on liquidity and leverage risks in investment funds both signal a need for industry preparedness.
As part of ESMA’s 2018 Supervisory Convergence Work Programme, ESMA has stated that it will work on a procedure for the imposition of leverage limits, develop guidance on the use of liquidity management tools, and develop fund stress testing principles. ESMA conducts peer reviews in the interest of fostering convergent supervisory approaches and the application of rules in the EU. One peer review that is currently underway is ESMA’s review of the guidelines on ETFs and other UCITS issues: this assessment is focusing on the supervisory practices of six NCAs in relation to efficient portfolio management techniques. ESMA’s on-site visits will take place in Q1 2018 while the final report is expected to be published in Q3 2018.
MiFID II brings with it positive developments for ETFs. Before MiFID II there was no legal requirements to make ETF trading volumes public. The new pre and post trade transparency regime under MiFID II means that it will be easier to see the activity, demand and liquidity within the European ETF market. What the MiFID data will tell us has the potential to bring significant product innovation.
Regulation in Ireland and Luxembourg
In Ireland, the Central Bank of Ireland (“CBI”) has taken a very active role in leading industry discussions. Last year in 2017 the CBI released a discussion paper regarding ETFs and this move was met with the support of the Irish ETF industry. The CBI covered 3 major themes in the consultation; investor expectations, liquidity and the requirement for additional regulation. We await the outcome of the consultation. The publication of the consultation will be an opportunity for the Irish ETF industry to discuss their ideas on the future of ETFs. France’s AMF recently moved to strengthen the requirements on ETFs, it has issued guidance on monitoring procedures in the event of liquidity reduction, valuation issues and counterparty default. Liquidity risk management is vital for the effective functioning of the ETF market. With ETFs covering less liquid underlying markets; a tracking error can occur. In stressed market conditions the creation and redemption of ETF shares can result in liquidity risks.
In Luxembourg on the 5th January 2018 the CSSF announced a change in their position in relation to the assessment of the eligibility criteria of non-UCITS open-ended ETFs and other UCIs. Previously US ETFs were seen as automatically equivalent to UCITS ETFs. The CSSF took a flexible approach in allowing UCITS to invest in non-UCITS as long as the non-UCITS “effectively” complied with the UCITS rules. The CSSF’s move is as a result of ESMA’s insistence that there be regulatory harmonisation across Europe. The CSSF has now made it clear that a Luxembourg fund must dis-invest, taking into account the best interests of the investors, if they have invested in non-UCITS ETFs. Luxembourg UCITS funds are of course still able to invest 10% of their assets in non-eligible assets.
European Standards and Best Practice for ETFs
It could be argued that the current regulatory framework was not specially designed for ETFs. Does the regulatory landscape need to be reformed? It is a difficult question to answer and need’s significant industry debate and analysis. We believe the asset management industry holds many of the answers but it will need to collectively participate in consultations before any consensus is achieved. However there is a view that the regulatory framework does not have to change and instead a clear set of ETF industry standards could be developed. For example a systematic risk classification of ETFs could help investors identify the risks associated with different types of ETFs and lead to increased investor protection. For example the planned review of UCITS could go hand in hand with a review of regulation impacting ETFs. Another approach to consider would be one similar to the European regulatory framework for the Pan-European Pension Products (“PEPP”) or would that approach be too heavy handed? More industry debate will be needed to answer this question. Another angle to consider is whether we should be looking at the instruments and strategies used in the ETF markets rather than the adding on another layer of “product” regulation.
In attempting to answer the question on whether there is a need for regulatory reform to support the ETF market, we also need to consider whether we are focusing on the right issues when we are discussing the ETF market. Market discipline is also important. The CBI has identified that the role of the authorized participants (APs) is at the centre of the ETF industry their role is critical in the creation and redemption mechanism. APs are the ETF liquidity providers and have the exclusive right to change the supply of ETF shares on the market. The development of AP standards and best practice around the trading processes would ensure transparent, consistent industry standards and would create significant efficiency around ETF creation and redemption requests.
The ETF industry also needs to consider if the industry itself and investors understand clearly the definitions being used for active and passive investing. There are fiduciary duties owned to investors, one of which is that they must receive the correct information to make informed and educated decisions. The industry must also consider the effect of ETFs on the allocation of capital and increased automation in the capital markets.
IOSCO’s paper on the principles for the regulation of ETFs is due to be released in early 2018, which is an update to the paper IOSCO published in 2013. The release of the IOSCO paper is awaited with interest by the industry. Our view is that it will be very useful for guiding the discussion around policy, regulatory developments and future industry best practice.
In 2018 the culture of fund boards and fund management companies will be a key theme for European regulators. Culture is the set of behaviours used by everyone in the organisation. There is not a model of culture which can be applied, there is not a one size fits all, this means that an ETF board must decide and agree their unique culture.The first two questions a board must consider are often the most difficult; what is the organisation’s current culture and what culture does an organisation want to set.
The FCA in the UK believes that there are 4 drivers that a board can influence; leadership, governance, incentives and purpose. It is a challenge for ETF boards to measure how the culture they agree is implemented and measured. It is not for compliance or legal departments to drive and articulate the approach of the board. It is the responsibility of the ETF board and senior management to define a mission statement and purpose. The board need’s to examine if change is needed in the organisation in light of their mission statement, and then how this change would be actioned. Boards need to ask all stakeholders how they are articulating, identifying and implementing “best” practice. The board needs to know what flags would be raised to notify them if actions fell below their best practice standards.
How does an ETF board ensure that their culture is continuously and actively implemented by delegates is also a matter for consideration. ETF boards will need to ensure that they document how their best practice standards are implemented or matched by delegates.
The road ahead for ETF regulation
Looking ahead ETF industry participation and consensus is needed to develop best practice and industry standard. ETF investor education is vital so that investors understand the ETF universe so that it can continue to grow while keeping costs low. Industry lead initiatives combined with a plan from policy makers to develop and reform the regulatory framework would help ensure the continued growth of ETFs in 2018 and beyond.