Recently released guidelines by the European Securities and Markets Authority (Esma) are designed to put exchange-traded funds on a surer footing, and may enhance the acceptability among regulators of structured or synthetic versions.
Many European-based ETFs are marketed to Asian jurisdictions under the Ucits brand of funds. Just as Ucits rules are being revamped to make these funds more transparent and suitable for retail investors, so are other investment products, notably ETFs.
The major sticking point remains treatment of collateral by ETFs based on total-return swaps. Depending on what rules the European Commission ultimately adopts, this will mean big changes on how synthetic ETFs operate.
Just as Ucits has allowed the use of derivatives – an allowance that is now being recodified – the Esma guidelines seek to differentiate between ETFs that also use derivatives to recreate an exposure and those that can physically replicate an index.
Moreover, the Esma proposed guidelines are meant to add transparency and safety to synthetic ETFs, so that these too can be deemed suitable for retail investors.
“This would make it easier for Asian regulators to approve new synthetic ETFs,” says Guy Harles, partner at Arendt & Medernach, a Luxembourg law firm.
European regulation can be confusing, due to its multi-faceted nature. However since the global financial crisis, the European Commission has been pushing for an update and harmonisation of rules around all types of investments.
In most cases, these rules are proposed by the Commission, approved by the Council of Ministers (representing the member governments) and passed into law by the European Parliament. Afterwards Esma is tasked with drafting ‘level 2’ guidelines, the nitty gritty of regulation, although these are recommendations only, and the European Commission has full discretion in interpreting how Esma drafts match the ‘level 1’ law.
This is leading to a multitude of initiatives running in parallel. The Alternative Investment Fund Management Directive was the first to be approved by the European Parliament last year. The Commission has since finalised the level 2 rules, occasionally vetoing Esma suggestions, and now it is up to the member governments to translate these into national laws.
Last week, Luxembourg became the first member state to file a bill in its local parliament to make AIFMD law, with it likely to be effective by January. While national governments technically have three years to phase in AIFMD, Luxembourg’s quick implementation means in practical terms it will be the law of the land early next year, says Harles.
Other parts of European infrastructure being updated include Ucits, with an important consultation process now underway, and a second version of the Markets in Financial Instruments Directive (Mifid), designed to update how investment products are sold.
In all of these cases, Europe is requiring all manner of products to distinguish between those suited for professional or very rich investors and those suited for retail investors. Ucits 5 and Mifid 2 will both require products to be categorised as simple or complex, with relevant disclosures, key fact sheets and restrictions.
In the case of structured ETFs, which can qualify as Ucits, the issue is around leverage, how they track benchmarks, use of securities lending, repurchase agreements and reverse repos to create total-return swaps. The European Commission wants more disclosure around an ETF’s index, its composition and how it rebalances.
This will mean synthetic ETFs will have to be more transparent about their benchmarks. One reason for regulators in Asia to hesitate over synthetic ETFs is that the index can be somewhat arbitrary; there’s no visibility if, say, the sponsor bank simply changes it.
Another consequence will be that total-return swaps must comply with Ucits rules around diversification and risk. This is going to impact how collateral is treated, particularly how it is reinvested and the liquidity of that process.
Depending on how the final rules are drafted, synthetic ETFs will have to operate on significantly different bases. Although it remains to be seen how keen investment banks will be to make markets in such products, it should give Asian regulators far more comfort around approving structured ETFs under the Ucits brand, and serve as a model for Asia-domiciled ETFs to also use derivatives.