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The SEC's ETF proposal: Potentially transformative
What market impacts might the SEC's ETF proposal have on the investment management industry?
The exchange-traded fund (ETF) market recently received news of the beginnings of a long-awaited change to the way it is regulated and goes to market. The Securities and Exchange Commission (SEC) offered the investment management industry the opportunity to comment on a new proposed ETF rule, which it says "is designed to create a consistent, transparent, and efficient regulatory framework for ETFs and to facilitate greater competition and innovation among ETFs."1 This proposed change will enable ETF providers to go to market more quickly, reduce barriers to entry, and pave the way for operational efficiency. Let's explore some of the significant market impacts these proposed changes may have on the investment management industry.
Analysis of the impact of this proposal should keep in mind that this is a proposed rule, and that the SEC seeks feedback from the industry. The proposal contains approximately 700 questions for industry participants in its 286 pages. For firms familiar with Deloitte's regulatory ready research2, this proposal is squarely in the sensing and influencing stage.
Consider the potential market impact
The potential impact of exemptive relief for investment managers is significant. As of December 2017, there were 1,900 ETFs registered with the SEC, operating under 3003 exemption letters granted by the SEC. Not all ETFs are affected by the proposal, such as ETF-structured unit investment trusts (UITs). The cost of an exemptive relief letter to an investment manager is estimated to fall between $20,000 and $75,000.4 The real benefit, however, may not be the savings from the exemptive orders themselves, but instead the savings associated with standardization of industry processes and procedures through operational change. Creating and processing of creation shares and baskets will likely benefit from economies of scale over time, given the opportunity to standardize processes across many formerly different ETFs. This savings is offset by the cost associated with complying with other reporting components of the proposed rule, though it is likely the savings outweigh this cost.
The proposed rule streamlines challenges currently associated with ETFs, such as different treatment of active and index ETFs and custom basket utilization. Do you think the market may benefit from the significant opportunity afforded through lowering costs associated with operations, increasing competition, and encouraging innovation? In what time frame? What about investors? Could they benefit from these changes through potentially lower operating costs, which would support the competitive pressure for lower fees, and greater investment choices in the ETF market?
One of the changes addressed by the proposal includes standardizing the creation basket regulation and allowing the use of flexible baskets for creation and redemption by authorized participants. This flexibility will be governed by written fund-level policies and procedures. It also may lead to increased liquidity for ETFs by facilitating the arbitrage process for authorized participants. ETFs will likely work with authorized participants to improve the process within the newly afforded flexibility. This change will level the competitive playing field among ETFs currently operating under differing exemptive relief requirements. The proposal provides more latitude in creating a basket that doesn't have to mirror an index, which may allow some actively managed ETFs to operate in a more efficient and cost-effective way.
Impacts beyond the ETF market itself
There is likely to be an impact beyond the ETF market as a result of this proposal. With an expanding ETF market, lower costs, and more informed investors, a shift in investor demand towards ETFs is an important point to consider. The impacts would be seen by broker-dealers and investment advisers whose customers may show greater interest in the economic advantages offered by ETFs. Investors may further shift from mutual funds to ETFs, as the proposed amendments are adopted. Could this shift to provide the products investors favor also impact the economic model for brokerage firms and investment advisers? Will the proposed regulation amplify the different cost and distribution models of ETFs and mutual funds?
One wild card aspect of the proposal is the uniform treatment of active and traditional index-based ETFs. There still appears to be a significant "freeriding" opportunity that will likely hamper active equity ETF development. Freeriding occurs when investors replicate the investment portfolio without investing through the fund. Active bond ETF formulation will likely be less inhibited by potential freeriding, due to the difficulty in replicating a large bond portfolio. However, there may be some interesting combinations of holdings and acceptable custom basket transparency that support active equity managers and fulfill the goals of the SEC. As it stands, we predict that most new ETFs under the proposed rule will likely be either traditional passive ETFs or enhanced beta products. Whether the rule changes the desire of active equity managers to publish fund holdings on a daily basis in the future remains to be seen.
From a board perspective, the proposed rule does not add any new obligations to boards overseeing ETFs. However, there is an inherent expectation that an ETF board will play a role in the oversight of the custom basket process, likely through the review of established policies and procedures in accordance with the proposed rule. ETF boards may also want to review the investment adviser processes for monitoring and tracking custom baskets. Boards may have a responsibility to ensure their construction and acceptance are in the best interest of the ETF and its shareholders.
The SEC has provided an opportunity to deliver feedback and help shape a potentially highly impactful regulation. We encourage all to consider how this proposal will impact your business and investors when providing comments. Assessing this proposal with both near-term changes and long-term strategies in mind may enhance the impact of the regulation to your organization. The due date for comments on this proposal to the SEC is October 1, 2018. Please share your thoughts on the SEC's ETF proposal with us. Join the conversation on Twitter at @DeloitteFinSvcs.
1 SEC, Release Nos. 33-10515; IC-33140; File No. S7-15-18, RIN 3235-AJ60, Exchange-Traded Funds
2 Doug Dannemiller, Ankur Gajjaria, "Building regulatory-ready organizations," Deloitte Insights, 2017
4 SEC, "Proposed Rule 6c-11" 2018
5 "SEC may make it easier to create exchange-traded funds," MarketWatch, https://www.marketwatch.com
QuickLook is a weekly blog from the Deloitte Center for Financial Services about technology, innovation, growth, regulation, and other challenges facing the industry. The views expressed in this blog are those of the blogger and not official statements by Deloitte or any of its affiliates or member firms.
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