ESMA Wants Stronger Regulation Of UCITS And ETFs
Thursday, July 28, 2011

The European Securities and Markets Authority has published a discussion paper which seeks views on how the regulation of structured Undertakings for Collective Investment in Transferable Securities (UCITS) and UCITS exchange traded funds (ETFs) can be strengthened to better protect investors.

Having reviewed the current regulatory regime governing UCITS and ETFs, ESMA is of the belief that the existing requirements are not sufficient to take account of the specific features and risks associated with these types of fund.

The paper examines the possible measures that could be introduced to mitigate the risk that particularly complex products, which may be difficult to understand and evaluate, are made available to retail investors. ESMA also cites concerns in the paper about the potential systemic risk caused by these types of fund and their impact on financial stability.

ESMA was established on January 1, 2011 as part of the new European Union framework of three new European financial supervisory authorities, which also includes the European Banking Authority and the European Insurance and Occupational Pensions Authority. The three bodies replace the previous EU committees responsible for financial market services, which only had consultative competence.

“Investor protection is one of the core missions of ESMA," commented Steven Maijoor, Chair of ESMA. "With the publication of this discussion paper, we seek views on policy orientations to improve the transparency and quality of information provided to investors buying UCITS ETFs and structured UCITS."

"Also, specific safeguards need to be developed for activities like securities lending used by UCITS ETFs or for complex strategies pursued by some structured UCITS," Maijoor continued. "However, in order to preserve the integrity of the UCITS brand and to protect investors, it cannot be excluded that it may be necessary for ESMA to issue warnings to retail investors about the risks of these products or even to limit the distribution of certain of such funds to retail investors. In this context, ESMA may need to ask for appropriate powers for inclusion in the relevant sectoral legislation."

For ETFs, ESMA has identified the following topics for which guidelines should be developed and on which feedback is sought:

• Use of an identifier: ESMA believes that UCITS ETFs should use an identifier, in their name and in their fund rules, prospectus and marketing material, which identifies them as an Exchange-Traded Fund;
• Index-tracking issues: The Authority is of the view that the prospectus of index-tracking ETFs should contain a clear and comprehensive description of the index to be tracked and the mechanism used to gain exposure to the index;
• Synthetic ETFs: ESMA proposes that the information provided to investors in the prospectus of synthetic ETFs should at least include information on the underlying of the investment portfolio or index, the type of collateral which may be received from the counterparty and the risk of counterparty default and the effect on investors’ returns;
• Securities lending activities: For securities lending activities, ESMA suggests that the collateral received should comply with the criteria for OTC transactions set out in Committee of European Securities Regulator’s Guidelines on Risk Measurement and Calculation of Global Exposure and Counterparty Risk for UCITS. Also, the Authority is of the view that investors should be informed about the policy in relation to collateral;
• Disclosure of main risks of actively-managed ETFs: For this type of ETF, ESMA proposes that investors should be clearly informed of the fact the fund is actively managed and of the main sources of risks arising from the investment strategy;
• Disclosure of the leverage policy when used by ETFs: The prospectus of leveraged ETFs should disclose the leverage policy and the risks associated with it, as well as a description of how the daily calculation of leverage impacts on investors’ returns over the medium to long term; and
• Secondary market investors: ESMA is considering the possibility to require UCITS ETFs to give all investors, including those who acquire units on the secondary market, the right to redeem their units directly from the UCITS.

ESMA will develop draft guidelines for UCITS ETFs and structured UCITS after considering responses to the discussion paper, the comment period for which closes on September 22, 2011. The proposed guidelines will be subject to further public consultation, and the results of this will be used by ESMA to finalize the guidelines.