Grappling with systemic concerns
In Europe, as well as globally, retail and institutional investors have been steadily embracing the use of exchange-traded funds. Last year, ETFs in Europe saw net inflows of $22bn, according to ETF Global Insight, while Ucits funds suffered net outflows of $119bn according to the European Fund and Asset Management Association.
Regulators and investors are still discussing how they should treat ETFs in the future. Synthetic and physical ETFs are seen as being significantly different in their structure and potential risks.
In the past month and a half, papers from the European Securities and Markets Authority and the European Banking Authority have continued to highlight regulators’ concerns about synthetic and physical ETFs as well as offering proposals for potential changes. In the next few months, the International Organization of Securities Commissions and the Financial Stability Board are expected to issue new papers on how ETFs should be regulated.
Iosco, the organisation that regulates the world’s securities and futures markets, is scheduled to publish regulatory guidelines and the FSB, which represents the G20, will address ETF vulnerabilities with the aim of strengthening regulatory, supervisory and other policies dealing with financial stability.
In January, Esma published a consultation paper seeking comment on its proposed guidelines on Ucits ETFs and other Ucits-related issues. The proposals cover both synthetic and physical Ucits instruments and detail the obligations for Ucits ETFs, index-tracking Ucits, efficient portfolio management techniques, total return swaps and strategy indices. Esma wants comments by the end of March and will finalise the guidelines for adoption in the second quarter.
Although Esma believes some ETFs and Ucits products are too complex to be sold without advice to retail investors, it refrained from labelling some products as complex because that is an area governed by the markets in financial instruments directive under review by the European Commission.
Esma is still considering the advice from the Securities and Markets Stakeholder Group to reduce potential conflicts of interest by prohibiting entities from the same group from acting as both ETF provider and the derivative counterparty. This is in line with US regulations for mutual funds and ETFs.
At the beginning of last month, the European Banking Authority published a paper entitled “Financial innovation and consumer protection – An overview of the objectives and work of the EBA’s standing committee on financial innovation in 2011-2012”.
The paper raises many concerns previously highlighted by the Bank for International Settlements, the Financial Stability Board, and Esma – namely risks from an investor, provider, swap counterparty, market maker and market perspective.
The Lehman bankruptcy in September 2008 brought to the fore the importance of knowing who your counterparty is. After Lehman, many compliance officers started to prohibit investment in derivatives, products that use derivatives and those that carry counterparty or issuer risk. More recently, regulatory intervention has caused many investors to state a preference for physically backed ETFs.
Most ETFs in Europe are Ucits funds, and although they account for only 3.5% of all Ucits funds, they have been growing at a faster rate than other funds (asset growth of 47% per year over the past 10 years for ETFs, versus 5% for other Ucits funds).
The feuding over physical versus synthetic among providers has created uncertainty for investors trying to determine if, when and what type of ETF they should consider. Because most ETFs in Europe are Ucits funds, it has also created a quandary for regulators.
At the end of February, the European industry had 1,270 ETFs with 4,485 listings, assets of $302.3bn from 37 providers listed on 21 exchanges, according to ETF Global Insight. Measured by the number of funds, synthetic ETFs comprise 63% of the total, or 801 funds. By contrast, physical ETFs account for $184.3bn, or 61%, of assets in Europe. In the year to the end of February, physical ETFs received 65.4% of the $4.7bn of net new assets invested into ETFs listed in Europe. In 2011, synthetic ETFs suffered net outflows of $3.7bn while physical ETFs gained $28.9bn.
However, the vast majority of ETFs in Europe are structured as Ucits funds and the requirements of that regime are focused on protecting the interest of investors. The Esma proposals rightly recognise this fact and in seeking to address concerns, we must be mindful of the systemic concerns raised by the FSB and others and the open question of how to regulate the exchange-traded exposures that are not structured as funds. This debate has some way to run yet.