SEC looks to patch holes in regulatory framework

For nearly three decades, exchange-traded funds in the United States have lived in regulatory limbo. With the June 28 reproposal of an ETF rule, the Securities and Exchange Commission is looking to correct that condition and plant itself and this $3 trillion market on solid ground.

While many have rightly observed that the latest effort — an ETF rule was last proposed in 2008 but waylaid by the financial crisis — is akin to closing the stable door after the horse has bolted, the proposal attempts to standardize and level the playing field for a highly competitive market.

As practiced, the exchange-traded product landscape is held together by separate no-action letters and individual relief from various laws and SEC rules, mostly the Investment Company Act of 1940, which provide the framework for oversight of mutual funds.

While the rule, as proposed, clears up a regulatory mess quite well, said Dave Nadig, managing director of ETF.com, an independent editorial division of CBOE Holdings, it also opens up potential challenges that will require industry coordination and diligence for the more than 1,600 products covered by the proposed rule. (ETFs structured as unit investment trusts, share classes or feeders to another fund or structure, and those that explicitly use leverage, would still have to rely on their own relief.)

In the most obscure corner of the ETF market, authorized participants, usually broker-dealers, play a critical role by transacting directly with the fund to deliver cash or securities in exchange for ETF shares, and vice versa. They stand in the middle of the market for traders attempting to capture and close an arbitrage,when there is an imbalance in the intraday price of ETF shares relative to the underlying holdings.

Authorized participants also smooth large orders with institutional investors looking to save basis points on a transaction by working as directly as possible with the fund, rather than buying or selling in the open market.

APs, as they are known, are indirectly affected under the new proposal in two ways. First, the rule proposes that ETF issuers standardize and disclose their AP agreements. Second, the ETF would have to disclose daily on its website and before the market opens, the basket of securities with which it will transact, and, in the case of so-called custom or negotiated baskets, these would have to be disclosed daily ex-post once the window for creating or redeeming shares has closed. Additionally, the ability to use custom baskets would now apply to all ETFs.

"Will the use of custom baskets promote a more efficient creation and redemption process?" asked SEC Commissioner Kara Stein in her public remarks when the proposal was announced. "Is the policies and procedures requirement specific enough to prevent wrongdoing, like 'cherry-picking' or 'dumping?' Should we instead only allow custom baskets in certain defined scenarios, and only under specified conditions?"

This part of the rule proposal provides not only more sunlight, but also levels the playing field for issuers of all sizes.

The ETF market appreciates the simplicity in funds setting a single basket for securities or cash going in or out. But custom baskets, which do not necessarily represent a pro rata slice of the fund, can be used in a way that is beneficial to all fund shareholders.

Examples include index transitions or portfolio changes for a transparent, actively managed ETF, which also are covered by the rule. (Notably, the SEC says it will no longer differentiate between index-tracking and actively managed funds, as long as they are transparent.)

"Careful consideration of the scope and parameters of (custom basket) policies and procedures will be a key area of focus for ETF advisers and ETF boards," said Adam Teufel, a Washington-based partner at Dechert LLP. "As stated in the proposing release, the SEC envisions its exam staff reviewing records of custom basket transactions on routine exams, so developing appropriate policies and procedures, and ensuring compliance with those policies and procedures, will be a key area of focus."

"The SEC has really upped the transparency requirements on spreads, on baskets and compliance checks," said Michael Venuto, co-founder and chief investment officer of New York-based Toroso Investments. "Most of us in the business do a daily compliance check, but it is only inspected quarterly. I work with my fund administrator and trading subadviser to ensure that everything is in accordance with the prospectus. But these rules may be proposed in anticipation of new entrants … to codify the unwritten rules."

ETF issuers take pride in the product's transparency, with most disclosing the fund's complete holdings daily as well as various metrics related to the underlying securities, including industry, sector, and geographic region, valuation, and percent of holdings. But the SEC is now proposing (and requesting comment) on the disclosure of trading spreads, market price premiums and discounts to per share net asset value, and how closing prices are determined.

Such statistics and compliance rigor currently are not mandated or uniform across issuers.

"ETF issuers will need time to both build and self-adopt standards," said Mr. Nadig. "It will take an industry effort and represents a significant data challenge."

The proposed rule and comments can be found on the SEC website. Comments are open until early September.