Why did IOSCO release these principles? What was the aim?
The growth in exchange-traded funds (ETFs) globally has drawn the attention of regulators around the world. Various market participants have expressed concern about the potential impact of ETFs on investors and the marketplace. The International Organization of Securities Commissions (IOSCO) is aiming to provide both the industry and regulators with a set of principles to assess the quality of the regulations and industry practices concerning ETFs. The focus of these principles is to provide a common framework to help regulators assess and govern ETF activities within accepted boundaries, which in turn will provide confidence to investors and other stakeholders.
One principle encourages the disclosure of related fees and expenses, including the eventual impact of securities lending on these—how might regulators interpret this?
Regulators might interpret IOSCO’s guidance as supporting disclosure of securities lending splits, which would result in lending agents’ fees being disclosed to the street. Arm’s length lending agents might take some issue with this section, as they will likely see it as being in response not to their own practices, but to the small number of ETF providers lending their own books of business—in turn creating concern among ETF investors regarding fee splits.
While investors and funds on first brush might be keen to see disclosure of lending fees and splits, there are also potential issues that run counter to their interests. There are good reasons for lending agents to have different fees for different clients, for example, the amount or type of lendable assets affect the value of the lending portfolio. If disclosure of splits becomes a requirement, lending agents could be forced to standardise. If regulators do choose to go down this road, it will be important to ensure that ETFs and other funds face a level playing field with consistent standards.
What have ETF providers and their lending agents done in this regard already?
From a Canadian perspective, there are strong regulations governing securities lending for ETFs and other mutual funds, which provide funds and their investors with significant assurances regarding what is permitted in terms of fund activities, including securities lending. Of course, regulators do grant exemptions to various rules on a case-by-case basis, for example, allowing ETF providers or their affiliates to act as their own lending agents or allow third-party lending. These situations could potentially affect some of the protections for funds and investors. It is up to ETF providers to fully disclose their activities, and to ETF investors to inform themselves regarding any exceptions a given fund may have received.
There seems to be a focus on retail investors in the report—how do ETF providers market their ETFs to retail investors, and what do they tend to tell them about securities lending activity? Is informed consent possible, and why?
In Canada, ETF providers cannot sell directly to retail investors, so they market to retail investors through registered advisors. Securities lending activities are not new tools; mutual funds have been lending for years. The status quo will likely continue in terms of disclosure requirements. In terms of expanding awareness, the securities lending industry has taken some good steps towards expanding public awareness that securities lending provides various market benefits related to liquidity, price discovery and so forth. The Canadian Securities Lending Association has been particularly effective in this regard.
Specific disclosures related to lending—and the informed consent associated with them—are generally contained in offering documents and other financial reports, which disclose to investors whether or not an ETF or mutual fund is allowed to engage in securities lending, as well as the fees earned by the funds through lending. Securities lending revenue is paid to funds net of agent fees for providing the lending service. These service fees cover a number of activities depending on the type of lending arrangement, for example: ensuring the funds seeking to lend are compliant with relevant regulations; performing due diligence on borrowers; managing collateral; and, providing indemnities against certain risks associated with the lending programme.
How does IOSCO address counterparty exposure and collateral management in its report?
IOSCO’s guidance speaks to a various concerns, such as overexposure to a single counterparty or transacting with related parties. There is also a focus on the quality of the collateral provided, and an intent to ensure it is of the same nature or quality as the securities making up the reference index or benchmark. The guidance will likely encourage regulators in markets around the world to ensure that strong rules are in place around such activities. Here in Canada, strong rules are already in place regulating counterparty exposure and collateral quality under NI 81-102, the regulations governing Canada’s ETFs and mutual funds
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