John McGuire, Partner at Morgan, Lewis & Bockius, explains the recent US regulatory developments that will have the greatest impact on the ETF market.
The SEC has proposed a number of rule changes in the last year. Of those, which are most relevant to ETFs?
Since ETFs are registered investment companies, just like mutual funds, all the SEC rule proposals focusing on mutual fund regulation are going to affect ETFs. I think the two that will have the biggest impact on ETFs are:
- Proposed requirements on a funds’ use of derivatives and other financial transactions
- Proposed liquidity risk management rules
What’s the background on the proposals that are most relevant to ETFs?
Neither proposal primarily focused on ETFs, but neither proposal excluded ETFs either. In the case of the derivatives proposal, it comes more than four years after the SEC issued a Concept Release on funds’ investments in derivative instruments. The proposal would effectively replace a patchwork of SEC Staff positions that has evolved over the last thirty-five years. The derivatives proposal is a comprehensive approach of proactive oversight that is intended (among other things) to limit funds’ economic exposures that result from derivatives investments and other financial transactions. In support of their proposal, the SEC cited a concern for potential losses in funds that make extensive use of derivatives.
In the case of the liquidity risk management proposal, this comes after lingering concerns about liquidity dating back to the 2008 financial crisis. The SEC cited the rise of fund strategies that rely on securities that tend to be less liquid, such as high-yield bonds, emerging market securities, and alternatives
What could be the implications of the new proposals?
The derivatives proposal would regulate fund investments in derivatives in three ways:
- By imposing certain portfolio limitations on leverage, which would act to limit the exposure a fund may obtain through derivatives.
- By requiring assets to be segregated and significantly limiting the types of assets that can be used for segregation.
- By requiring certain funds to adopt a formal derivatives risk management program.
For ETFs, most of the focus has been on possible impact on certain leveraged ETFs. While it may have some impact on leveraged ETFs, I think most ETFs have to be concerned about the limitations that may be put on assets that can be segregated to offset a derivatives position. This could impact directly any ETF that uses derivatives either to get direct investment exposure or as a hedge, such as a currency hedged ETF, but does not generally hold a lot of cash. Fortunately, I don’t believe that was the SEC’s intent, so I am hoping that this gets fixed in any final rules.
With respect to the liquidity risk proposal, applying certain aspects of it to ETFs seems a bit misplaced. The proposal would require funds to classify their holdings in “liquidity buckets” based on how quickly the securities can be converted to cash. This would seem to be a waste of time and effort for ETFs, which simply do not have the same need to convert assets to cash. ETFs that transact almost exclusively in-kind have virtually no need to convert their holdings to cash in order to meet redemptions.
This seems like a shift in the SEC’s approach, what brought this about?
The financial crisis of 2008 and the increased influence of the banking regulators since then have moved the SEC away from their traditional focus of disclosing risks and more toward controlling risks. It is all a bit ironic given that mutual funds and ETFs, as opposed to banks, weathered the financial crisis pretty well.
Do you foresee further SEC rules on ETF regulation? If so, what else do you think they will look at?
We will definitely see more ETF regulation. Just recently the SEC approved generic listing standards for actively managed ETFs listed on BATS and NYSE Arca, which was a very positive regulatory step. The most obvious and needed future ETF rule, would be adopting a rule that affirmatively permits ETFs. Currently, every ETF must obtain and rely on an SEC exemptive order to exist. Resources would be much better spent adopting a rule, rather than issuing hundreds of exemptive orders.
About John McGuire
W. John McGuire is a partner at Morgan, Lewis & Bockius LLP, based in its Washington, DC office, and heads the firm’s registered funds practice. He concentrates on investment company and investment adviser regulatory issues, including development of new products and services; federal and state registration and compliance issues; mergers and acquisitions involving investment companies and investment advisers; interpretive and “no-action” letter requests; SEC exemptive orders; and related mattersincluding development of new products and services; federal and state registration and compliance issues; Securities and Exchange Commission (SEC), FINRA, and state investigations and enforcement actions; mergers and acquisitions involving investment companies and investment advisers; interpretive and “no-action” letter requests; SEC exemptive orders; and related matters..
John routinely handles matters involving the establishment, representation and counseling of exchange traded investment companies (ETFs), their advisers and listing markets. He has worked on several of the key ETF legal milestones, including the first fixed-income ETFs, the first Section 12(d)(1) relief for ETFs, actively managed ETFs, leveraged and inverse ETFs and the first ETFs in a master-feeder structure.
Before entering private practice, John served on the staff of the SEC in its Investment Management Division. He regularly speaks at industry conferences and has authored or co-authored several articles covering a wide variety of securities regulatory issues and the books Mutual Fund Regulation and Compliance Handbook and Regulation of Exchange-Traded Funds.
The positions expressed in this material are those of the author as of 8/12/16 and may or may not be consistent with the views of Brown Brothers Harriman & Co. and its subsidiaries and affiliates (“BBH”), and are intended for informational purposes only. Information contained herein is based upon various sources believed to be reliable and subject to change without notice. Furthermore, these positions are not intended to predict or guarantee the future performance of any currencies or markets. This material should not be construed as research or as investment, legal or tax advice, nor should it be considered information sufficient upon which to base an investment decision.