ESMA Declines To Split Europe’s ETF Market

Last Updated: 30 November 2022

Europe’s securities market regulator, ESMA, has stopped short of enforcing a split between physically-backed and derivatives-based funds in Europe’s exchange-traded fund (ETF) market, opting not to follow other national regulators in placing restrictions on the use of derivatives by ETFs, or subjecting derivatives-based ETFs to separate naming rules.

In a new consultation paper, issued today, ESMA sets out its proposed guidelines for Europe’s ETF market and, more broadly, for all UCITS funds. UCITS is the widely used, regulated format for investment funds in Europe.

Apart from ETFs, ESMA’s draft rules also cover other UCITS tracking indices, those funds making use of securities lending or repo transactions and all those engaging in over-the-counter derivatives transactions with other financial institutions. Following a two-month consultation period, ESMA intends to draft and then introduce new rules for the sector by the summer of this year.

The European regulator’s draft rules come after a year of intense debate about perceived risks in the fast-growing ETF market. In a series of publications issued last spring, financial policymakers spoke out about the potential risks for global financial stability to which ETFs might be contributing.

While ESMA appears deliberately to have avoided the splitting of Europe’s ETF market into different categories—physically-backed and derivatives-based—that some parties, notably BlackRock, the industry’s largest issuer, have been calling for, the regulator says it remains concerned, more broadly, about the ongoing “retailisation” of complex financial products.

Here, ESMA stresses that its initiative should be seen in the context of other, ongoing, reviews of financial market regulation in Europe.

A further demarcation of “complex” and “non-complex” financial products is likely under the current redrafting of the Markets in Financial Instruments Directive (MiFID) by the European Commission. The EC is expected to apply more stringent rules for the distribution of so-called “structured UCITS”, ESMA notes. Structured UCITS are a category of funds using derivatives to provide investors with pay-offs linked to the performance of certain indices or asset classes, and this fund type seems likely to include synthetic ETFs (those using swaps) as a matter of course.

Under MiFID, execution-only (i.e., non-advised) sales of financial products perceived as complex may only be allowed after intermediaries are satisfied clients have passed an “appropriateness test”.

In today’s draft rules, ESMA is, however, proposing one new naming convention, one that should more clearly separate ETFs from other exchange-traded products such as ETCs and ETNs. All exchange-traded funds that fall within the UCITS guidelines should carry the identifier “ETF”, says the regulator. To qualify for this identifier, the UCITS must have one share class that is continuously tradeable on a regulated market or multilateral trading facility (MTF), with at least one market maker responsible for ensuring that the price of the fund’s units does not deviate significantly from its net asset value, says ESMA.

And for a sub-category of those ETFs that do not track indices, or which are actively managed, additional disclosures will be required, ESMA suggests.

The regulator also proposes tightening the rules on ETFs’ secondary market tradeability, indicating concern at the possibility of investors executing trades at prices that do not correspond to funds’ intrinsic value.

UCITS ETFs should all carry a warning of potential secondary market illiquidity, says ESMA, while the fund’s issuer should ensure that market maker(s) continue to offer redemptions to investors in the secondary market, as well as “ensuring the protection of unit holders” if such redemptions are interrupted for any reason. This suggestion appears to put a greater onus on fund issuers than on stock exchanges to ensure that ETFs remain liquid, once listed.

Another option for ETF issuers would be to introduce a mechanism for investors to redeem their fund units directly, rather than having creation and redemption requests funnelled through intermediaries called “authorised participants”. Such a direct redemption facility would potentially come with significant additional costs, however, the regulator notes.


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