The Technical Committee of the International Organization of Securities Commissions ("IOSCO") published for comment a consultative report on the Principles for the Regulation of Exchange Traded Funds (the "Report"). The Report proposes fifteen principles designed to apply to all exchange traded funds ("ETFs") that are organized as collective investment schemes ("CIS"), but not other exchange traded products ("ETPs") that are not organized as CIS, such as exchange traded notes. The proposed principles are intended to be common investor-protection principles and guidelines against which the industry and regulators can assess the quality of regulation and industry practices concerning ETFs. The fifteen principles are as follows:
ETF Classification and Disclosure
- Regulators should encourage disclosure that helps retail investors to clearly differentiate ETFs from other ETPs.
- Regulators should seek to ensure a clear differentiation between ETFs and traditional CIS, as well as between index-based and non index-based ETFs through appropriate disclosure requirements.
- Regulators should encourage all ETFs, in particular those that use or intend to use more complex strategies, or other complex techniques, to assess the accuracy and completeness of their disclosure, including whether the disclosure is presented in an understandable manner and whether it addresses the nature of risks associated with such strategies or techniques.
- Regulators should consider imposing disclosure requirements with respect to the way in which an ETF will replicate the index (or the asset basket or the reference portfolio) it tracks (e.g., physically holding a sample or full basket of the securities that comprise the index (or the asset basket or the reference portfolio) or synthetically).
- Regulators should consider imposing requirements regarding the transparency of an ETF's portfolio or other appropriate measures in order to provide adequate information to investors concerning: (i) the index (or the asset basket or the reference portfolio) tracked and its composition; and (ii) the operation of performance tracking in an understandable form.
- Regulators should consider imposing requirements regarding the transparency of an ETF’s portfolio or other appropriate measures in order to facilitate arbitrage activity in ETF shares.
- Regulators should encourage the disclosure of fees and expenses for investing in ETFs in a way that allows investors to make informed decisions about whether they wish to invest in an ETF and thereby accept a particular level of costs.
- Regulators should encourage disclosure requirements that would enhance the transparency of information available with respect to material securities lending and borrowing activity.
Marketing and Sale of ETF Shares
- All sales materials and oral presentations used by intermediaries regarding ETFs should present a fair and balanced picture of both the risks and benefits of such products, and should not omit any material fact or qualification that would cause such a communication to be misleading.
- In evaluating an intermediary's disclosure obligations, regulators should consider who has control over the information that is to be disclosed.
- Before recommending the purchase, sale or exchange of an ETF, particularly a non-traditional ETF, an intermediary should be required to take reasonable steps to ensure that recommendation is based upon a reasonable assessment that the product is consistent with the customer’s experience, knowledge, investment objectives, risk appetite and capacity for loss.
- Intermediaries should establish a compliance function and develop appropriate internal policies and procedures that support compliance with suitability obligations when recommending any ETF.
Structuring of ETFs
- Regulators should assess whether the securities laws and applicable rules of securities exchanges within their jurisdiction appropriately address potential conflicts of interests raised by ETFs (e.g., with respect to custom indices created by affiliates, securities lending activities with affiliates, affiliated authorized purchasers and asset swaps between synthetic ETFs and affiliated counterparties).
- Regulators should consider imposing requirements to ensure that ETFs appropriately address risks raised by counterparty exposure and collateral management.
General Market Integrity and Efficiency
- ETF exchanges should consider adopting rules to mitigate the occurrence of liquidity shocks and transmission across correlated markets (e.g., automatic trading interruption mechanisms).
IOSCO has requested general comments on the proposed principles and on specific concerns cited in the Report. Comments are due on or before June 27, 2012.