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Swap-based ETF issuers breathe sigh of relief at new rules

Swap-based ETF issuers breathe sigh of relief at new rules

Swap-based exchange traded fund (ETFs) providers have welcomed the new draft rules from the European regulator which have not singled out synthetic ETFs as many feared.

The guidelines published by the European Securities and Markets Authority (ESMA) did not target ETFs which use a swap to deliver the return, but instead addressed some of the main risks relating to all ETFs as well as other Ucits products, such as index trackers.

However, in July last year, ESMA warned it may curtail the distribution of these funds to retail investors after it branded some of them particularly ‘complex’.

In response to ESMA’s consultation last year, the European Systemic Risk Board, chaired by Jean-Claude Trichet (pictured), even suggested the possible withdrawal of the Ucits label from ‘complex’ and ‘opaque’ ETFs, to ensure that Ucits products remain simple.

But yesterday’s paper has largely been welcomed by swap-based ETF providers whose products have been considered in line with their physical counterparts, as well as other index-tracking funds under the Ucits umbrella.

Viewed on a more level playing field in this sense, it is clear that the counterparty risk stemming from the swap component has not been targeted as the sole form of risk. Instead, all Ucits index trackers have come under the spotlight, to reveal that other forms of risk, ranging from securities lending through to tracking error, should also be considered.

Within the consultation the two main points that stand out for ETF providers concern securities lending and collateral, as well as tracking error.

Alain Dubois, chairman of Lyxor, said: ‘This is an excellent consultation and we support all the proposals ESMA has made.

‘The final conclusion is that there is no need for specific ETF regulation and that Ucits is a framework that should be looked at as a whole. But only limited adaptations of the current framework is needed.’

Dubois said: ‘One of the most important proposals is over securities lending. This is significant because it is the first time Europe will be regulating securities lending.

‘The other important proposal is in transparency of tracking error. Tracking error should matter to investors because it is a risk that the fund won’t track the index it is supposed to follow.’

In the draft guidelines, ESMA said the prospectus for index-tracking Ucits products should include a clear description of the index as well as details of its underlying components. It should also include information on how the index will be tracked and the implications of the chosen method for investors, in terms of exposure to the underlying and the counterparty risk.

Among other factors, ESMA is proposing providers should disclose whether index-tracking Ucits follow a full replication model or use a sampling policy.

For example, physical ETF providers offer ETFs which buy all the components in the underlying index, known as full replication, or they can use a ‘sample’ to leave out some of the more illiquid stocks.

Dubois said: ‘If you do sampling for an ETF, then this will incur more tracking error.’

ESMA also proposed that, in the funds’ annual and half-yearly reports, index-tracking Ucits should state the size of the tracking error at the end of the period under review.

This report should also provide an explanation of any divergence between the target and actual tracking error for the relevant period.

Another leading swap-based ETF provider said: ‘This has been a sensible consultation. When it all started in April last year, swap-based ETFs were singled out as a threat to the financial system.

‘But the last eight-nine months has highlighted that ETFs are no different to what tens of thousands of other funds are doing, while complying with the high standard of regulations under Ucits.’

He added that synthetic ETFs, in disclosing their collateral composition and swap exposure, have been at the more transparent end of the funds industry.

Furthermore, it is not just the derivative component of a swap-based ETF which investors should be aware of, as they should also take into account securities lending and other issues within the wider funds industry.

Indeed, the ESMA guidelines aim to improve transparency over securities lending, recommending that the diversification and haircut be strengthened.

Joe Linhares, head of EMEA, said: ‘BlackRock welcomes ESMA’s proposed guidelines on ETFs and securities lending and we support financial regulatory reform that increases transparency and protects investors.’

However, the world’s largest ETF issuer still believes there needs to be more granular categorisation within the ETF industry.

Linhares said: ‘We continue to advocate a new European classification system across fund and non-fund products, which would enable investors to clearly distinguish between highly regulated ETFs and ETNs / ETCs.

‘Within the classification of ETFs we propose a further differentiation between physically and derivative replicating ETFs, based on their primary investment policy.

‘Introducing a new European classification system will answer investor calls for greater transparency and clarity, which is vital in today’s market place. This pan European classification system will require cooperation across regulatory functions and we look forward to supporting this initiative.’

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