In recent years, regulators have expressed a number of concerns about the rapidly developing exchange-traded product1 (“ETP”) market. These concerns should undoubtedly be seen in the context of a broader regulatory debate about the structuring and distribution of investment products to retail investors.
In the context of exchange-traded funds (“ETFs”), the largest subset of the ETP category, we have also seen supranational bodies like the International Monetary Fund (IMF), the G20 Financial Stability Board (FSB), the Bank for International Settlements (BIS) and the International Organisation of Securities Commissions (IOSCO) become involved in the regulatory debate. Their interventions have been important in framing the debate, as well as raising questions of systemic risk and the infrastructures that support the funds industry.
This wave of apparently separate initiatives points to a convergence and the development of a new regulatory ecosystem, which will address both the suitability and availability of investment products for Europe’s retail investors.
As regulators seek to define the future framework for ETPs, some key questions are emerging. What is a suitable product? What is a sophisticated strategy? In defining product complexity, should we look at the complexity of the investment outcome or the complexity of the process involved in delivering the outcome? Should we seek to regulate the product though regulation and intervention, or to prescribe the requirements for the delivery of the investment exposure?
What Are We Now?
Financial instruments that trade and settle through exchanges have historically included equities, relatively simple derivatives such as futures and active mutual funds.
Exchange-traded instruments offering investment exposures include those structured as funds, others as bonds or certificates and others, meeting neither criterion.
One defining feature of these crude categorisations is that the level of regulation declines as we move from the funds world to the notes to the “other.” Regulation has not kept up with the rapid pace of market evolution so, while we currently have a degree of product regulation, there is markedly less control at the distribution point. Rules for the distribution of investment products are typically set at the local market level, rather than on a Europe-wide basis.
This is particularly noticeable in Europe’s ETP market, where the practice of listing on public markets means it’s difficult to restrict (or “gate”) access to these instruments.
For example, product features such as a high minimum subscription amount may help assure local regulators that the product is more suited to an institutional investor than to a retail one. But for an ETP which sets a high minimum level for primary market transactions, this feature does not carry through easily to an exchange listing, where transactions may take place in much smaller amounts.
To consider European ETPs on a more granular basis, it’s worth noting that most are structured as funds compliant with the European UCITS regime.
Under UCITS, a fund structured and authorised in an individual member state and deemed UCITS-compliant by that home member state’s competent authority may be “passported” for sale within other EU member states via a relatively straightforward registration process.