The quickly expanding exchange traded fund universe has took the financial industry by storm, and now, regulators are scrutinizing the relatively new investment vehicle to rein in potential risks that the tool might pose.
“We have a vehicle that has evolved at a pace that has outstripped the other parts of the ecosystem: the exchanges, the market structure and the safety mechanisms,” Ben Johnson, director of global ETF research at Morningstar, told the Financial Times.
Given the rapid growth of the industry, market observers and regulators are taking a closer look at the ETF universe and new rules to keep the markets running smoothly.
For instance, ETFs still rely on half-century year old listing procedures. ETFs are structured as an act 1940 fund, but they came into existence in the U.S. in 1993. Some argue that a new set of uniform rules need to be designed specifically for ETFs.
“ETFs have been shoehorned into a set of regulations that are over 75 years old,” Johnson told the Financial Times. “It has been a case of make it up as you go. That creates a lack of uniformity and a lack of real transparency with respect to the rules that dictate what goes and doesn’t go into this broader ecosystem.”
The Securities and Exchange Commission has proposed limits on derivatives in fund products to protect investors against amplified losses, notably in leveraged and inverse ETFs. Proposals call for limits of aggregate derivatives exposure to 150% of the fund’s total assets or 300% if the use of derivatives serves to limit losses from market moves. However, critics warned that this one-size-fits-all approach would not efficiently curtail risk due to the varying risk levels in different asset classes.
“The idea is to protect investors, but you may do a better job by slapping on warning labels. If you don’t use derivatives, you could get to the same place with margin,” David Mazza, head of ETF and mutual fund research at State Street Global Advisors, told the Financial Times. “If you want to take on leverage, you could do so with a margin account even if a product’s leverage was capped at a certain per cent.”
Actively managed ETFs are slowly gaining traction but still remain one of the least populated areas of the ETF universe due to the transparent nature of the fund structure, which has drawn criticism from money managers. However, proponents like Peter Tchir of Brean Capital, an asset manager, argue against non-transparent structures, contending that “either they (providers) should live with the disclosure or they should not have an ETF.”
Additionally, after the so-called mini flash crash of August 24, 2015, which caused some 1,278 securities, mostly ETFs, to halt trading in response to a sharp decline, the industry has tweaked procedures around “limit up, limit down” rules requiring trades to be halted during violent moves. Exchange rules will continue to be fine tuned to adjust to the new age of ETFs, with some even calling for more alignment over rules governing suspensions in futures and cash markets.
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