LSEG Response to Consultation Paper: ESMA s guidelines on ETFs and other UCITS issues (ESMA/2012/44) Submitted online at: www.esma.europa.eu Odiri Obiakpani Lucia Bordigato Regulatory Strategy Regulation & Post Trading London Stock Exchange Group plc Borsa Italiana 10 Paternoster Square Piazza degli Affari, 6 London EC4M 7LS 20123 Milan +44 (0) 20 7797 1886 +39(0)272 422 676 oobiakpani@londonstockexchange.com lucia.bordigato@borsaitaliana.it 30 March 2012 Executive Summary 1. The London Stock Exchange Group (LSEG) supports the majority of the guidelines proposed by ESMA in its consultation paper and fully supports ESMA in promoting the transparency of UCITS products and improving investor understanding particularly in relation to Exchange Traded Funds (ETFs). 2. We support ESMA s conclusion that products with broadly similar characteristics should be subject to the same level of regulatory requirements and that investors in such products should be able to rely on an equivalent level of regulatory protection. 3. We agree with ESMA s proposed definition of ETFs, however, we would suggest that this wording is amended, as the reference to market maker in the definition could be misleading. 4. We do not agree that there should be a further identifier to distinguish between synthetic and physical ETFs. It is our view that a simple distinction purely on this basis may be overly simplistic and could lead some less sophisticated investors to rely solely on these identifiers for their understanding of the products. 5. We believe that the guidelines should not be put into force immediately, so that UCITS providers have sufficient time in which to ensure the smooth transition to the new rules. Final Page 1 of 10
INTRODUCTION London Stock Exchange Group (LSEG) welcomes the opportunity to respond to the Consultation Paper ESMA s guidelines on ETFs and other UCITS issues. LSEG fully supports ESMA s efforts to promote the transparency and understanding of UCITS products. This submission represents the views and experience of London Stock Exchange plc, Borsa Italiana, and other market operators and investment firms within LSEG. LSEG is well qualified to respond to a consultation on UCITS Exchange Traded Funds and Structured UCITS. It operates one of Europe s key markets for Exchange Traded Funds (ETFs). There are currently 15 issuers offering more than 1,000 ETFs on LSEG markets (590 on Borsa Italiana and 533 on the London Stock Exchange), providing exposure to a diverse range of asset classes and markets. The total combined turnover in 2011 was around 195 billion. In our response, we only deal with those aspects where we have relevant experience on our markets and not some of the wider points, where market participants will have relevant views. We confirm that we acknowledge that this response may be published by ESMA. Final Page 2 of 10
RESPONSE TO INDIVIDUAL QUESTIONS I. Index-tracking UCITS Q1 Do you agree with the proposed guidelines? In principle, we agree with the guidelines for disclosure required in the prospectus and the annual and half yearly reports of index tracking UCITS, as proposed in Box 1 of the consultation paper. However, would suggest that points (b) and (e) should be incorporated as one point, because their objectives are the same. We also suggest changes to the wording of the new point (b), to make it clear that physical replication of ETFs may rely both on full replication, as well as sampling replication. And to show that synthetic ETFs may also rely on different types of swap-structure. Our proposed amendment is as follows: Box 1 Index-tracking UCITS Text proposed by ESMA 1. The prospectus of an indextracking UCITS should include: a). b) Information on how the index will be tracked and the implications of the chosen method for investors in terms of their exposure to the underlying index and counterparty risk. c). d). e) Details of whether the indextracking UCITS will follow a full replication model or use, for example, a sampling policy. Amendment 1. The prospectus of an indextracking UCITS should include: a). b) Information on how the index will be tracked, including an indication of the replication model, and the implications of the chosen method for investors in terms of their exposure to the underlying index and counterparty risk. If the index-tracking UCITS will follow a physical replication model, indication of the adoption of a full replication model or of a sampling policy. If the index-tracking UCITS will follow a synthetic replication model, details of the structure used. c). d). e) Details of whether the indextracking UCITS will follow a full replication model or use, for example, a sampling policy. Final Page 3 of 10
Q2 Do you see merit in ESMA developing further guidelines on the way that tracking error should be calculated? If yes, please provide your views on the criteria which should be used, indicating whether different criteria should apply to physical and synthetic UCITS ETFs. Tracking error contributes to the assessment of the fund s investment policy and the quality of replication. It could be a useful tool for investors to use when comparing the performance of one index-tracking UCITS against another. Therefore, further guidance from ESMA on the calculation methodology would be welcome. Q3 Do you consider that the disclosures on tracking error should be complemented by information on the actual evolution of the fund compared to its benchmark index over a given time period? We agree with ESMA that transparency of index-tracking is important and that all relevant issues, such as those outlined in Box 1 of the Consultation Paper should be included in