New Regulatory Framework Suggested for ETF Market

Yesterday, the International Organization of Securities Commissions (IOSC) published a report calling for increased regulation of the Exchange Traded Funds (ETFs) market.  ETFs are “open ended collective investment schemes” that are traded like stocks.  ETFs “seek to replicate the performance of a target index and are structured and operate in a similar way.”  ETFs are becoming increasingly popular for their low cost and liquidity, so the IOSC believes they require increased regulation to protect consumers and investors.

The purpose of the report is to “outline principles against which both the industry and regulators can assess the quality of regulation and industry practices concerning ETFs.”  The report presents suggestions only, and jurisdictions can modify and adopt the principles based on their needs.

Currently, ETFs represent about 7% of the global market fund but is controlled by just a few large players.  Europe has already increased regulations of ETF products to better protect consumers and investors.

Critics of the current ETF regulatory standards say that “ETF investors are not reaping the full financial rewards of securities lending and are broadly unaware that they are liable to cover any losses, if the borrower defaults and fails to return the stock as agreed.”

The IOSC created nine Principles that ETF regulators should adhere to.

Principle 1: Regulators should encourage disclosure that helps investors to clearly differentiate ETFs from other ETPs.

Principle 2: Regulators should seek to ensure a clear differentiation between ETFs and other CIS, as well as appropriate disclosure for index-based and non index- based ETFs.

Principle 3: Regulators should require appropriate disclosure with respect to the manner in which an index-based ETF will track the index it references.

Principle 4: Regulators should consider imposing requirements regarding the transparency of an ETF’s portfolio and/or other appropriate measures in order to provide adequate information concerning:

.     i)  any index referenced and its composition; and

.     ii)  the operation of performance tracking.

Principle 5: Regulators should encourage the disclosure of fees and expenses for investing in ETFs in a way that allows investors to make informed decisions about whether they wish to invest in an ETF and thereby accept a particular level of costs.

Principle 6: Regulators should encourage disclosure requirements that would enhance the transparency of information available with respect to the material lending and borrowing of securities (e.g., on related costs).

Principle 7: Regulators should encourage all ETFs, in particular those that use or intend to use more complex investment strategies to assess the accuracy and completeness of their disclosure, including whether the disclosure is presented in an understandable manner and whether it addresses the nature of risks associated with the ETFs’ strategies.

Principle 8: Regulators should assess whether the securities laws and applicable rules of securities exchanges within their jurisdiction appropriately address potential conflicts of interests raised by ETFs.

Principle 9: Regulators should consider imposing requirements to ensure that ETFs appropriately address risks raised by counterparty exposure and collateral management.

Click here to read the entire report.