April 8, 2012 6:06 pm

ETFs: more regulation makes sense

Better-focused rules might bolster confidence

The financial services industry is not always a fan of more regulation. But, when it comes to exchange-traded funds, there is guarded support – at least in principle. That makes sense. Assets under management at ETFs (which track performance of a basket of assets yet trade, like shares, on an exchange) have ballooned, to $1.4tn at end-2011; customers span institutional and retail investors. But ETFs have quickly become more complex, diversifying from funds replicating indices physically, to ones trying to deliver desired (sometimes leveraged) returns via derivatives. Regulators have signalled potential concerns, from use of securities lending (which bolsters returns but could form liquidity and redemption risks), to conflict of interest worries if an institution were to be both a synthetic ETF provider and a derivative counterparty. While global inflows have been strong this year, lustre has been lost. More focused rules might bolster investor confidence.

Nowhere is the issue more sensitive than in Europe, where “synthetic” funds make up almost half the total. So responses to the pan-European regulator’s consultation about fresh guidelines – which closed last week – have been robust. For example, BlackRock, one of the biggest ETF providers, suggests rules need to go further to ensure that potential conflicts are properly managed and disclosed. Clear identification of ETFs won support, but with less agreement about whether this should include upfront labelling of “physical” and “synthetic” funds. Conversely, there was an industry fightback against curbs on securities lending practices (even “generally” returning all such income to the fund).

Some arguments are technical, and a few tweaks to the draft proposals may be desirable. But regulators should not be swayed easily. This is an industry in which complexity is multiplying rapidly. Investors should know exactly what they are buying.

E-mail the Lex team in confidence at lex@ft.com

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