Market participants have embraced a new set of guidelines on exchange-traded funds (ETFs) published by European watchdog the European Securities and Markets Authority (ESMA) this month, lauding the potential to improve transparency in the instruments.
ESMA’s guidelines, which follow on from a consultation the organisation held in January this year, set out the information that should be given to investors about index-tracking UCITS (funds for retail investors) and UCITS ETFs; they also set out the criteria for financial indices in which UCITS may invest.
“This review of ETFs has been a long time in coming,” said Steve Wood, founder of Global Buy-Side Trading Consultants and former global head of trading at Schroeder Investment Management. “As they get more convoluted, ETFs are effectively becoming structured products in some cases – and until now, they have often been slipping under the regulatory radar. I wouldn’t be surprised if ETFs were to be the source of the next big scandal in financial services.”
ETFs are baskets of securities normally benchmarked against an index. They offer investors a simple, low-cost means to gain exposure to a given asset class, set of securities or region without the time-consuming stock picking process. However, some observers pointed out over the past few years that the increasing complexity of some ETF products may be putting investors at risk.
ESMA published the guidelines following a review of the current regulatory regime, which was found to be “insufficient” to address the risks associated with these kind of funds and trading techniques. Under the new rules, UCITS that are classified as UCITS ETFs will have to carry the identifier UCITS ETF in their name, as well as ensure appropriate redemption conditions for secondary investors by opening the fund for direct redemptions when the liquidity in the secondary market is lacking.
For Wood, the rising complexity of ETF products has long concealed the potential for abuse. While pointing out that over-regulation could backfire if investors were inundated with too much information in the form of large regulatory documents, he suggested the need for a more open, more coherent picture of ETFs and their structures was genuine, and welcomed the new guidelines.
“These instruments may not do what it says on the tin,” he said. “Some investors are using ETFs because they don’t have a licence to trade futures. It’s important to improve transparency in these products. If ESMA’s guidelines help provide institutional and retail investors with greater clarity on what they are getting into, that is a very positive thing.”
ESMA is currently running a further consultation that will determine the appropriate treatment of repo and reverse repo arrangements in the context of the ETF guidelines. Once adopted by ESMA, the guidelines on repo and reverse repo arrangements will be integrated into the guidelines on ETFs and other UCITs issues in a single package. The consultation runs until 25 September 2012.