Will the SEC's recent request for comment on the finer points of exchange-traded products bear fruit?
The last two times the Securities and Exchange Commission made broad requests of the ETP market — in 2001 and 2008 — more pressing matters eventually occupied the regulator's staff than an emerging financial product set.
Now, due to the incredible growth and flurry of increasingly complex exchange-traded products, the SEC has issued a 53-question Request for Comment on Exchange-Traded Products, focusing mostly on how ETPs are listed, traded and distributed.
While the mid-June release has yet to make waves among market observers, the incredibly direct nature of the SEC's line of questioning will eventually bring many companies and organizations in the ETP ecosystem to share their views and how they could be impacted by any reinterpretation of existing rules by the commission.
Barely brushing ETP issuers, a core line of questioning asks about the ecosystem of market participants, listing exchanges and broker-dealers that facilitate distribution.
“This request is grounded in the changed circumstances around non-index products,” says Rajib Chanda, partner at Simpson Thacher & Bartlett LLP in Washington. “It's part and parcel with the SEC feeling its way as a prudential regulator — understanding the precise role of arbitrageurs in this market, what is expected of the exchanges — in light of the Financial Stability Oversight Council.”
“It's a surprisingly smart list of questions,” said David Nadig, director of exchange-traded funds for financial research provider FactSet Research Systems Inc. “Yet one question really captures everything that the SEC is after.”
Question 30 asks: “Should certain characteristics of an ETP receive particular emphasis in the commission's evaluation of whether a proposed rule filing related to that ETP is consistent with the Exchange Act? If so, which ones? For example, should the commission's evaluation focus on the nature, characteristic or liquidity of the specific investments, holdings, indices or reference assets of the ETP and on the public availability of information about these underlying or reference assets? Should the commission's evaluation focus on the effectiveness or efficiency of the creation and redemption process in facilitating arbitrage opportunities with respect to an ETP? What other factors, if any, should the commission consider in its evaluation of whether a proposed rule filing related to an ETP is consistent with the Exchange Act?
In order to reach the entire ETP market, particularly those outside of the Investment Company Act of 1940, the question focuses on the Exchange Act, which encompasses listing requirements, ongoing oversight, and the dissemination of data.
Other questions focus on pricing and arbitrage — are ETFs transparent enough such that the market price and the NAV don't wildly diverge; on broker-dealer sales practices and investor understanding; and on the future of a market in which ETP asset growth continues.
Recent commentary and actions from the commission and individual commissioners indicated this request for comment was coming.
“I worry that these larger questions have been getting lost in the current ETF exemptive application and exchange listing process, where each product is considered independently, without the kind of broad attention that is necessary to garner the depth of public input I think we need on these questions,” said Commissioner Kara Stein in a November speech at Columbia Law School.
Ms. Stein had just run through more macro concerns on the effect of ETPs on the capital markets and the interplay between ETPs and their reference assets. “As ETFs increasingly invest in less liquid assets, could redemptions amplify fire sale risks?” she asked.
“There's no ETF Act,” said Mr. Nadig, “but what this request for comment could lead to is a change in enforcement of the Exchange Act.”
According to XTF Inc., U.S. ETPs currently hold nearly $2.2 trillion in assets across 1,731 products, weighted heavily to indexed equities. At the end of 2001, when the SEC reached out to the market on actively managed ETFs, 119 products held $85 billion in assets. In 2008, when the SEC explored an “ETF Rule,” assets were $540 billion across 842 products.
“There's been a growth in number, not necessarily in assets, of more complex products,” said Mr. Chanda.“As underlying (and reference) assets for ETPs become more esoteric, bespoke or illiquid, to what extent is it actually possible that there will continue to be an effective arbitrage for some products?”
“All of the transparency measures around ETPs are primarily for the arbitrage,” said Mr. Nadig. “It was the nut of exemptive relief and critically important — the only thing the SEC wanted to hear about at the time.”
