New regulations that would govern the approval of ETFs in the US could cut costs and speed up the process for asset managers launching new products. Here’s what you need to know about why and how the SEC may soon revisit regulating ETFs.
The Securities and Exchange Commission (SEC) is revisiting a prior proposal that would streamline its approval process for exchange traded funds (ETFs) – a move that could bring some much-needed certainty for asset managers wishing to innovate in this space.
Unlike mutual funds, which are regulated by the Investment Company Act of 1940, there are no specific rules relating to ETFs. Instead, asset managers who want to launch new ETFs in the US must request exemptions from certain parts of the 1940 Act.
The SEC currently considers each new product on a case-by-case basis, which can lead to delays and extra costs tied to protracted legal debates if the product under review is complex or unique. The SEC is now said to be considering proposals that would set clear guidelines around the issuance and supervision of ETFs. Many hope this will reduce the cost and time to market for new entrants and level the playing field between managers who have been in the space for years and those new to the ETF market.
Well-framed, explicit regulation would improve certainty and predictability in the US ETF market, better facilitating growth and innovation. However, some might be concerned that the SEC could introduce prescriptive rules that would constrain certain portfolio strategies. Whatever the result, the question is not: will the SEC act? But rather, when will the SEC act and what will those rules look like?
ETF Regulatory Revival
In 2008, the SEC came close to laying a regulatory foundation for ETFs when it published a proposal to permit certain ETFs to begin operating without obtaining an exemptive order. But these plans fell off the list of regulatory priorities with the emergence of the global financial crisis.
More recently, the issue has come back into focus in the US. There have been some high profile, publicly debated applications for authorization within the US ETF segment. These applications describe new asset classes, like Bitcoin and other cryptocurrencies, and include innovative aspects that have not yet been deemed appropriate for retail investors.
Non-transparent or semitransparent portfolio usage and the use of custom baskets of securities instead of standard pro rata slices of the fund are some of the hotly debated ETF innovations currently being scrutinized by the SEC. However, the SEC has not approved custom baskets since 2012, when it mandated that all new ETFs must use pro rata baskets. A new, prescriptive ETF rule set would create a standard application process.
ETFs in the Spotlight
There are currently several global initiatives to review whether ETFs require their own specific regulations. Regulatory interest has been sparked by the phenomenal growth of ETF products across the globe. ETFs have also become increasingly more complex, adopting strategies like smart beta, active management, and emerging asset classes, like cryptocurrencies. This has encouraged regulators to look at whether the current rules provide sufficient investor protection.
Earlier this year, the Central Bank of Ireland published a discussion paper highlighting the distinctive features of ETFs. This followed similar ETF studies by other national regulators, and by the International Organization of Securities Commissions (IOSCO) and the Financial Stability Board (FSB).
In 2018, the European Securities and Markets Authority (ESMA) will execute an omnibus review of UCITS and AIFMD. It’s likely they will also look at whether ETFs need their own regulation or, at the very least, should be considered specifically within UCITS and AIFMD regulations. Standalone regulations seem unwarranted, but insertions into the UCITS rulebook are expected.
A Matter of Timing
Given increasing pressure from the industry and a general global regulatory focus on ETFs as a systemically important segment of the capital markets, it is possible the SEC will want to issue a proposal relatively soon – perhaps before the end of the year. Just last month, a US Treasury Department report stated that ETF regulations warranted review in order to “reduce cost and delay for new entrants.” We await an official announcement from the SEC, so asset managers will need to keep an eye open for the proposals and respond to the consultation in a timely manner.
The SEC already has the necessary expertise, having recently appointed Dalia Blass, a noted ETF specialist, as Director of the Division of Investment Management. Blass previously advised on the failed application of the Winklevoss Bitcoin Trust ETF, and was part of the SEC staff in 2008 when the original ETF proposals were framed. She also recently filed custom basket exemptive relief applications for several managers while working at a global law firm.
At this point, the SEC appears to be reviewing their 2008 proposal. But here are some key areas ETF managers and sponsors can expect under the proposed rules:
- Exemptive relief applications likely will not be necessary for future launches
- Managers may be allowed to use custom baskets under specific conditions provided their use is in the best interest of the ETF
- Any new regulation may define the parameters or set standards for disclosures related to semitransparent and non-transparent active ETF portfolios
- Portfolio liquidity may be scrutinized more heavily by the SEC
- “Self-indexers” may see additional conditions prescribed
- Elements of complexity such as inverse exposures, leverage, and novel asset classes (e.g: Bitcoin) may soon be allowed