IOSCO addresses impact of ETF regulation on lending
25 June 2012 Madrid
Image: Shutterstock
Large ETF providers in some jurisdictions have substantially increased the disclosure to investors regarding the collateral held and the use of securities lending, as well as the management of counterparty risk, said IOSCO.
The board of the International Organisation of Securities Commissions has published its final report on principles for the regulation of exchange-traded funds, containing nine important principles intended to guide ETF regulation.
There has been a sharp increase in funds invested in these types of products, with assets managed under ETF structures totalling almost $1.9 trillion at the end of January 2013, representing roughly 7 percent of the global mutual fund market.
The growth has naturally attracted the attention of regulators, which are concerned about the potential impact of ETFs on investors and on the broader marketplace as the industry continues to launch new products.
IOSCO’s principles address ETFs that are organised as collective investment schemes (CIS) and do not apply to other, non-CIS, exchange-traded products (ETPs).
One principle encourages the disclosure of related fees and expenses, including the eventual impact of securities lending on these, as well as the accurate and understandable disclosure to address the types of risks investors may be exposed to particularly through ETFs using complex strategies that may involve the use of leverage (or reverse leverage).
“Similar to other CIS, ETFs also may engage in securities lending activities,” said the IOSCO report. “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 more closely achieve the performance of its reference index and may, subject to the split of revenues from such activities with the securities lending agent, which could be the same entity as or an affiliated entity of the ETF operator and the ETF, [and] therefore improve the ETF’s performance.”
The scope and scale of ETF securities lending activity differs across jurisdictions, and even among ETFs within the same jurisdiction, said the report.
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 inform investors about conflicts of interest that could arise when such revenues accrue (at least in part) to the ETF’s operator.
The report gives an example of a significant industry player who, in June 2012, introduced a 50 percent limit on the amount of assets that one of its European ETFs can lend out to a third party—well below the maximum permitted by current European regulations (100 percent).
In parallel, the company also decided to provide an indemnity, so that investors would not face financial losses in the case of a default by a counterparty to a securities lending transaction involving one of its ETFs.
“In this sense, in those jurisdictions where there are not restrictions on the amount of securities that may be loaned, such disclosure should be designed to help investors understand whether revenues are received by parties other than the ETF or its investors (eg, a lending agent),” said IOSCO.
“Such disclosure arguably becomes even more significant where ETFs are marketed to retail investors as having low (or no) management fees. If securities lending revenues represent a significant source of return, another option would be to require disclosure of gross returns from securities lending from other sources of fund income.”
The statement went on to clarify that this would 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 involved (eg, securities lending-agents)
These disclosures 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 (eg, 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 optimise its returns.”
The board of the International Organisation of Securities Commissions has published its final report on principles for the regulation of exchange-traded funds, containing nine important principles intended to guide ETF regulation.
There has been a sharp increase in funds invested in these types of products, with assets managed under ETF structures totalling almost $1.9 trillion at the end of January 2013, representing roughly 7 percent of the global mutual fund market.
The growth has naturally attracted the attention of regulators, which are concerned about the potential impact of ETFs on investors and on the broader marketplace as the industry continues to launch new products.
IOSCO’s principles address ETFs that are organised as collective investment schemes (CIS) and do not apply to other, non-CIS, exchange-traded products (ETPs).
One principle encourages the disclosure of related fees and expenses, including the eventual impact of securities lending on these, as well as the accurate and understandable disclosure to address the types of risks investors may be exposed to particularly through ETFs using complex strategies that may involve the use of leverage (or reverse leverage).
“Similar to other CIS, ETFs also may engage in securities lending activities,” said the IOSCO report. “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 more closely achieve the performance of its reference index and may, subject to the split of revenues from such activities with the securities lending agent, which could be the same entity as or an affiliated entity of the ETF operator and the ETF, [and] therefore improve the ETF’s performance.”
The scope and scale of ETF securities lending activity differs across jurisdictions, and even among ETFs within the same jurisdiction, said the report.
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 inform investors about conflicts of interest that could arise when such revenues accrue (at least in part) to the ETF’s operator.
The report gives an example of a significant industry player who, in June 2012, introduced a 50 percent limit on the amount of assets that one of its European ETFs can lend out to a third party—well below the maximum permitted by current European regulations (100 percent).
In parallel, the company also decided to provide an indemnity, so that investors would not face financial losses in the case of a default by a counterparty to a securities lending transaction involving one of its ETFs.
“In this sense, in those jurisdictions where there are not restrictions on the amount of securities that may be loaned, such disclosure should be designed to help investors understand whether revenues are received by parties other than the ETF or its investors (eg, a lending agent),” said IOSCO.
“Such disclosure arguably becomes even more significant where ETFs are marketed to retail investors as having low (or no) management fees. If securities lending revenues represent a significant source of return, another option would be to require disclosure of gross returns from securities lending from other sources of fund income.”
The statement went on to clarify that this would 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 involved (eg, securities lending-agents)
These disclosures 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 (eg, 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 optimise its returns.”
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