07.27.2012
By Terry Flanagan

European Watchdog Sets Out Strict Rules For ETFs and Ucits Funds

New guidelines issued by the European Securities and Markets Authority (Esma) promise to shake up the region’s exchange-traded funds (ETFs) sector.

The pan-European regulator wants to strengthen investor protection and harmonize regulatory practices across the region regarding ETFs and other Ucits, or Undertakings for Collective Investment in Transferable Securities. Esma’s new guidelines, following an earlier public consultation in January, will allow investors to gain basic information about Ucits and ETFs in a bid to increase transparency.

The new rules will also mean that European fund managers will have to return all profits made from securities lending to their investors, which was a big revenue earner for ETF providers. Under the practice, hedge funds and other short-sellers borrow shares in return for a fee, but Esma believes that as the fund takes on the risk of lending the shares it, and not the manager, should be the one rewarded for it. BlackRock, for example, the world’s largest ETF fund manager through its iShares unit, currently keeps 40% of its stock lending fees, returning 60% to the fund to reduce charges. Esma is also giving funds the power to recall these lent securities at any time.

In addition, Esma wants investors to know levels of exposure in their ETFs, the names of counterparties and the types of securities used in synthetic ETFs. Esma is also forcing firms to provide details on the amount of collateral in Ucits funds. Ucits are public limited companies that are cross-border retail investment funds.

“These comprehensive guidelines increase the level and the quality of information provided by Ucits to their investors, clarify the criteria for the management of collateralized transactions such as securities lending, repo and reverse repos and OTC derivatives, and set out the types of financial index in which Ucits may invest,” said Steven Maijoor, chair of Esma.

“Furthermore, these guidelines are a valuable response to many of the issues identified in the on-going debate on shadow banking and will constitute an important step in the development of the regulatory framework of Ucits.”

ETFs, which are funds that track baskets of shares, bonds or commodities which are traded like stocks, were invented in 1993 and have been on an upward growth trajectory ever since due to their low costs and simplicity since they generally track established indexes, but have struggled somewhat this year in Europe due in no small part to the ongoing eurozone sovereign debt crisis.

“Many institutions are using ETFs and, in many cases, for multi-asset class investing,” Deborah Fuhr, a partner at ETFGI, a research consultancy, told Markets Media last month.

The new rules are not expected to come into force across the European Union until early next year due to Esma starting a further consultation process on repo and reverse repo arrangements which will run until September 25.

In March, the European Commission sought to tighten controls over the so-called ‘shadow banking’ sector that has been blamed for aggravating the financial crisis. Hedge funds and private equity are seen as shadow banking players, although some also throw in investment funds, insurers and other entities. And this week, the Commission launched an in-depth consultation on issues arising from investment funds, which will run in tandem to Esma’s efforts on ETFs and other Ucits, in a bid to maintain investor confidence in money market funds as well as “deepen the Commission’s insight” into the world of shadow banking.

“The consultation focuses on the issue of money market funds and how such funds should be regulated in future; the fund industry’s involvement in securities lending and repurchase (repo) arrangements; and the fund industry’s exposure to certain OTC derivatives that, in future, will be subject to central clearing and the fund industry’s approach to investors’ redemptions,” the European Commission said in a statement.

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