EFAMA RESPONSE TO THE IOSCO CONSULTATION REPORT ON PRINCIPLES FOR THE REGULATION OF EXCHANGE TRADED FUNDS EFAMA is the representative association for the European investment management industry. EFAMA represents through its 26 member associations and 59 corporate members approximately EUR 14 trillion in assets under management of which EUR 7.9 trillion was managed by approximately 54,000 funds at end March 2012. Just above 36,000 of these funds were UCITS (Undertakings for Collective Investments in Transferable Securities) funds. For more information about EFAMA, please visit www.efama.org EFAMA membership includes a very large proportion of the European investment management industry, as well as nearly the entire European ETF industry. EFAMA therefore fully supports initiatives to promote the understanding and increase the robustness of ETFs and other investment funds and welcomes the opportunity to comment on the principles proposed by IOSCO for the regulation of Exchange Traded Funds. I. General remarks Many of the issues raised in this Consultation Report are not specific to ETFs but also concern other CIS as well as other types of Exchange Traded Products (ETPs). In our view, the principles regarding disclosures and transparency of the assets of the fund (principles 3, 4, 5 and 7), securities lending, collateral and derivatives (principles 8 and 14) and marketing (principles 9, 10, 11 and 12) are not ETF specific at all. The vast majority of European ETFs are fairly simple products which aim at replicating the performance of an index and are subject to the UCITS regulatory framework that already adequately deals with many of the issues raised in this consultation report. This robust framework will also be further strengthened by the upcoming ESMA guidelines on UCITS ETFs and other UCITS issues. We therefore believe that it would be inefficient to regulate these issues specifically for ETFs and would encourage IOSCO to: Either restrict these guidelines to those principles that are specifically related to ETFs Or to extend the scope of these guidelines to all CIS except for the principles that are ETF specific (following the logical approach taken by ESMA in its guideline on ETFs and other UCITS issues). rue Montoyer 47, B 1000 Bruxelles +32 2 513 39 69 Fax +32 2 513 26 43 e mail : info@efama.org www.efama.org VAT Nr BE 0446.651.445
2 Furthemore, we respectfully question the relevance of the distinction made between socalled traditional (i.e. physical) and non traditional (i.e. synthetic) ETFs for the purposes of this consultation report and the principles IOSCO will issue for the regulation of ETFs. Such differentiation seems to be based on the perception that synthetic ETFs are more complex or more risky than physical ETFs which is not necessarily the case in practice. We are indeed convinced that the degree of complexity of an ETF (and indeed any CIS generally) is not related to the method used by a fund to replicate the performance of an index but rather to the fact that they use complex investment strategies (typical examples of such complex investment strategies may include inverse or leverage strategies). Differences, if any, in the regulatory treatment of different categories of ETFs (and other types of CIS) should therefore be based on these complex investment strategies rather than on the method they use to replicate an index. II. Comments on the proposed principles for the regulation of ETFs Chapter 2 Principles related to ETF Classification and Disclosure Principle 1 Regulators should encourage disclosure that helps retail investors to clearly differentiate ETFs from other ETPs. EFAMA strongly supports this principle. We fully agree with IOSCO s views on the need for appropriate disclosures to help retail investors to easily differentiate Exchange Traded Funds that are organized as collective investment schemes from other types of Exchange Products (such as ETCs, ETNs, ETIs or ETVs). In practice it may indeed be difficult for a retail investor to distinguish ETFs from other types of ETPs which, at least in Europe, are very often not subject to the same regulatory standards and therefore do not offer the same guarantees as ETFs in terms of investors protection (bearing in mind that the vast majority of EU domiciled ETFs are UCITS). Principle 2 Regulators should seek to ensure a clear differentiation between ETFs and traditional CIS, as well as between index based and non index based ETFs through appropriate disclosure requirements. Although we believe that the distinction between ETFs and other types of CIS is far less critical from an investor s protection viewpoint than the distinction between ETFs and other types of ETPs (for the reasons mentioned in our comments on principle 1), we have no objection against this principle. It is important to bear in mind that the vast majority of ETFs in the European Union are nothing more but nothing less than UCITS that are listed on a regulated market. We believe that these disclosure requirements are already covered to a large extent by the existing KIID and prospectus requirements for UCITS and will be usefully completed by the additional transparency requirements foreseen in the
