Evolution not revolution on guidelines from Esma
The European Securities and Markets Authority’s eagerly anticipated guidelines on exchange-traded and other Ucits funds represent classic regulatory progress: they may be considered evolutionary, but revolutionary they are not.
Largely principles-based, the guidelines – which member states must make “every effort” to comply with – do contain considerable detail.
This will serve ETF investors and ultimately the ETF industry well and requires changes in the operating models of some promoters as well as having revenue impact.
The spirit of transparency that underlines the traditional ETF model is now partly codified in the guidelines, starting with the requirement that the identifier “Ucits ETF” must be in the title of the fund.
This move is welcome because it provides a clear distinction from non-fund products such as exchange-traded notes and exchange-traded commodities, which benefit by association with their well-regulated exchange traded fund stablemates.
But it will not please ETF providers that argued strongly that the label “physical” or “synthetic” should also be in the title.
Esma was convinced that this would raise more problems than it would solve, accepting that such a binary option would have created difficulties for hybrid products.
In last year’s battle between synthetic and physical providers, the synthetic supporters were quick to point out the counterparty risk introduced by securities lending, and Esma has included this activity in the guidelines with clear benefits to the end investor.
The guidelines dictate that all revenues arising from efficient portfolio management techniques such as securities lending must be returned to the fund and it is worth noting that this applies to all Ucits funds and not just Ucits ETFs.
While the fee to be returned is net of any direct or indirect operational costs, Esma is clear that “these costs and fees should not include hidden revenue”.
It has hammered home this point with the requirement to disclose the recipients of fees and indicate their relationship to the Ucits management company or custodian.
The collateral arrangements relating to securities lending exposure are also brought within the guidelines. They and the collateral rules relating to swap counterparty exposure are harmonised with additional granularity added to the previous guidelines on risk measurement and counterparty risk for Ucits – another welcome development.
The importance of key investor information documents, or Kiids, is also underscored. Providers will have to disclose their replication methodology as well as factors likely to affect the ability of the fund to track its reference benchmark.
Esma specifically names the effect of transaction costs, illiquid index components and dividend reinvestment, and it will require synthetic funds to disclose the impact of commission and financing costs associated with using swaps in the Kiid while physical funds will have to show transaction and rebalancing costs and the impact of optimisation strategies.
It is not clear how securities lending revenues and costs will be treated.
The ability of the secondary market investor to redeem directly at fund level is provided for and while it seems a good initiative, it might be problematic in practice.
The guidelines make it clear that direct redemption may occur where the market price and the net asset value “significantly” vary.
What might be considered “significant” is not quantified and while the absence of a marketmaker is the instance cited where this might be invoked, it is likely that a promoter would be more inclined to suspend the fund rather than allow direct redemption where it would have to bear any price differential.
Esma’s guidelines are a positive step in addressing concerns about ETFs and the broader Ucits universe.
The regulation of exchange-traded funds in general remains an ongoing project and we are likely to see some further changes through regulation of distribution. The need for some regulation around retail investors’ access to ETNs and ETCs remains.
For now, the challenge for promoters is to understand the detail and implications of the latest round of oversight and adapt accordingly in the transition period.