Draft ICI Comment Letter on FSB Note on "Potential Financial Stability Issues Arising from Recent Trends in Exchange-Traded Funds"; Please Provide Comments by 5/12
[25178]
May 9, 2011
TO: ETF (EXCHANGE-TRADED FUNDS) COMMITTEE No. 12-11ETF ADVISORY COMMITTEE No. 29-11
INTERNATIONAL COMMITTEE No. 10-11
SEC RULES COMMITTEE No. 43-11 RE: DRAFT ICI COMMENT LETTER ON FSB NOTE ON “POTENTIAL FINANCIAL STABILITY ISSUES ARISING FROM RECENT TRENDS IN EXCHANGE-TRADED FUNDS”; PLEASE PROVIDE COMMENTS BY 5/12
As we previously informed you, on April 12 the Financial Stability Board (FSB) issued a Note entitled “Potential financial stability issues arising from recent trends in exchange-traded funds.” [1] The Note highlights a number of recent developments in the exchange-traded fund (ETF) market that the FSB believes warrant increased attention by regulators.
The FSB has invited feedback from the public on the Note. ICI’s draft comment letter is attached, and is summarized briefly below. Please provide comments to Mara Shreck (mshreck@ici.org or 202/326-5923) by Thursday, May 12.
Summary
The draft letter states that the ICI agrees in principle with the FSB’s recommendation that authorities and market participants improve their understanding of the potential risks inherent in financial products, the ways financial innovations may interact with one another to amplify negative effects, and the ways in which such risks can be mitigated. The letter expresses concern, however, that in raising potential risks with respect to what it terms “synthetic” ETFs, [2] the FSB does not clearly differentiate among the wide range of ETFs which can be subject to materially different regulatory requirements and therefore have very different risks and characteristics, including derivatives-based ETFs that operate under different regulatory regimes.
After providing some background on the U.S. ETF market, the draft letter explains that ETFs typically register as open-end investment companies under the Investment Company Act of 1940. It goes on to describe a number of regulatory requirements under the Act and related regulations and guidance that limit the ability of ETFs to engage in many of the practices that concern the FSB. These include prohibitions on affiliated transactions and other forms of self-dealing; tight restrictions on leverage; daily valuation of fund shares using mark-to-market valuation; a requirement to redeem shares daily (for open-end funds); separate custody of fund assets; and the most extensive disclosure requirements faced by any U.S. financial product. Finally, to address concerns expressed by the FSB with respect to securities lending by ETFs, the draft letter describes the relevant guidelines for ETFs regulated under the Investment Company Act.
Mara Shreck
Associate Counsel
endnotes
[1] See ICI memo 25128 (April 20, 2011). The Note is available at http://www.financialstabilityboard.org/publications/r_110412b.pdf.
[2] According to the Note, “synthetic” ETFs “obtain the desired return through entering into an asset swap, i.e., an OTC derivative, with a counterparty… They are typically provided by asset management arms of banks. One factor supporting their growth resides in the synergies created within banking groups if the derivative trading desk acts as swap counterparty to the asset management arm providing the ETF.”