In an attempt to provide better clarity on the inner workings of the exchange traded fund industry, regulators are requiring fund companies to disclose the market makers that help improve efficiency in ETF trades in the secondary market.
The Securities and Exchange Commission approved a rule to include requirements for ETFs to report which banks are the most active middlemen in the $2.4 trillion market, reflecting concerns behind large institutional orders and the impact on ETF prices for everyday investors, reports Dave Michaels for the Wall Street Journal.
“They are being very honest about it – they don’t understand how ETFs work and how they are impacted by stressed markets,” John McGuire, a partner at Morgan, Lewis & Bockius LLP whose clients include many ETF providers, told the WSJ.
SEE MORE: SEC is Putting the ETF Industry Under the Microscope
The new rule will come into effect starting 2018. The changes are part of the broad SEC review of ETF trading and complexity that regulators have been conducting since 2011.
The new regulations may also be seen as a direct response to the so-called mini flash crash on August 24, 2015 that triggered trade halts and made it harder for ETF shares to recover.
[related_stories]ETF shares are traded on exchange with constant buying and selling in the secondary market. Consequently, the ETF’s price can fluctuation throughout the day and potential diverge from its underlying net asset value, or the fair value of its underlying holdings.
When the ETF’s price diverges from its underlying value, middlemen or market makers like Goldman Sachs or Morgan Stanley can step in by supplying or removing ETF shares from the market to bring ETF prices back inline with the underlying value. The market makers would then profit off the arbitrage opportunity from the price discrepancy between the two markets.
Some observers, including the SEC Commissioner Kara Stein, are worreid that with over 1,750 ETFs on the market, there are not enough market makers to effectively monitor and arbitrage each ETF that diverges from its NAV.
“Do ETFs face a greater risk of market makers stepping back during times of extreme volatility?” Ms. Stein asked in a speech this year.
ETF providers, though, argued that the new requirements will impeded market efficiency.
“Increased transparency…may have detrimental impacts on the vibrant ETF market and individual shareholder investment,” fund sponsor Invesco Advisers Inc. wrote in a letter to the SEC earlier this year. Revealing which market makers play a big role in supporting ETFs “may discourage” market makers “from participating in the ETF market entirely.”
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