I have just come back from Paris where I attended an open hearing on ESMA’s discussion paper on guidelines for UCITS Exchange-Traded Funds and Structured UCITS.
ESMA is an independent EU Authority that fosters supervisory convergence both amongst securities regulators, and across financial sectors by working closely with the other European Supervisory Authorities competent in the field of banking (EBA), and insurance and occupational pensions (EIOPA).
ESMA published a discussion paper in July 2011, offering stakeholders the opportunity to comment on the proposed guidelines. During the open hearing in Paris, stakeholders were invited to share any further remarks regarding these guidelines.
Generally, the participants were satisfied with the overall efforts made thus far by ESMA. However, there were two general remarks that were mentioned on several occasions during the hearing.
All headline grabbing buzz words that have been used lately in the press around the topic of exchange-traded products (ETPs) like systemic risk, synthetic replication, securities lending, transparency, etc. are applicable to many financial products and are not ETF-specific. Many ETP stakeholders are concerned that this has not been effectively communicated by regulators. In fact, some argue that many financial products are far less regulated than UCITS-compliant ETFs and yet remain far less scrutinised. Also, at the moment ETFs represent about 5-10% of the total AUM in European domiciled mutual funds. Their small size relative to funds, it is argued, make them unlikely to pose any sort of systemic risk. Furthermore, mutual funds--like ETFs--also use derivatives and engage in securities lending. These funds tend to be far less transparent than most ETFs but no one is complaining about it, some highlighted.
Another common remark made at the hearing was that there is a lack of clear and consistent definitions and guidelines within the industry, leaving each unique European regulatory body to interpret the existing guidelines differently and thereby making cross-border business very difficult and costly.
ESMA have proposed to split products into “complex” and “non-complex” products and to restrict the sale of complex funds to retail investors. This proposal opened the floor to a lively discussion around the definition of a “complex” product. Participants argued that some products using complex structures are very simple to understand whereas some products are very difficult to understand but employ relatively simple structures. It was also argued whether an investor only needs to know the risk/return profile of their investment or also how exactly the product is constructed.
One participant made an interesting analogy to a car engine. “Do you need to know exactly how the engine works or is it sufficient to know that it brings you safely from A to B--if used with caution?” Nevertheless, it is difficult to draw the line between “complex” and “non-complex” products and therefore a very precise definition would be required if any distinction is to be meaningful and ultimately enforceable.
In addition, ESMA suggested that ETFs should carry an identifier, which clearly marks them as ETFs. A further distinction should be made between synthetic and physical ETFs and actively-managed ETFs--a mandate that we endorse wholeheartedly.
The ETF providers present were seemingly all in favour of using an identifier to label products clearly as being ETFs (and not ETCs or ETNs). However, the synthetic ETF providers present at the hearing were against making the distinction between synthetic and physical ETFs and actively-managed ETFs more apparent. They argued that this would be very confusing for investors as there are different methods for physical replication (sampling/full) as well. These stakeholders voiced their preference for including one to two sentences about what ETFs are seeking to replicate and how they actually achieve their objective.
The topic of transparency split the audience once again, leading to another lively discussion. ESMA have proposed guidelines for additional transparency surrounding things like collateral, index constituents, securities lending etc. One stakeholder argued that ESMA is asking for too much. Index constituents should not be disclosed very frequently as it represents intellectual property. Also, such disclosure is not required by mutual funds. It was also argued that disclosing index methodologies should be sufficient. Participants not only raised legal concerns about such frequent disclosure but also argued that knowing the methodology is more important then knowing the exact constituents. On the topic of securities lending, it was argued that this is a very common practice within the financial industry and is not an ETF specific risk.
Another point receiving a good deal of attention was the definition of the tracking error. The audience asked for the establishment of a uniform definition of the tracking error as each European regulator interprets the existing guidelines differently and therefore each provider uses a slightly different definition; making the comparison of different ETFs following the same benchmark quite challenging. The stakeholders present dismissed the proposal of implementing a maximum tracking error as this would be difficult to achieve. Each market experiences a different volatility, each product uses a different structure and the latest market developments show that volatility is not constant. The audience rather pledged to disclose a measure of target tracking error for each ETF which could be breached during exceptional market conditions.
In summary, the most pressing need expressed by the stakeholders present at the ESMA hearing was clearer, more uniform definitions and regulations to help level the playing field for providers and investors alike.
ESMA will now go back to analyse the feedback received during the open hearing and prior to the hearing based on the questions in the discussion paper. After consolidating them, ESMA will publish a new version of its guidelines which will go through the same process before being finalised. We will continue to monitor these developments closely.
