Investors could be prevented from buying swap-based ETFs on an execution-only basis under the European Commission’s proposals for the revised Markets in Financial Instruments Directive (MiFID II).

In a document released on 20 October, the Commission said that although it was right that investment firms could sell UCITS funds without assessing the knowledge and experience of a client, it was appropriate to exclude from this category those “financial instruments, including collective investments in transferable securities (UCITS), which embed a derivative or incorporate a structure which makes it difficult for the client to understand the risk involved.”

UCITS funds have historically been designed for sale to the general public, and therefore the investment firms selling them do not need to carry out an appropriateness test to determine if they are suitable for investors. The Commission, it appears, is preparing to segment UCITS into non-complex and complex categories, with complex funds being prevented from sale on an execution-only basis.

“You’ll only be able to sell non-complex funds on an execution-only basis. Investing in complex funds won’t become impossible for retail investors, but selling them will become more complicated,” said Bert Verdoodt, a senior associate at Clifford Chance.

It remains unclear how exactly the complex UCITS category will be defined, but it seems likely that synthetic (derivatives-based) ETFs are likely to be included.

“The distinction between complex and non-complex UCITS that MiFID refers to is based on the concept of structured funds, as set out in the current UCITS regulations,” says Bert Verdoodt. “But the definition of a structured UCITS is rather vague. There is a risk that swap-based ETFs will fall under the structured funds definition.”

Some regulators, for example the UK’s Financial Services Authority, have called for barriers to be put in the way of synthetic fund sales to the general public. Issuers of synthetic ETFs have, however, pointed out that physical ETFs which lend out their stocks are incurring similar risks to derivatives-based funds and that all ETFs should continue to be considered as ‘non-complex’ products.

“We don’t think that a split of ETFs into complex and non-complex would be beneficial for the market. You might argue that an ETF on a leveraged or volatility index is complex, but we don’t see why this label should be applied to a straightforward FTSE 100 tracker. We’re trying to make this point in our discussions with the regulators,” said one synthetic ETF issuer.

However, regulators may not be easily swayed on the topic. According to a report in the Financial Times in June, French regulator Autorité des Marchés Financiers (AMF) has been gaining support for a dual category approach in the UCITS fund market, even though Europe’s fund industry has been resisting the change.