At the EDHEC-Risk Days Europe conference in London on March 27, a roundtable discussion on ETF regulation, bringing together a number of key stakeholder groups, served as a useful overview of many of the questions currently being asked about how best to supervise and regulate the ETF marketplace.
Panellists were Tony Hanlon and Clement Boidard, of the Financial Services Authority (FSA) and the European Securities and Markets Authority (ESMA) respectively, to represent the regulators. Representing the fund providers were Alain Dubois, Chairman of Lyxor, and Scott Ebner, Global Head of ETF Product Development for SPDR ETFs. Representing institutional users of ETFs were Gian Luigi Costanzo, Chairman of Generali Fund Management, and Jaime Martinez Gomez, CIO of Fonditel. Pedro Fernandes, Head of ETPs Europe for NYSE Euronext, provided the view from the securities exchanges, and Frederic Ducoulombier, Director of the EDHEC Risk Institute in Asia, the view from academia.
There was general agreement that transparency across all UCITS funds should improve, and that ETFs have been a leader in the progress that’s already been made on that front. But what the discussion also made clear is that there are still some open questions about how and where to draw lines in the sand about what information investors should have, and about how to monitor and regulate all of the ancillary activities tied into the ETP industry.
Hanlon, who is Manager of the Asset Management Sector for the FSA, identified the three greatest sources of risk for ETFs as stemming from the naming of products, conflicts of interest, and operational risk. Fund taxonomy is crucial as it’s often all an investor uses to understand what they’re buying, and the factors he stressed might need addressing through a naming convention include whether a fund is UCITS-regulated or not, whether it involved a complex strategy such as leveraged, inverse, or customised exposure, whether the fund uses physical or synthetic exposure, and indeed what stock lending or collateral policies are applied. As key sources of conflicts of interest in ETFs he cited the division of stock lending revenue between the investor, the provider and the lending agent, and also in the fund’s dealings with affiliates of the provider acting as market maker or swap counterparty. And the main operational risks included trading errors, the demands of daily liquidity, and settlement delays.
Hanlon also expressed concern over the practise of securities lending in synthetic ETFs. This is an area that’s not often talked about; in general it is the physical funds whose securities lending is highlighted as a risk, as was mainly the case on this panel . In most cases any securities lending activity facilitated by synthetic products is done at the bank level, behind the scenes, not by the fund itself. It’s true there could be systemic risk in this, which is why it’s understandable that the regulators would be concerned, and it may have some limited effect on the lending bank’s solvency. But it’s not a direct risk for investors in synthetic ETFs, as their exposure is to the swap counterparty, not to the specific risk that the counterparty’s stock loans go sour. As such it’s probably more an issue for banking regulation than ETF regulation.
Clement Boidard, Policy Officer for ESMA, echoed many of the findings of ESMA’s recent consultation paper, including that more information is needed on fund-level securities lending activity in physical ETFs, specifically on the collateral being used to secure the loans. Another concern he had was over the growth of ETFs tracking black-box strategy indices, in some cases where a swap counterparty is responsible for providing a series of returns, and even the fund manager may not be fully aware how the strategy works or the returns to expect.
EDHEC’s Ducoulombier felt transparency around the structure would be welcome, but that it’s not enough without accompanying safeguards. Limits on counterparty risk should be consistently applied across all ETF structures, not just synthetic funds. This makes sense, as there are currently no limits on the amount of securities lending, and hence counterparty risk, that a physical fund can take on. Ducoulombier’s view was that on its own, a naming convention with markers to signify the replication method would have a net negative effect, possibly frightening investors needlessly from certain funds and instilling a false sense of security with respect to others, without regard to the actual risks or tactics to mitigate them.
As important as the issues discussed was a big question that went unanswered by anyone on the panel. From the audience, EDHEC Risk Institute Director Noel Amenc voiced the problem that no matter how much disclosure you achieve on the risks of a fund, there is still no clarity or consistency on how the compensation for taking on those risks should be distributed, and whether ETF investors are being adequately protected and fairly treated on that front. We have raised similar points in the past, arguing for example that since in most cases investors are taking all of the risk from the lending of the fund’s securities, they should receive all of the associated revenue.
