Europe’s securities markets regulator, the European Securities and Markets Authority (ESMA), has published new guidelines for the region’s exchange-traded funds (ETF) market, posing major operational challenges for Europe’s ETF and index industry.

The regulator says it wants to strengthen investor protection and harmonise regulatory practices for all UCITS (funds authorised for distribution to retail investors within the European Union), including ETFs.

In a press release accompanying the issuance of the new guidelines, ESMA says its aim is to “increase the level and the quality of information provided by UCITS to their investors, clarify the criteria for the management of collateralised transactions such as securities lending, repo and reverse repos and OTC derivatives, and set out the types of financial index in which UCITS may invest.”

ESMA also makes clear that its fund rules should be seen in the context of the ongoing discussions amongst politicians and regulators over “shadow banking”, a catch-all term that encompasses financing activities undertaken by non-bank entities.  ETFs have been drawn into the shadow banking debate in particular as a result of their use of derivatives, securities lending and repo transactions, all of which are seen as key shadow banking activities.

The new guidelines “are a valuable response to many of the issues identified in the on-going debate on shadow banking and will constitute an important step in the development of the regulatory framework of UCITS,” ESMA says.

In its ETF guidelines, ESMA introduces a number of new requirements for fund promoters and index providers.

In particular:

• All UCITS-compliant ETFs will have to carry the identifier “UCITS ETF” in their name;
• ETF issuers will have to grant investors a facility for direct redemption of fund units if secondary market liquidity in their funds is "not satisfactory";
• UCITS involved in securities lending activities will have to inform investors clearly about these activities and the related risks, return all revenues (net of operating costs) to fund investors and ensure that securities lent may be recalled at any time;
• UCITS involved in OTC financial derivative transactions (such as all “synthetic” ETFs) or in securities lending will have to ensure that the collateral associated with these transactions complies with strict qualitative criteria and diversification limits; and
• UCITS investing in so-called financial indices will have to ensure that investors are provided with the full index calculation methodology, as well as ensuring that the index respects strict criteria on rebalancing frequency and diversification.

ESMA’s new rules on direct redemption, the rebate of securities lending revenues and the diversification of collateral taken in derivatives trades and lending transactions are likely to prove the most challenging for Europe’s ETF industry operators. Meanwhile, the regulator’s push for full transparency in financial indices also threatens a wholesale rethink of current commercial practices.

In an earlier consultation paper, ESMA noted that a direct redemption facility might impose significant additional costs on fund issuers, but it has decided to require fund issuers to guarantee this option for investors in certain circumstances.

Specifically, ESMA says that UCITS ETFs that generally do not accept direct redemptions will have to disclose this information in the prospectus. But if issuers cannot ensure that the stock exchange quotations of their funds stay in line with the ETFs' net asset value, then they will have to make provisions to help investors redeem their shares at a fair price.

"Secondary market investors of UCITS ETFs generally redeem only on the stock exchange and not at the level of the fund," ESMA notes. "This practice is allowed by the UCITS Directive as long as the stock exchange value ofthe units of the UCITS does not significantly vary from the net asset value of the UCITS."

Many ETF providers have historically earned significant extra revenues from securities lending, keeping up to half or more of the fees generated in this way, but now face losing this revenue stream.

ESMA has also ruled that assets transferred out of UCITS funds as part of securities lending or repo trades should be recallable at any time, disregarding comments from a number of market participants that such a demand was against market practices and would prevent UCITS from entering into fixed-term transactions.

And many ETF issuers argued during the consultation process preceding the issuance of today’s new guidelines that the collateral received as a result of derivatives trades or lending transactions should be subject to minimum standards for creditworthiness and liquidity, but should not have to follow diversification rules. ESMA has ruled, however, that the exposure to any single issuer in a basket of collateral should not exceed 20% of a fund's net asset value.

Although ESMA says it will place the onus on fund issuers, rather than index providers, to ensure that the rules of financial indices are made transparent, the publication of all index methodologies for UCITS funds will also represent a substantial change to current industry practice.

In today’s published guidelines, the regulator notes that it received “strong pushback from stakeholders on the disclosure of the calculation methodologies of financial indices”, but decided to impose a requirement for full disclosure, so as to allow investors to replicate the performance of an index themselves.

ESMA says it believes that such index-related information is “of utmost importance for investors”. The regulator says it is prepared to offer further guidance to market participants, should further clarity be needed on the precise information to be disclosed.

The regulator has also decided to refuse many market participants' requests to allow UCITS funds to invest in indices that allow intraday or daily rebalancing. This decision appears to be aimed at limiting excessive trading activity in UCITS following indices based on highly active hedge fund strategies.

ESMA told IndexUniverse.eu that its ETF rules are unlikely to come into force until early next year. Concurrently with the publication of today’s guidelines, the regulator launched a new consultation on UCITS funds’ involvement in repo and reverse repo transactions, with a deadline for responses of 25 September. Following this further consultation period, ESMA will expand its UCITS guidelines to include an additional section on such repo trades, with the full guidelines coming into effect two months after translations have been made into all the EU’s 23 official working languages.

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