Businesses often market products by giving them catchy names that draw on direct positive associations or indirect connotations to quickly catch people’s attention. Exchange-traded funds are so called not only because such funds are easily accessible to ordinary investors via the secondary market, but also because investors are attracted to the idea of being able to liquidate their positions at will during trading hours.
Given this, it likely came as a surprise to many when the European Securities and Markets Authority (ESMA) raised this reliance on secondary markets as a problem in its July discussion paper on guidelines for UCITS (Undertakings in Collective Investment in Transferable Securities) ETFs and structured UCITS. It suggested that investors who buy ETFs on secondary markets should be able to redeem them directly with the issuer. Are the regulators right in raising this issue? More importantly, would investors benefit from such implementations?
There are two underlying regulatory concerns that led to this proposal. The first is closely linked to the mechanics of ETF distribution. Although ETFs derive their reputation as simple and safe investment products from their direct membership of the UCITS family, and therefore fall under the purview of the UCITS Directive, this protection only applies to investors who hold direct registered accounts with the issuer. So it would seem to offer less protection for investors who obtain units via nominee accounts with their brokerages or other intermediaries.
In its consultation document, ESMA says: “The market participants who acquire creation units may be the only recognised investors in the UCITS ETF and the rules in the UCITS Directive designed to protect unit holders will not necessarily apply to investors who acquire shares on the secondary market when they are not registered unit holders.”
A private investor who wishes to buy ETF units from an issuer would normally first open an account with a broker, say Selftrade, for example, and use this account to access the secondary market to purchase the securities. Suppose one has bought 1,000 shares of SPDR Euro Stoxx 50 ETF on the London Stock Exchange. After the transaction has been cleared and settled, the UK central securities depository, CREST, would hold a record of the units of shares under the name of the broker, who in this example is Selftrade, not the investor. Although the end investor is the beneficial owner of the securities, this ownership is established via an indirect, two-tiered relationship: one contractual arrangement between the investor and the intermediary, and another agreement between the intermediary and the issuer.
Although provisions exist for individuals to open membership accounts with depositories such as CREST via the sponsored membership route, it is not a common practice among private investors.
Another potential complication in indirect ownership lies in the bookkeeping process at the UCITS fund itself. The share register of a UCITS fund, which records holders of all its outstanding securities, may not keep reference to the beneficial owners of the units, the end investors, but rather only the legal owners of the securities, which again are the nominee companies.
With respect to the protection offered to “recognised investors” in the context of redemption, the UCITS Directive clearly sets out the obligation on the part of UCITS, and by association, ETFs, to repurchase units directly from investors: “Subject to Regulation …. a UCITS must redeem or repurchase units at the request of the unit-holder.”
But who are the unit-holders? Because the distribution channel of ETFs relies heavily on intermediaries such as authorised participants, market makers, liquidity providers and brokerages that are the usual point of contact for end investors, ESMA fears that regulations that have been devised for investor protection may not be meeting their intended objectives. In this case, the protective band binds the issuer with the intermediaries, rather than with the investors.
The second issue
The second concern raised by ESMA pertains to an ETF’s unique operational methodology. In ESMA’s words: “ETF units are not usually redeemable from the fund other than by authorised participants of creation units. Investors who acquire units on the secondary market must buy and sell shares with the assistance of a stock broker and investors may incur brokerage fees and pay more than the current net asset value when buying units and receive less than the net asset value when selling units.”