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ESMA refines proposed framework to deal with complexity of ETFs and other Ucits

Friday, February 3, 2012 by Olivier Sciales

The European Securities and Markets Authority has published on January 30 a consultation paper proposing future guidelines for exchange-traded funds established as Undertakings for Collective Investment in Transferable Securities and other issues related to the Ucits regime.

The Esma proposals cover both physical ETFs, which replicate the performance of stock, bond, commodity, currency or other indices by holding shares or other securities in the proportions that make up the index in question, or a sample thereof, and synthetic ETFs, which use swap transactions to obtain the economic performance of the index, using a basket of securities as collateral.

The consultation paper, ESMA/2012/44, proposes regulatory requirements covering Ucits ETFs, other index-tracking UCITS, efficient portfolio management techniques, total return swaps and strategy indices, which seek to replicate a quantitative or trading strategy.

The proposals envisage additional obligations regarding collateral where any Ucits funds, not just ETFs, use total return swaps, tighten the eligibility criteria for investment by Ucits in strategy indices, oblige Ucits ETFs to identify themselves as such, and seek to facilitate the redemption of ETF shares by investors directly with the fund’s provider or on a secondary market.

A Ucits ETF is defined as “a Ucits, at least one unit or share class of which is continuously tradeable on at least one regulated market or multilateral trading facility 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.”

According to chairman Steven Maijoor, Esma has drawn up the proposals in response to concerns about the increasing complexity of ETF products marketed to retail investors, which involve investment strategies and risks far removed from the simple replication of well-known indices covering highly liquid markets.

Regarding a mooted distinction between complex and non-complex Ucits, Esma says it will wait for the outcome of negotiations on the revised MiFID directive, on which the European Commission has proposed removing structured Ucits from the scope of instruments automatically categorised as non-complex.

The guidelines have been broadened to reflect 65 responses to a discussion paper issued by Esma in July 2011, which urged the authority to cover not only ETFs but all Ucits engaged in securities lending or tracking an index.

The discussion paper on policy orientations on Ucits ETFs and Structured Ucits (ESMA/2011/220) examined possible measures to mitigate the risk of highly complex products that might be difficult to understand and evaluate being made available to retail investors, the potential systemic risk such funds might cause, and their impact on financial stability.

Esma proposes that all Ucits exchange-trade funds be obliged to use ‘ETF’ in their name as an identifier, and that investors should be provided with additional information about the investment policy and valuation of actively-managed ETFs that do not track an index or seek to outperform one.

It is also seeking feedback on an appropriate regime for secondary market dealings in ETF shares. For example, one option is that that a Ucits ETF or its management company should replace the market-maker if it is no longer willing or able to act as such, and if necessary make arrangements for investors to sell shares directly back to the fund or manager if redemption in the marketplace is disrupted. Alternatively, investors could be given the right to redeem their shares directly with the ETF at any time.

The consultation paper proposes that index-tracking ETFs disclose through their prospectus the index being tracked and details of its components, the means by which it replicates the index and its implications, for example counterparty risk in the case of synthetic ETFs, the degree of tracking error exhibited by the fund and the factors likely to affect this, such as transaction costs, liquidity and dividend reinvestment.

Esma says index-tracking leveraged ETFs should disclose their leverage policy, its costs and risks, and the impact of short exposure combined with leverage.

Esma recommends that collateral posted to mitigate counterparty risk in securities lending transactions should comply with the criteria set out in the July 2010 guidelines of the Committee of European Securities Regulators on Risk Measurement and Calculation of Global Exposure and Counterparty Risk for UCITS (CESR/10-788), as well as the strengthening of diversification and haircut criteria.

These requirements would also apply to repo and reverse repo activities. This is designed to ensure that collateral posted in the context of efficient portfolio management techniques should respect the Ucits diversification rules, and that Ucits should have a documented and appropriate haircut policy for each category of assets received as collateral.

Esma proposes that all Ucits investing in total return swaps be subject to the same obligations on collateral management as with securities lending. On Ucits investing in strategy indices, it mostly follows the proposals in the 2011 discussion paper on eligibility of indices, including the 20/35 per cent diversification requirement, disclosure to investors and due diligence to be carried out by the Ucits.

The authority also reiterates the need to tackle issues such as the sale of complex ETFs to retail investors and the absence of harmonised regulation on the manufacturing and management of these products.

Esma also says it will consider whether and how guidelines agreed for Ucits can be applied to regulated non-Ucits funds established or sold within the EU and the establishment of harmonised definitions covering all exchange-traded products.

The consultation paper calls for industry members and other stakeholders to submit comment on the draft guidelines by March 30. The final guidelines should be ready for adoption by mid-2012 and apply to any new investment made, collateral received, or document or marketing communication issued after that date. Requirements relating to information to investors and the general public, including a fund’s Key Investor Information Document, will take effect at the latest 12 months after the guidelines are adopted.