knowledge 18 September 2018 |

New Opportunities for ETFs

Separately, the Central Bank of Ireland (the “Central Bank”) confirmed that it will maintain its current requirement for daily portfolio disclosure to the public, at least for the moment. However, the Central Bank will continue to consider this matter and will engage in relation to portfolio disclosure at European and international regulatory forums. Given that Ireland is the domicile of choice for European ETFs, the expectation is that following the conclusion of such engagement on portfolio transparency, a uniform application of regulatory principles will apply across the EU.

The relevant changes are set out in a feedback statement published by the Central Bank (here) following on from its Discussion Paper 6 on Exchange Traded Funds (“DP6”), published on 15 May 2017.

Background

An ETF is an investment fund which is not only admitted to trading on a regulated market but is also actively traded on a stock exchange or other markets. ETFs were first established in 1990 and have experienced exponential growth since then. Ireland is the largest European centre for ETFs, and many of the largest global ETF promoters domicile their European products in Ireland.  For the most part, Irish authorised ETFs are passported for sale on a cross-border basis, mostly within the EU’s single market.

DP6 highlighted a number of areas relevant to ETFs, which the Central Bank considered warranted further consideration.  These related to the role of active ETFs, the market liquidity implications for the assets in which ETFs invest and how to achieve the right balance in terms of portfolio disclosure requirements. DP6 also focused on the potential risks that may be inherent in the ETF structure, and in particular, the issue of interconnectedness and how this might give rise to additional risk factors.  

On 14 September, the Central Bank published its Feedback Statement on DP6 (the “Statement”).

The Statement

The Statement summarises the responses the Central Bank received  in respect of DP6 and sets out some policy changes which have resulted from the feedback received regarding share class dealing arrangements and listed and unlisted share classes.

• Share Class Dealing Arrangements – while one of the Central Bank’s fundamental principles for investment funds is that dealing deadlines must be the same for all share classes, it has permitted different dealing arrangements for ETFs with cash and in-kind share classes, reflecting the commercial considerations of both the ETF and the Authorised Participants (“APs”) who deal with it. The Central Bank will extend its current approach with respect to cash/in-kind share classes to include unhedged and hedged share classes within an ETF.
• Listed and Unlisted Share Classes – the Central Bank has decided to permit listed and unlisted share classes within an investment fund and will develop guidance on appropriate disclosure requirements to apply to both types of classes.

These changes will be welcomed by industry.  The new approach to share class dealing arrangements should help to protect investors from unfavourable exchange rates on returns. Perhaps more significantly, permitting an investment fund to have both listed and unlisted share classes will permit existing investment funds to establish ETF share classes within the same fund, thus generating economies of scale and ultimately leading to lower costs and higher liquidity.

Although many respondents to DP6 called for the Central Bank to move from its daily portfolio disclosure requirement, the Central Bank has decided against changing its current position, at least for the moment.  According to the Statement, the Central Bank will continue to consider this matter and will engage in relation to portfolio disclosure at European and international regulatory forums. Given such international focus, the expectation would, therefore, be that the regulatory approach to portfolio transparency (viewed as a hurdle to the development of the actively managed European ETF industry) will reach a point where it is consistently applied by all regulators.

Next Steps

The Statement is not intended to conclude the Central Bank’s work on ETFs, but to provide a clear view of the current landscape with a view to continued engagement on the topic.  The Central Bank intends its work in relation to ETFs to contribute to current European and international work streams on ETFs and be of assistance to other regulatory authorities and market participants more broadly.  The list below highlights some of the issues that the Statement identifies as suitable for consideration at EU/international level:

• public disclosure of the identity of APs and Official Liquidity Providers (“OLPs”);
• sufficiently clear and precise public disclosure of the costs which are borne by and on behalf of an ETF and which indicate the basis on which each cost is calculated, including OLP remuneration;
• permitting secondary market investors to divest themselves of ETF shares by direct redemption and/or identifying a better way to enable secondary market investors to dispose of ETF shares where secondary market liquidity is impaired;
• managing conflicts of interest that arise where parties related or contracting with an ETF are part of the ETF provider's group;
• considering requirements relating to counterparty exposure with the aim of encouraging more open-door, diverse, competition-friendly practices that will strengthen the ETF ecosystem;
• ETF liquidity;
• ensuring the information efficiency of underlying securities – a potential impact from greater investment in index tracing ETFs may be decreased informational efficiency of underlying securities as well as increased non-fundamental volatility of those securities;
• creating a more homogenous market infrastructure for ETFs from a structural, listing and regulatory perspective; and
• introducing homogenised rules obliging intermediaries to communicate with beneficial owners in an ownership chain.