the Prospectus. However, we would suggest that, in order to have a common approach and to enable investors to make useful comparisons, ESMA should set out the standards by which this information should be disclosed. For example, this could be in the form of a chart that compares ETF and Index values, such as typical vendor graphic analysis, or a list that summarises the data at the end of a predetermined (say, one year) period. II. Index-tracking leveraged UCITS Q4 Q5 Do you agree with the proposed guidelines for index-tracking leveraged UCITS? Do you believe that additional guidelines should be introduced requiring index-tracking leveraged UCITS to disclose the way the fund achieves leverage? We agree with the guidelines proposed in Box 2 of the Consultation Paper. We also agree with the policy decision to extend the scope of the guidelines to include other (non-etf) UCITS. This will ensure that there is a level playing field between ETF UCITS and non-etf UCITS, with regards to disclosure. Final Page 4 of 10
III. UCITS Exchange Traded Funds Definition of UCITS ETFs and Title Q6 Do you agree with the proposed definition of UCITS ETFs? In particular, do you consider that the proposed definition allows the proper distinction between Exchange-Traded UCITS versus other listed UCITS that exist in some EU jurisdictions and that may be subject to additional requirements (e.g. restrictions on the role of the market maker)? We agree with ESMA s proposed definition of ETFs, which states that for a UCITS to be identified as a UCITS ETF, it needs to be continuously traded on at least one regulated market or multilateral trading facility (MTF) The definition goes on to say that there should be at least one market maker which takes action to ensure that the stock exchange value of its units does not significantly vary from their net asset value.. We would suggest that this wording is amended, as the reference to market maker in the definition could be misleading. This is because, in our experience, it is usually the authorised participant and not the market maker that guarantees the alignment of the market value of an ETF to its net asset value, through the creation/redemption mechanism. As defined by Directive 2004/39/EC (Article 4(1)(8) MiFID), a market maker is defined as a person who holds himself out on the financial markets on a continuous basis as being willing to deal on own account by buying and selling financial instruments against his proprietary capital at prices defined by him. Therefore, a market maker could be (but is not necessarily) an authorised participant. Also, we would like to note that it is the market operator that makes the decision of whether to have a market maker on the secondary market as a requirement for admission to trading, with regard to the features of the market it operates, and that this is a provision of Exchange Market Rules. Therefore we would propose the following amendment: Final Page 5 of 10
Box 3 of the Consultation Paper Definition of UCITS ETF and identifier Text proposed by ESMA Amendment 1. A UCITS exchange-traded fund (UCITS ETF) is a UCITS at least one unit or share class of which is continuously tradable on at least one regulated market or multilateral trading facility (MTF) with at least one market maker which takes action to ensure that the stock exchange value of its units or shares does not significantly vary from their net asset value. 1. A UCITS exchange-traded fund (UCITS ETF) is a UCITS at least one unit or share class of which is continuously tradable on at least one regulated market or multilateral trading facility (MTF) with at least one market maker authorised participant whose activity ensures that the stock exchange value secondary market price of the units or shares does not significantly vary from their net asset value. Q7 Do you agree with the proposed guidelines in relation to the identifier? Yes, we fully support this approach and would point out that the vast majority of the ETFs on the LSEG s markets already use this identifier. Q8 Do you think that the identifier should further distinguish between synthetic and physical ETFs? No, we do not agree that there should be a further identifier to distinguish between synthetic and physical ETFs. This is because a simple distinction on this basis may not always be possible, as there are variations in replication methods within the synthetic and physical product groupings. Furthermore, as stated in our response to the ESMA Discussion paper, Policy orientations on guidelines for UCITS ETFs and Structured UCITS (2011/220), we believe that introducing a replication marker in the identifier would be overly simplistic. It is our view that this could lead some less sophisticated investors to rely on these identifiers for their understanding of the products. We feel that it is important to encourage investors to look into the details of products and to seek to understand the particular risks involved and the mechanics of the replication. Final Page 6 of 10
