Alert July 09, 2013

IOSCO Releases Final Report on Principles for ETF Regulation

In June 2013 the Board of the International Organization of Securities Commissions (IOSCO) published its Final Report on Principles for the Regulation of Exchange Traded Funds (the “Final Report”), which articulates nine high level principles designed to provide both the industry and regulators with the means to assess across multiple jurisdictions the quality of regulation and industry practices concerning exchange-traded funds (ETFs).  The Final Report generally defines ETFs as open-ended collective investment schemes (CIS) that seek to replicate the performance of a target index (but may be actively managed) and trade throughout the day like a stock in the secondary market (i.e., an exchange).  The Final Report addresses only ETFs, and its recommendations do not apply to other forms of exchange traded products (ETPs) not organized as CIS, such as exchange-traded commodities (ETCs), exchange-traded notes (ETNs), exchange-traded instruments (ETIs), and exchange-traded vehicles (ETVs).

In a related release, IOSCO noted that numerous consultations among IOSCO’s member regulators and repeated engagements with representatives of the global ETF industry have led to the Final Report and, as a result, it reflects a shared consensus within the global regulatory community about an approach to ETF regulation.

The nine principles are set forth below.  The Final Report also includes commentary for each set of principles discussing various means of implementation.

Disclosure - differentiation among ETFs, and from other CIS and ETPs

  1. Regulators should encourage disclosure that helps investors to clearly differentiate ETFs from other ETPs.
  2. Regulators should seek to ensure a clear differentiation between ETFs and other CIS as well as appropriate disclosure for index-based ETFs and non index-based ETFs.
  3. Index tracking and portfolio transparency

  4. Regulators should require appropriate disclosure with respect to the manner in which an index-based ETF will track the index it references.
  5. Regulators should consider imposing requirements regarding the transparency of an ETF’s portfolio and other appropriate measures in order to provide adequate information concerning: 
     
    • Any index referenced and its composition; and
    • The operation of performance tracking.
  6. Disclosure - costs, expenses and offsets

  7. 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.
  8. Regulators should encourage disclosure requirements that would enhance the transparency of information available with respect to the material lending and borrowing of securities (e.g., disclosure on related costs).
  9. Disclosure – strategies and related risks

  10. Regulators should encourage all ETFs, in particular those that use or intend to use more complex investment strategies, 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 the ETF’s strategies.
  11. Conflicts of interest

  12. 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., arising out of the involvement of an index provider, authorized participant, or swap counterparty affiliated with an ETF’s sponsor).
  13. Managing counterparty risks

  14. Regulators should consider imposing requirements to ensure that ETFs appropriately address risks raised by counterparty exposure and collateral management in the contexts of both physical EFTs (in which the assets tracked by the ETF are owned by the ETF) and synthetic ETFs (in which the performance of the assets tracked by the ETF may be obtained with the use of derivative instruments).

A concluding section of the Final Report briefly addresses several issues that ETFs share with other financial products, such as the role of intermediaries in the marketing and sale of ETFs and the potential for ETFs to affect market stability, and references separate IOSCO recommendations relating to those issues.