ESMA outlines Future Regulatory Framework for ETFs and other UCITS Issues

European Securities and Markets Authority (ESMA) publishes a consultation paper (ESMA/2012/44) setting out future guidelines on UCITS Exchange-Traded Funds (UCITS ETFs) and other UCITS-related issues. The proposals cover both synthetic and physical UCITS ETFs and detail the obligations to come for UCITS ETFs, index-tracking UCITS, efficient portfolio management techniques, total return swaps and strategy indices for UCITS.

ESMA is an independent EU Authority that contributes to safeguarding the stability of the European Union's financial system by ensuring the integrity, transparency, efficiency and orderly functioning of securities markets, as well as enhancing investor protection.

In the summer of 2010 ESMA started looking into the operation of UCITS making use of the new investment freedoms introduced by the UCITS III Directive and the Eligible Assets Directive (2007/16/EC) in order to identify the possible impact on investor protection and market integrity. As part of this work, ESMA published a discussion paper on policy orientations on guidelines for UCITS Exchange-Traded Funds and Structured UCITS on 22 July 2011 (ESMA/2011/220), responses to which were due by 22 September. This consultation paper represents the next stage in the development of ESMA guidelines in this area.

ESMA’s proposals therefore go wider than ETFs and cover such areas as the use of total return swaps by any UCITS, for which ESMA envisages additional obligations with respect to the collateral to be provided, or UCITS investing in strategy indices, where the requirements on eligibility of such indices have been tightened. The proposals also include placing an obligation on UCITS ETFs to use an identifier and facili-tating the ability of investors to redeem their shares, whether in the secondary market or directly with the ETF provider.

ETFs will need labelling, more transparency requirements overall

For UCITS ETFs, ESMA proposes the obligatory use of an identifier for all funds that fall within the scope of the harmonised definition. In addition, investors should be provided with more information when the UCITS ETFs does not track an index and is actively managed. Finally, ESMA is seeking stakeholders’ feedback on the appropriate regime for secondary market investors (see section 4 of the consultation paper), and in particular the possibilities for them to dispose of their shares.

Concerning index-tracking UCITS, ESMA proposes additional disclosure requirements on such issues as the index to be tracked and the method of replication and the tracking error (see section 3 of the consultation paper).

Requirements for securities lending and collateral management are introduced

With regard to securities lending, ESMA proposes that collateral posted to mitigate counterparty risk should comply with the criteria set out in the CESR Guidelines on Risk Measurement and Calculation of Global Exposure and Counterparty Risk for UCITS of July 2010 (CESR/10-788), while recommending that the diversification and haircut criteria be strengthened. These requirements would also apply to repo and reverse repo activities. Therefore, according to the draft guidelines, collateral posted in the context of efficient portfolio management techniques should respect the UCITS diversification rules and UCITS should have a documented and appropriate haircut policy for each category of assets received as collateral.

Following the feedback received from the first public consultation1, ESMA decided to address certain of the proposed guidelines to all UCITS investing in total return swaps and strategy indices respectively. For total return swaps, ESMA proposes to apply the same obligations on collateral management as for securities lending. Finally, regarding strategy indices, ESMA confirms most of the policy orientations presented in the discussion paper on eligibility of indices, disclosure to investors and the due diligence to be carried out by the UCITS.

Retailisation of complex products remains a concern

In the discussion paper published in July 2011 (ESMA/2011/220), ESMA expressed its concerns about the increasing number of complex products sold to retail investors and the lack of regulatory convergence in relation to the manufacturing and management of such products. ESMA reiterates the need to tackle these issues and will continue to contribute actively to the regulatory response to these problems.