Regulators wrestle with rapidly expanding ETF industry

The relentless pace of growth seen in the exchange traded fund industry is attracting the attention of both domestic and international regulators. Assets held in ETFs pushed through the $5tn barrier in January and show no signs of slowing.

The rapid expansion of these investment vehicles has left some wondering if the right regulations are in place to police them, particularly as the legislations currently in force were not written with ETFs in mind.

“Europe sees ETFs as Ucits funds,” explains Robert Taylor, head of global asset management regulatory strategy at the UK’s Financial Conduct Authority and chairman of the International Organisation of Securities Commission’s (IOSCO) Investment Management Committee. “While in the US they use the 1940 Act [the Investment Company Act of 1940] to oversee the market. Are these regulations sufficient if investors want some sort of redress from an asset manager?”

Ever since the 2008 financial crisis, regulators have been trying to anticipate future risks, he says. “We have seen growth in the ETF market and if you were a regulator you might sit back and ask if this could turn into some sort of a disaster if there was a severe market downturn.”

Will to engage

Questions have been raised as to just what steps regulators are taking, admits Mr Taylor, but he claims there is a clear will across the globe to engage with the issue. He believes good work is being a carried out by regulators at a national level, and cross-border bodies such as IOSCO are then taking that combined level of knowledge and trying to identify what issues need further examination. Indeed Madrid-based IOSCO has launched a probe into the ETF industry over fears it could destabilise global markets.

Much of the debate centres around the type of action regulators should be taking. “We want to move our role from all the emphasis being on what you might call our gatekeeper role and more to developing our supervisory framework,” says Martin Moloney, special adviser on policy and risk at the Central Bank of Ireland (CBI), admitting it is not yet clear what the role and limits of regulators are in the ETF space.

The CBI led a discussion paper, published in May 2017, on the regulation and supervision of ETFs, and is developing a new framework for the sector based on this industry consultation.

He highlights concerns over the replicability of indices as the ETF space evolves and becomes more complicated, and whether outsourcing delivers value for money. But the key question comes down to just how resilient ETFs will be in difficult market conditions and whether market discipline alone would be enough to ensure investors are not left short-changed.

“We are trying to make sure investors are not getting into something radically different from what they think they are getting into,” says Mr Moloney. “Lots of people are attracted to ETFs because of their liquidity, but can the market continue to be liquid in difficult market conditions?”

There are some good working practices in the ETF market, he says. “So for us the issue will be how do we move the market towards those best practices which are promoting resilience, but doing it in the least intrusive manner.”

Déjà vu 

When ETFs first launched they were passive vehicles tracking mainstream indices, but as the industry has expanded it has expanded into more complex areas, most noticeably smart beta. And this is ringing warning bells for Mr Taylor at the FCA. 

“Are there similarities with the structured products fiasco in 2008 when it comes to smart beta? Clients didn’t understand structured products, and now smart beta is becoming much more difficult for retail investors to understand.”

This is not such an issue in Europe it is in the US, he admits, as the US has more retail investors whereas Europe’s ETF market is, at least for now, largely institutional. Nevertheless, the increasing complexity of the market is something for regulators to stay on top of, he warns.

ETFs may be a relatively new investment vehicle, and this lack of track record may worry some investors, but their rise has coincided with one of the most volatile market periods we have seen for almost 100 years, insists Sander van Nugteren, managing director, ETF and index investments, at BlackRock, whose iShares brand is the largest ETF provider on both sides of the Atlantic.

 “In my mind they have come through that with flying colours. We haven’t had easy markets, we have had fixed income ETFs being tested, and experience shows that in times of market stress, people turn to ETFs for liquidity.”

And one recent piece of regulation is increasing interest in ETFs. An updated version of the Markets in Financial Instruments Directive, or MiFID II, came into effect in January, with the intention of strengthening protection for investors and improving transparency across European financial markets. Although it is too early to identify just what impact this will have, early indicators are that transparency has indeed been improved, says Mr van Nugteren.

“MiFID II is a fantastic catalyst for the ETF industry. All this transparency is good for us.”