This post provides highlights of IOSCO’s consultation paper on ETFs published Wednesday, March 14. The short version is that there isn’t much new here; this is largely a rehash of other government ETF white papers and reports issued over the last two years. Some of the nuances are more developed however. Readers interested in a closer dissection of the major issues for securities finance and collateral management should check out Finadium’s September 2011 report here.
Disclosure
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.
Means of implementation:
Regulators might address this concern by requiring an ETF to provide disclosure in its prospectus, in offering documents, or in other disclosure documents, that reflects its actual operations, particularly its use of complex strategies, investments in derivatives, or securities lending agreements.
ETFs also may engage in securities lending activities. In the case of index-based ETFs, such activities may result in returns that can partly offset the ETF’s management fee, helping the ETF to better track its benchmarks and may, subject to the split of revenues from such activities between the ETF operator and the ETF’s shareholders, therefore improve the ETF’s performance.
Transparency
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.
While the FSB noted concerns with regard to ETF securities lending, this issue is not specific or inherent to ETFs, but to a much broader scope of products and/or activities. Moreover, the scope and scale of ETF securities lending activity differs across jurisdictions and even among ETFs within the same jurisdiction. In some jurisdictions, there are restrictions on the amount of securities that may be loaned. In other jurisdictions where a significant amount of securities may be loaned, regulators could require specific disclosure, for example, to help to manage conflicts of interest that could arise when such revenues accrue (at least in part) to the ETF’s operator. Such disclosure should be designed to help investors understand whether revenues are received by parties other than the fund or its investors (e.g., a lending agent). Such disclosure arguably becomes even more significant where ETFs are marketed to retail investors as having low (or no) management fees. Another option, if securities lending revenue represents a significant source of return, would be to require disclosure of gross returns from securities lending from other sources of fund income designed to allow investors to assess how such revenues have contributed to the performance of the ETF and to assess the efficiency of the ETF’s operator in distributing such revenues to other service providers such as a securities lending agent. Such disclosure would allow the ETF’s operator to inform, investors about the major trade-offs the ETF may have to balance when handling such revenues or how such revenues might be shared between the ETF and its operator. Such additional disclosure might also be desirable when dividend management leads to specific tax treatment and/or to risk-return trade-offs that may materially impact the ETF’s performance (e.g., when the ETF’s operator manages dividends actively by using, for instance, dividend options). In addition, it could help investors to assess counterparty risks to which they may be exposed, especially when an ETF lends its assets in order to optimize its returns.
Conflicts of Interest
Conflicts of interest also may arise in the context of securities lending if the lending agent is an affiliate of the CIS. For example, the lending agent could charge the CIS fees that are higher than it charges to non-affiliates or provide services, the nature and quality of which are not as high as to those provided by other unaffiliated service providers.
With regard to securities lending, regulators could require the CIS operator to obtain quotes from non-affiliates or otherwise ensure that fees are fair and reasonable and that the affiliate can provide services equal to those provided by non-affiliates.
Physical replication ETFs
Additionally, jurisdictions might consider requiring appropriate disclosure of ETFs risk management policies with regard to securities lending, as well as of their lending agent(s).
Question for the consultation: Are there particular financial stability concerns raised by ETFs that are not addressed by this paper?
a) Securities lending
Securities lending is not exclusive to ETFs or even to CIS but rather occurs on a global scale in other areas of the financial industry, and its systemic implications remain to be better quantified. Greater recourse to securities lending could raise concerns in the absence of appropriate safeguards as to counterparty and liquidity risks, which would tend to materialise particularly in the presence of liquidity shocks. For instance, [in some jurisdictions,] where securities lending is particularly prevalent, there could be a risk of a market squeeze in the underlying securities if lenders were to suddenly recall on-loan securities on a large scale in order to meet redemptions. Such trends have also recently prompted the new European Securities and Markets Authority (ESMA) to draft new policy orientation guidelines on these matters. In this regard, the FSB is currently working on a set of policy recommendations in the area of shadow banking, with a work steam also dedicated to study the systemicimplications of securities lending and repo well beyond the ETF/fund management industry.