3 ESMA guidelines on UCITS ETFs and Other UCITS issues which will be adopted in a near future (notably the use of an identifier for UCITS ETF ). Principle 3 Regulators should encourage all ETFs, in particular those that use or intend to use more complex strategies, or other complex techniques, 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 such strategies or techniques. EFAMA supports this principle but believes that it should apply to all types of CIS and not only to ETFs. Principle 4 Regulators should consider imposing disclosure requirements with respect to the way in which an ETF will replicate the index (or the asset basket or the reference portfolio) it tracks (e.g., physically holding a sample or full basket of the securities composing the index (or the asset basket or the reference portfolio) or synthetically). EFAMA agrees with this principle but, again, believes that it is not specific to ETFs and should apply to all types of CIS that seek to replicate an index and not only to ETFs. To the extent that the methodology chosen by an ETF (or any other CIS) to replicate an index forms an integral part of its investment strategy, we believe it should be adequately disclosed in the offering documents of the fund (prospectus or similar documents). Principle 5 Regulators should consider imposing requirements regarding the transparency of an ETF s portfolio or other appropriate measures in order to provide adequate information to investors concerning: i) the index (or the asset basket or the reference portfolio) tracked and its composition; and ii) the operation of performance tracking in an understandable form. EFAMA support these principles with the understanding that they should apply to all index tracking CIS and subject to the following comments: Concerning the transparency of the portfolio, IOSCO should bear in mind that providing all the components of the index on a real time basis may not always be possible as some index providers insist on the protection of their intellectual property rights on the proprietary indices they are developing. Therefore, a reasonable level of disclosure of the index constituents along with an appropriate time lag would, in our opinion, be sufficient; Concerning the criteria for the evaluation of performance tracking, EFAMA welcomes the definitions of Tracking Error and Tracking Difference proposed by IOSCO. Furthermore, we support the IOSCO proposition that any forward looking statements on the anticipated level of tracking error should not be perceived as a legal commitment or a hard limit which
4 would apply under any circumstances (even under extreme market conditions) therefore raising liability related issues for fund providers/distributors. The tracking error may vary from time to time depending on a range of circumstances (liquidity in the market, taxes applied on the underlying securities, etc) and the ex post tracking error may therefore significantly deviate from ex ante figures. Principle 6 Regulators should consider imposing requirements regarding the transparency of an ETF s portfolio or other appropriate measures in order to facilitate arbitrage activity in ETF shares. EFAMA agrees with this principle (see however our comments on Principle 5). Principle 7 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. EFAMA agrees with this principle and believes that, as a general rule it should apply to all CIS. In that context, we believe that the disclosure of the fees in the KIID for UCITS is a good example of best practice which could be used as a model for other CIS as well as other types of financial products sold to retail investors (in the spirit of the Packaged Retail Investors Products (PRIPS) initiative in Europe). Principle 8 Regulators should encourage disclosure requirements that would enhance the transparency of information available with respect to the material lending and borrowing of securities. As IOSCO rightly notes in its Consultation Report, securities lending is by no means an activity which is particular to ETFs. Many other CIS, not to mention other market participants, engage to a certain extent in securities lending. Consequently, we firmly believe that any disclosures specifically relating to the lending and borrowing of securities should not be limited to ETFs but apply on an equal footing at least to all collective investment schemes (and arguably to other market participants engaged in the same type of activities) in order to ensure a level playing field. An approach limited to ETFs might prompt a wrong perception of costs incurred in other investment funds and thus create a distortion of competition to the detriment of ETF providers. Furthermore, if IOSCO s policy objective is to enhance the transparency of information made available in respect of securities lending activities generally, limiting the application of such requirements to ETFs alone would only partially achieve this objective.
