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Regulators starting to tighten leash on ETFs

ETFs and Mutual funds

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Exchange traded funds are all the rage these days, and regulators have quickly realized that oversight hasn't kept up with the explosion.

Not only do regulators want to ensure that investors aren't getting screwed, they're also worried about the effects ETFs have on marketplace stability. The Bank of England recently pointed out that the complexity, opacity and interconnectedness of ETFs can "amplify propagate stress across markets." In layman's terms: they can really mess things up.

For that reason, the Financial Stability Board has already made some comments on the future of ETFs, and the International Organization of Securities Commissions -- the big global regulatory body -- has just put out a proposal for regulation of ETFs in hope of getting feedback.

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Some of IOSCO's proposals are straightforward, more or less masking the rules that already govern mutual funds. Example: making sure that ETFs sold to investors appropriately match the clients' risk appetites and investment objectives.

From there they start to get more complex. The more basic end of the spectrum centres on disclosure. At the moment, many investors are simply confused as to what an ETF actually is -- yes, really -- and it's only getting more confusing because more complex ETFs are created all the time. On this front, some industry members back the regulators, with BlackRock suggesting that only the simplest products should be classified as ETFs.

Then there is the issue of strategy disclosure. The first ETFs -- like SPDR -- merely held a basket of securities that replicated stock market indexes, such as the S&P 500. They've since become much more complex, such as leveraged ETFs, that offer clients two or more times the movement of the underlying index or commodity, like gold. One of the big problems is that investors don't know these strategies use derivatives, and are therefore designed to achieve their stated objectives on a daily basis. These ETFs get of whack if you hold them for months. So explaining this clearly instead of simply marketing 'two times the gains,' for instance, would help clear the air.

The more complex issues involve structure and counterparty exposure. If you want to dive into the details, check out the IOSCO document. But on the issue of structure, a growing number of ETFs are based on newly manufactured indices, rather than long-standing ones, such as the S&P 500. Regulators worry there are conflicts of issues when an index creator are affiliated with the corresponding ETF because non-public information could be shared. The current proposals suggest putting a wall up between the two.

As for counterparty exposure, synthetic ETFs could be in trouble if their swap counterparty defaulted, and right now there is no requirement for collateral to be of the same nature and quality of the securities that make up the tracked index. IOSCO's suggestion: "collateral should be prudently valued (i.e. at least daily, independently, and allowing for haircuts and discount rates to mitigate valuation uncertainties) and be sufficiently liquid and of high quality.

"By satisfying these conditions, in the event of the counterparty's default, the ETF may more easily find either a new counterparty to the swap contract, or turn to physical replication, or liquidate the basket of collateral to return monies back to investors at a limited discount."

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About the Author
Reporter and Streetwise columnist

Tim Kiladze is a business reporter with The Globe and Mail. Before crossing over to journalism, he worked in equity capital markets at National Bank Financial and in fixed-income sales and trading at RBC Dominion Securities. Tim graduated from Columbia University's Graduate School of Journalism and also earned a Bachelor in Commerce in finance from McGill University. More

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