Europe eases up on ETFs

ESMA's new rules not the clampdown many expected.

January 31, 2012

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story_images_EUBenefits Canada For months, ETF providers have been worried about a potential clampdown by regulators. With the ETF industry growing rapidly, regulators in the US and Europe have had their sites set on clipping providers’ wings a bit. But if the European Securities and Markets Authority is any indication, that crackdown might not happen.

Today, ESMA will publish draft rules designed to protect ETF investors – although active managers and other industry participants have called for sweeping rules to curb ETFs, those calls haven’t filtered down on the regulatory front, at least when it comes to this first piece of rulemaking.

The focus of ESMA’s rules will be improving the quality of information ETFs provide to investors. They’ll also ask ETFs to disclose their securities lending practices and give greater detail about the securities they hold. The regulator stopped short of handing ETFs the killer “complex” label that would mean investors have to buy them from advisors.

All this is good news for the industry – and it could just point to regulators’ softening stance on exchange-traded products in the future. I think it’s also good news for investors – pushing ETFs into the advisor realm really would have been a huge mistake in my view, especially for a product that has been deservedly lauded as an investment democratizer in the retail space.

Surprisingly, amidst all the disclosure rules, ESMA did not address one factor that has dogged investors and could provide a real risk – tracking error. It happens more than you think in an industry that is meant to provide value to investors by closely tracking an index. Variation in performance on either side of the index can cost investors and it does bear scrutiny by regulators in the future. Will US regulators look more closely at this? Probably not – the most vocal ETF critics haven’t really set their sights on this issue, choosing instead to focus on the role of derivatives and the importance of collateral. However, EDHEC thinks it’s worrying and said so in this paper published last week.

No doubt, ETF providers will now be looking now to US regulators as they produce their own recommendations for the future of the industry. But if ESMA is any indication, it could be a much smoother ride for ETFs that some thought previously.

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"Eases up" is a relative term. Disclosing securities lending practices will keep those ETF sponsors who use related counter parties honest in the collateral they use. This has been a concern in Europe. Not so much in Canada where individual counter-party exposure is limited to 10% and no "related parties" act in these roles ... yet.

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