Debate has some way to go

Providers of ETFs champion their products as the best on offer from the entire fund management industry due to their high standards of transparency, low costs and efficiency in delivering returns to investors.

But this assessment was punctured last April when global regulators issued a stream of unprecedented criticisms. Their worries included the growing complexity of products, the use of derivatives, concerns about potential mis-selling and even fears that ETFs could pose systemic risks.

Regulators focused mainly on synthetic ETFs, which use derivatives to provide index returns, but they also drew attention to the risks involved in securities lending practices by physical ETFs.

The criticisms had an impact on synthetic ETFs listed in Europe, which saw investors withdrawing almost $5bn from these products last year.

Christos Costandinides, European head of ETF research and strategy at Deutsche Bank, says the debate over regulation has been beneficial because it has helped market participants become more familiar with how ETFs work.

He also says the focus of the debate has shifted beyond the merits of ETFs to broader underlying issues, such as transparency and reporting standards.

“The vast majority of the issues raised by regulators are pertinent to the general fund management industry in both the US and Europe.”

Evidence of a shift emerged at the end of January with the publication of new draft guidelines for ETFs by the European Securities and Markets Authority (Esma), which the regulator explicitly broadened to include all index tracking Ucits funds and any Ucits funds that engaged in securities lending.

Esma’s latest guidance indicated it had listened to the argument that ETFs should not be subject to any kind of special regime that would not apply to other Ucits funds.

Alain Dubois, chairman of Lyxor, the asset manager, says Esma has done “excellent work” following extensive consultation.

“Esma’s new guidelines indicate there is no need for specific rules for ETFs as they are already well regulated under the current Ucits framework. Esma’s report indicates that only limited adaptations to current regulations will be necessary,” says Mr Dubois.

However, numerous questions remain unresolved.

Steven Maijoor, Esma’s chairman, has confirmed the question remains open as to whether some ETFs should be reclassified as “complex” products. This issue will be determined by the European Commission as part of its review of Mifid (Markets in Financial Instruments Directive).

Whether synthetic and physical ETFs should have different labels or markers to distinguish them also remains open for debate.

Further, Esma has not decided whether the same group should be prevented from acting as a synthetic ETF provider and swap counterparty to the ETF to prevent any potential conflict of interest.

The regulator also suggested that ETF-like instruments, which currently offer fewer safeguards than ETFs structured as Ucits, should be subject to the same regulatory requirements as Ucits funds so investors enjoy equivalent levels of protection.

This suggests the scope of Esma’s reforms could broaden further still.

The UK’s Investment Management Association is calling for Esma to look at all exchange traded products sold to retail investors – not just Ucits funds.

“The European Commission’s Packaged Retail Investment Products initiative seeks to ensure that all retail products are subject to similar rules on disclosure and selling, but we are concerned that this important principle will be eroded if different pieces of legislation apply to different products,” says Julie Patterson, IMA director of authorised funds and tax.

The IMA is also calling for Esma to avoid labelling as complex all products that use derivatives because it sees this as a naive approach that does not take account of risks to investors.

Esma will undertake consultations before finalising guidelines, so the debate has some way to run.