5 Chapter 3 Principles related to Marketing and Sale of ETF shares As a preliminary remark on Principles 9 to 12, EFAMA does not clearly understand the reasons for which IOSCO believes there is a need to discuss marketing and sales standards specifically in relation to ETFs. In our opinion, provisions for marketing and sale of ETFs should be part of a global distribution framework for financial products in general and not differentiated from the requirements applicable to other CIS and other types of competing financial products. Principle 9 All sales materials and oral presentations used by intermediaries regarding ETFs should present a fair and balanced picture of both the risks and benefits of such products, and should not omit any material fact or qualification that would cause such a communication to be misleading. Subject to our preliminary remark above, EFAMA agrees with this principle. Principle 10 In evaluating an intermediary s disclosure obligations, regulators should consider who has control over the information that is to be disclosed. Subject to our preliminary remark above, EFAMA agrees with this principle. Principle 11 Before recommending the purchase, sale or exchange of an ETF, particularly a nontraditional ETF, an intermediary should be required to take reasonable steps to ensure that recommendation is based upon a reasonable assessment that the product is consistent with such customer s experience, knowledge, investment objectives, risk appetite and capacity for loss. EFAMA agrees with this principle which is already consistent with the rules on financial intermediation in the EU (MiFID Directive) through the suitability test in relation with the provision of investment advice. However, as already mentioned in our introductory remarks, we do not see any particular reason to single out non traditional (i.e. synthetic) ETFs in this context. Such differentiation seems to be based on the perception that synthetic ETFs are more complex or more risky than traditional (i.e. physical) ETFs which is not necessarily the case in practice. We are indeed convinced that the degree of complexity of an ETF (or indeed any CIS generally) and therefore the need to take the necessary steps to make sure it is understandable by a retail investor is not related to the method used by a fund to replicate the performance of an index but rather to the fact that they use complex investment strategies (examples of such complex strategies may include inverse and leverage). Principle 12 Intermediaries should establish a compliance function and develop appropriate internal policies and procedures that support compliance with suitability obligations when recommending any ETF.
6 EFAMA has no objection against this principle but believes that it is not specific to ETFs and should be applied with a degree of proportionality depending on the size and the legal status of the intermediary to which it applies. Indeed, the establishment of a compliance function is not appropriate to the situation of individual financial advisers being natural persons not integrated in a corporate distribution structure. We would therefore recommend including this notion of proportionality in Principle 12 and, to that effect, we would suggest the following wording: Where appropriate in view of the nature, scale and complexity of their business, intermediaries should establish a compliance function and develop appropriate internal policies and procedures that support compliance with suitability obligations when recommending any CIS Chapter 4 Principles related to the Structuring of ETFs Principle 13 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. EFAMA has no objection against this principle as such but we have major reservations against the means of implementation envisaged by IOSCO to put this principle in practice. More specifically: Creation of custom index by an ETF affiliate: We disagree with the idea that there would be an inherent conflict of interest when the index provider is an affiliated firm of the management company or even the management company itself. Provided that the prospectus is clear about what the management company (or its affiliate) is doing we do not see any particular issue in this respect. To the contrary, we believe that fund management companies should have the right and even be encouraged to create and manage indices themselves. In this context, we are very concerned by the suggestion made by IOSCO requiring firewalls between the staff responsible for the creation, development and modification of an index and the portfolio management team. Development of indices would be virtually impossible without the involvement of the portfolio managers whose investment objectives and strategy form the necessary basis for the index compilation. Furthermore, we do not understand why IOSCO is proposing such strict measures of independence for the entities responsible of the index maintenance and calculation, bearing
