The reforms of regulation standards needed after the financial crisis have placed a heavy burden on the exchange traded funds industry.
Although ETFs performed well throughout the crisis, with none of the problems associated with more complex financial products such as credit default swaps, ETF providers have found their operations and business models subjected to much greater scrutiny.
Much of this regulatory work remains unfinished and some proposals, such as the European financial transaction tax, could prove extremely disruptive. However, it is also clear that the ETF industry is benefiting from other reforms, such as the UK’s Retail Distribution Review (RDR).
US regulators are considering whether BlackRock and Vanguard – two of the largest players in the ETF industry – should be considered as systemically important financial institutions, (SIFIs) as they look to extend improved safeguards for large banks to fund managers with assets of more than $50bn.
Asset managers are putting up fierce resistance as the implications of a SIFI classification would be significant, not least in raising operating costs. It would bring considerable additional scrutiny, more stringent reporting requirements, the creation of recovery and resolution plans known as “living wills” and additional capital to be set aside.
But asset managers argue forcefully that the risks posed to the financial stability of a bank being “too big to fail” do not apply to their businesses. They also emphasise that they act as agents for their investors, unlike banks which can act as principals in risking their own capital.
Bill McNabb, chief executive of Vanguard, says it is unclear what impact a SIFI classification would have but he emphasises that asset management is already a well regulated sector.
“Smart regulation has been a good thing for the funds industry but we don’t want changes that make our value proposition less compelling to investors,” says Mr McNabb.
US regulators are also debating whether to approve proposals for non-transparent active ETFs. This would likely attract a number of mutual fund managers that do not currently participate in the ETF industry. However, the timing of any changes in these regulations remains unclear.
In Europe, requirements for clearer labelling of ETFs were introduced in 2012 by the European Securities and Markets Authority, the regional regulator. It also determined that ETFs should be treated equally with active mutual, establishing a level playing field for competition.
Ted Hood, chief executive of Source, the London-based ETF provider, points to comments last year by Steven Maijoor, Esma’s chairman, suggesting regulators are struggling to understand why the adoption of ETFs by retail investors has remained relatively low.
“There is a great deal that ETF providers and regulators could do in working together to help investors achieve their goals,” says Mr Hood.
The UK is seen as an important test of retail appetite for ETFs after RDR banned commission payments, known as retrocessions, to financial advisers for recommending products to clients. This created a level playing field between actively managed funds and ETFs which do not pay retrocessions.
The ending of retrocession payments in the US and the move to a fee-based model to financial advisers has proved hugely important in accelerating the adoption of ETFs.
Retail investors only account for a tiny part of the European ETF market, but RDR-type reforms have also been introduced in the Netherlands and are expected to spread further.
Mark Wiedman, chief executive of iShares, the world’s largest ETF manager, says the shift to fee- based accounts by financial advisers is no longer viewed as just an Anglo-Dutch experiment.
Real movement is under way in Switzerland and Germany. Across northern Europe banks are starting to view fee-based pricing as inevitable. It is even rippling into Asian markets, starting with the Singaporean operations of large global banks, who are beginning to think about the implications for their businesses, says Mr Wiedman.
He adds: “The inexorable growth of fee-based accounts will drive greater adoption of ETFs and other forms of passive investments, as has already been shown clearly in the US”.
Just as RDR-type reforms are expected to promote greater involvement with ETFs by retail investors, so the second Markets in Financial Instruments Directive (Mifid II) should encourage more usage by institutions. These wide-ranging reforms of European securities markets, finalised last month, are expected to lead to improvements in Europe’s fragmented ETF trading infrastructure, which has hindered asset gathering.
Currently, the majority of European ETF trading is done in private, bilateral over-the-counter transactions that go unrecorded. This makes it problematic to understand the true depth and liquidity of the market which has acted as a barrier for institutional investors. Mifid II will lead to the establishment of a “consolidated tape”, a single, complete record of ETF trading as well as fuller pre-and post-trade reporting that will provide a clearer picture of who is active in the market.
The establishment of a consolidated tape will “turn on the light” for ETF liquidity, says Mr Wiedman.
Another concern is the fallout from the scandal affecting the London interbank lending market. Reforms to Libor benchmarks have been widened to include to all financial indices that are widely used by ETF providers.
Sven Kasper, director of regulatory, industry and government affairs for Emea at State Street says it remains unclear how the European Commission’s proposals on benchmarks might affect US and third country based index providers. In a worst-case scenario, ETF managers in the European market might need to change to a different index provider, resulting in transaction charges and legal costs without any clear benefit to end-investors, cautions Mr Kasper.
But the regulatory “elephant in the room” remains proposals for a financial transactions tax in 11 European member states, including France and Germany.
These proposals, says Mr Kasper, are still in flux so the final design and scope of the FTT remains unknown. However, Greece, the current holder of the EU presidency and Italy, its successor, are both supportive of an FTT and intent on implementation.
Providers fear an FTT would mean every transaction required to create an ETF units would attract a charge. This, says Mr Hood would “demolish the appeal of the ETF as a wrapper” by imposing multiple charges on products offering eurozone exposures, said Mr Hood. He argues that the introduction of an FTT in Europe could be “a real disaster”, not just for the ETF industry, but for all savers and investors who will ultimately pay the costs of the tax.