Q9 Do you think that the use of the words Exchange-Traded Fund should be allowed as an alternative identifier for UCITS ETFs? Yes, in practice both terms are already commonly used and are largely interchangeable (within the EEA). Q10 Do you think that there should be stricter requirements on the minimum number of market makers, particularly when one of them is an affiliated entity of the ETF promoter? We refer to our response to Q6 and our proposed amendment, where we outline that the terminology should refer to authorised participant rather than to a market maker. That said, we agree that there should be a minimum of one authorised participant assuring that, through the creation and redemption mechanism in the primary market, the market price and the NAV are aligned With regard to the provision of market makers on the secondary market, we reiterate that this should be a provision mandated by the Exchange or MTF and should be regulated by the rules of the trading venue. We would highlight that on the LSEG s markets, each ETF is supported by at least one official market maker. Our rules mandate that registered market makers must display two-way prices continuously, within the applicable maximum spread and minimum quote size throughout the trading day. We do not agree that there needs to be a distinction made between third party authorised participants and authorised participants that are affiliated to the ETF promoter. Actively-managed UCITS ETFs Q11 Do you agree with the proposed guidelines in relation to activelymanaged UCITS ETFs? Are there any other matters that should be disclosed in the prospectus, the KIID or any marketing communications of the UCITS ETF? Yes, we agree that it is important for ETF issuers to be transparent in respect of product structures and to provide investors with the information they need to fully understand investment profiles and risks. Final Page 7 of 10
Secondary market investors Q12 Which is your preferred option for the proposed guidelines for secondary market investors? Do you have any alternative proposals? In our experience, investors that have bought an ETF on the secondary market rarely request the reimbursement from the issuer, even when this facility is available. This is mainly due to the difficulties of the administrative process and, consequently, to the related costs. We agree that in times of market disruption, it might be useful for unit/share holders to be able to redeem in the primary market. This provision already exists for ETFs distributed in Italy and is overseen by the Bank of Italy. For this reason we are in favour of option 2 of Box 5 in the Consultation Paper. However, we would suggest that investors should be made aware of the potentially high costs that they would incur by using this particular type of redemption. Redemption fees (either in the form of fixed fees or as percentage) are required by issuers for this service on the primary market, as well as a minimum number of shares required to be redeemed. This could be done through appropriate text in the prospectus Q13 Q14 Q15 With respect to paragraph 2 of option 1 in Box 5, do you think there should be further specific investor protection measures to ensure the possibility of direct redemption during the period of disruption? If yes, please elaborate. Do you believe that additional guidelines should be provided as regards the situation existing in certain jurisdictions where certificates representing the UCITS ETF units are traded in the secondary markets? If yes, please provide details on the main issues related to such certificates. Can you provide further details on the relationship between the ETF s register of unit-holders, the sub-register held by the central securities depositaries and any other sub-registers held, for example by a broker or an intermediary? No comment Final Page 8 of 10
IV. Efficient portfolio management techniques (Q16 31) We have not provided answers to the above questions in this section as we believe that these issues are best addressed by issuers and market participants. However, we agree that it is important for ETF issuers to be transparent about their product structures and that they should provide investors with the information that they need in order to understand fully the structures and risks across the product range. V. Total return swaps (Q32 38) No comment VI. Strategy indices Q39 Do you consider the proposed guidelines on strategy indices appropriate? Please explain your view. While we agree with ESMA s approach, which ensures that strategy indices can be treated as financial indices for the purposes of the UCITS directive, in order for them to be tracked by UCITS through swaps, it is not clear from the explanatory text, whether ESMA considers leveraged indices to be the same as strategy indices. Furthermore, we are unsure as to why ESMA has proposed more onerous requirements for strategy indices than those that would be required for financial indices. For example, in Box 8, ESMA requires that strategy indices must comply, not only with the requirements set out for financial indices, but also with further requirement such as: Point 6 Indices are not allowed to have daily rebalancing; Point 8 Mandatory publication of the constituents of the index; Point 12 Independent audit of the index; and Point 14 Independent valuation of the index Final Page 9 of 10
Q40 Do you think that further consideration should be given to potential risks of conflict of interests when the index provider is an affiliated firm of the management company? The common approach to manage any potential conflicts of interest that may arise is by making the relevant arrangements transparent and clear to all concerned and sometimes provided on an arm s length basis. So whether affiliated or independent, ETF issuers should be transparent as regards any strategy indices on which they rely and the management/operation of the indices. VII. Transitional provisions Q41 Do you consider the proposed transitional provisions appropriate? Please explain your view. Yes, we agree with the proposed transitional provisions. We believe that the guidelines should not be put into force immediately, so that UCITS providers have sufficient time in which to ensure smooth transition to the new rules. Final Page 10 of 10