ESMA Outlines New ETF Regulatory Framework
Friday, February 03, 2012

The European Securities and Markets Authority (ESMA) has published a consultation paper setting out future guidelines on the use by UCITS of exchange-traded funds (UCITS ETFs) and other UCITS-related issues.

In the summer of 2010, ESMA started looking into the operation of UCITS making use of the new investment freedoms introduced by the UCITS III Directive and the Eligible Assets Directive, in order to identify the possible impact on investor protection and market integrity.

As part of this work, ESMA published a discussion paper on policy orientations on guidelines for UCITS ETFs and Structured UCITS in July last year, with responses due by September 22, 2011. In that paper, ESMA had highlighted a number of broader issues that arise in the context of ETFs and UCITS using more complex investment techniques or structures.

It has been pointed out that the current Markets in Financial Instruments Directive (MiFID) framework treats all UCITS as automatically non-complex instruments for the purposes of the appropriateness test. However, the European Commission’s proposal for the review of MiFID suggests removing structured UCITS from the scope of instruments that are automatically non-complex. ESMA is awaiting the outcome of the negotiations on the revised MiFID, but will provide any further input on this point at the appropriate stage.

The new proposals make clear that the prospectus for an index-tracking UCITS should include, for example, not only a clear description of the index with details of its underlying components and information on how the index will be tracked, but also a description of factors that are likely to affect index-tracking UCITS’ ability to track the performance of the index, such as transaction costs, small illiquid components and dividend reinvestment.

In like manner, the prospectus for index-tracking leveraged UCITS should include a disclosure on the leverage policy, how this is achieved (for example, whether the leverage is at the level of the index or arises from the way in which the UCITS obtains exposure to the index), the cost of the leverage and the risks associated with this policy; on the impact of any short exposure; and on how the frequency of calculation of leverage impacts on investors’ returns over the medium- to long-term.

The new proposals cover both synthetic and physical UCITS ETFs, but go wider and cover such areas as the use of total return swaps by any UCITS, for which ESMA envisages additional obligations with respect to the collateral to be provided, or UCITS investing in strategy indices (an index which aims at replicating a quantitative strategy or a trading strategy), where the requirements on eligibility of such indices have been tightened.

The proposals also include placing an obligation on UCITS ETFs to use an identifier and facilitate the ability of investors to redeem their shares, whether in the secondary market or directly with the ETF provider.

ESMA is inviting comments on the matters in the consultation paper, which should be provided by March 30, 2012. It is expected that the guidelines, with appropriate transitional investment arrangements, will come into effect later this year.