7 in mind that the relevant calculation methodology is governed by objective and publicly available criteria and should therefore not generate conflicts of interest. Affiliation of the primary AP with the ETF provider: We disagree with the proposition that the primary AP should not be affiliated with the ETF provider. Furthermore, we see no point in requiring a minimum number of APs for ETF trading as such measure would not, in our view, improve the disposal opportunities for ETF investors. In this context, IOSCO should be aware that European ETFs structured as UCITS offer their investors also direct redemption opportunities in addition to secondary trading. Clearly, this already puts investors in UCITS ETFs in a superior legal position compared to unit holders of traditional investment funds. Securities Lending: Requiring ETF providers to obtain quotes from non affiliates on a continuous basis in order to ensure fairness of fees is not practicable. The market for securities lending in its current shape is quite opaque and limited to a handful of agents who as a rule are not willing to disclose their conditions for transacting without specific business prospects. In our opinion, market conformity checks on transactions conducted ex post are suitable, but also sufficient, to ensure that fees charged for securities lending are fair and reasonable. Principle 14 Regulators should consider imposing requirements to ensure that ETFs appropriately address risks raised by counterparty exposure and collateral management We agree with this principle but we believe that it should apply to all types of CIS, not only ETFs. In Europe, virtually all measures suggested by IOSCO for risk management by synthetic and physical ETFs are already in place under EU law. Chapter 5 Issues broader than ETFs Principle 15 ETF exchanges should consider adopting rules to mitigate the occurrence of liquidity shocks and transmission across correlated markets (e.g. automatic trading interruption mechanisms) EFAMA welcomes this principle to the extent that such rules would enhance financial stability (we are not convinced, however, that automatic trading interruption mechanisms are always the most appropriate tool to prevent liquidity shocks). This being said, as IOSCO rightly points out, the issue of liquidity shocks is related to capital markets in general more than to ETF in particular. Liquidity shocks may appear on any market and they will materialize through the financial instruments that is leading the concerned market.
8 III. Comments on specific concerns raised by TCSC5 in the Consultation Report Are there particular financial stability concerns raised by ETFs that are not addressed by this paper? Are there particular counterparty risks raised by ETFs? If so, should the FSB or the Joint Forum carry out further work to address counterparty risks? EFAMA is fully supportive of the objectives pursued by the Financial Stability Board and other international bodies such as the IOSCO and the European Commission to identify and close any regulatory gaps as well as inefficiencies in the supervision of the financial sector in general, with a view to mitigating systemic risks and reducing the possibilities of regulatory arbitrage. However, we are not aware of any financial stability risks which would be specifically raised by ETFs. In this respect, we wish to underline that the FSB, in its latest publications on shadow banking ( FSB report with recommendations to strengthen oversight and regulation of shadow banking 1 published in October 2011 and Progress report to the G20 on strengthening the oversight and regulation of shadow banking 2 published in April 2012) does not make any recommendation of regulatory actions in relation specifically to ETFs. From a European perspective, we also wish to reiterate the fact that the vast majority of ETFs in the European Union are nothing more but nothing less than UCITS that are listed on a regulated market. As such, ETFs in the European Union like any other UCITS are already subject to one of the most respected and widely recognized frameworks for public investment funds. This robust product regulation already addresses to a very large extent the concerns raised by the FSB in relation to ETFs regarding potential conflicts of interest, synthetic exposure, securities lending and the use of collateral (as further detailed in EFAMA s reply to the Financial Stability Board s Note on Potential financial stability issues arising from recent trends in Exchange Traded Funds 3 ). Furthermore, we support the current review of the UCITS framework carried out by ESMA aiming at introducing common EU standards for securities lending by UCITS and enhancing the requirements for collateral to be delivered to the fund. In our view, this review will further improve the quality of all UCITS products, including UCITS ETFs. However, it is important to bear in mind that the discussions at ESMA are being led with reference to the UCITS framework in general and are not limited to ETFs. Indeed, investment techniques commonly used by ETFs, in particular securities lending and derivative (swap) transactions are not specific to ETFs and can also be found in other types of investment funds. Hence, the only regulatory measures considered by ESMA in relation to ETFs concern their unequivocal labelling and adequate arrangements to ensure effective redeemability of fund units (which is of little relevance in the context of shadow banking and potential systemic risks). 1 http://www.financialstabilityboard.org/publications/r_111027a.pdf 2 http://www.financialstabilityboard.org/publications/r_120420c.pdf 3 Available at http://www.efama.org
9 We hope our comments will be helpful to IOSCO and obviously stand ready to provide any clarifications that may be required or to engage in further discussions on the subjects at hand. Brussels, 27 June 2012 [12 4034]