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ETF regulation has many benefits, says survey

Chris Hamblin, Editor, London, 21 November 2017

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The accountancy firm of EY has published a research paper that looks at the likely effects of regulation on exchange-traded funds (ETFs) worldwide. It notes that the likelihood of ETF-specific regulation is increasing as the industry expands and that, on the whole, that increase is beneficial for investors and firms alike.

The survey points to strong growth in future. The respondents predict ETF asset growth of around 15% per annum for the next three to five years, with global ETF assets perhaps reaching US$7.6 trillion (€6.47 trillion) by the end of 2020. Asset servicers have the most to gain from the growth of ETFs, especially in Europe and Asia. The report finds, however, that very few asset servicers have specialised platforms to support the detailed regulatory requirements of ETFs. White-label providers offer an increasingly popular way for new entrants to overcome barriers, especially in Europe and Asia and can help new promoters to gain regulatory approval.

ETF vehicles impose low costs and allow investors to know their inner workings well, so EY believes that the industry is right to fear little from regulation. In fact, 70% of respondent firms told it that investors welcomed regulatory scrutiny of ETFs (although the remainder were convinced of the opposite, with no vacillators). Regulators around the world are interested in keeping ETFs cheap, easy for investors to understand and 'suitable' for their needs. Providers think that initiatives such as the "Future of Financial Advice" (FOFA) reforms in Australia, the UK’s pension freedom reforms and MiFID II provide "tailwinds for growth, especially in the retail segment."

Even so, there are signs that the growing complexity of the ETF industry is making it harder for firms to move around the regulatory landscape. Very diplomatically, EY says that major EU initiatives such as the European Market Infrastructure Regulation (EMIR) and the second Markets in Financial Instruments Directive have created a combination of pluses and minuses for ETF promoters and investors. It says that various people see MiFID II "as favoring the industry but could also have unexpected effects on European markets." It does believe that MiFID II will benefit European ETFs in some ways but can offer them "no silver bullet." It is "potentially beneficial" in areas such as post-trade transparency (improving the visibility of liquidity); the ban on inducements; and trading frameworks (encouraging stock lending). It warns, however, that MiFID II seems increasingly unlikely to improve liquidity on exchanges. Big institutions will continue to use RFQs (requests for quotes) to demonstrate best execution, only reporting on exchanges.

The likelihood of ETF-specific regulation is increasing as the industry expands. This is a prospect that ETF providers once hoped to avoid, so EY finds it surprising that 68% of respondents now take a positive view of ETF-focused regulation. It has taken a closer look, however, and found significant variations. In the US, where the Department of Labour’s Fiduciary Rule is thought to help ETFs, people's views are much more positive than in Europe, where asset inflows and growth are attracting attention from regulators and the media. This year, the Central Bank of Ireland published a discussion paper on ETFs, the French Autorité des Marchés Financiers produced a paper that examined ETFs and their associated risks, and the European Union's Exchange and Securities Markets Authority announced its intention to embark on a 'peer review' about its guidance for UCITS (Undertakings For The Collective Investment Of Transferable Securities) ETFs and other UCITS-related issues as part of its plan for next year.
 
Debate over the effect of ETF regulation has traditionally centred on distribution. EY thinks that promoters ought to gain a better understanding of the potential benefits of regulatory changes because regulation is having an increasingly positive effect on ETF distribution. Most of its interviewees (61%) expect regulation to change the way in which ETFs are distributed (although the remainder do not, with no 'don't knows'). The US Fiduciary Rule, which places a legal fiduciary obligation on retirement advisors paid by commissions, is a prime example. In Europe, MiFID II will also restrict the inducements that asset managers can pay to distributors.

Away from distribution, EY expects regulation to have a less positive effect. Regulators seem to be paying more and more attention to systemic risks, typified by the International Organization of Securities Commissions' (IOSCO's) review of liquidity risks. EY's conversations with promoters also betrayed a growing awareness of how regulation can affect tracking error, and thus harm an ETF’s investment performance. For example, margin rules (which apply to uncleared transactions such as forward foreign exchange contracts) introduced by EMIR may make it harder for currency-hedged ETFs to track an index precisely, because funds are not 100% invested in underlying assets. Regulation, of course, is not the only external factor that can affect tracking error.

In the accounting sphere, the International Financial Reporting Standard known as IFRS 9 could also create problems for ETF providers because of the changes that investors may have to make to the ways in which they account for ETF investments on their own balance sheets.

EY advises firms to:

  • combine local understanding and global insight, helping HNW investors to understand the regulatory environment and any relevant technicalities;
  • identify the opportunities that regulatory change might create and use them to develop products and improve things for investors; and
  • develop a detailed view of regulatory threats and be willing to retire products or strategies that underperform as a result.

EY also notes that private banks are most likely to use ETFs as building blocks, or to achieve selected exposures to international markets. Wealth managers are most likely to use ETFs to achieve core exposures — for example, through model portfolios.

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