11-4062 efama reply esma discussion paper etfs and … · 2012-06-20 · 3 efama reply to esma...

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EFAMA reply to ESMA Discussion Paper

ESMA’s policy orientations on guidelines for UCITS Exchange‐Traded Funds and Structured UCITS

EFAMA1 welcomes the possibility to reply to ESMA’s Discussion Paper on ESMA’s policy orientations on guidelines for UCITS Exchange‐Traded Funds and Structured UCITS Firstly and most importantly, EU ETFs are UCITS that are listed on a Regulated Market. The listing by itself does not change their risk profile and the UCITS framework already provides for a very high level of investor protection, therefore EFAMA does not consider there is a need for ETF‐specific regulation, except with regard to listing rules. Furthermore, when considering investor protection and disclosure, we strongly encourage ESMA to take a horizontal approach to funds and non‐fund products alike, in the spirit of MiFID and of the PRIPs initiative. Any consideration regarding the marketing of ETFs cannot be dissociated from a review of other products which are also subject to MiFID, therefore any action should be taken within the MiFID Review, maintaining a level playing field vis‐à‐vis other financial instruments. This applies in particular to the question whether ETFs are “complex” or not. EFAMA would also welcome the opportunity to work with ESMA to come to a correct definition of “ETF”, as otherwise the label “ETF” might be misused and many other funds with listings or admission to trading might be incorrectly caught by ETF‐specific provisions. Lastly, we regret the short time given by ESMA to reply to this consultation (especially in view of the summer holidays), and encourage ESMA to carry out a thorough impact assessment including fact‐finding in addition to the consultation replies.

1 EFAMA is the representative association for the European investment management industry. It represents through its 26 member associations and 56 corporate members approximately EUR 13.5 trillion in assets under management, of which EUR 8 trillion was managed by approximately 53,000 funds at the end of 2010. Just under 36,000 of these funds were UCITS (Undertakings for Collective Investments in Transferable Securities) funds.

2 EFAMA reply to ESMA discussion paper on ETFs & Structured UCITS

RETAILISATION OF COMPLEX PRODUCTS FINANCIAL STABILITY AND SYSTEMIC RISK 1. Do you agree that ESMA should explore possible common approaches to the issue of marketing of synthetic ETFs and structured UCITS to retail investors, including potential limitations on the distribution of certain complex products to retail investors? If not, please give reasons. ETFs are only one of many different types of products sold to retail investors, therefore we strongly believe that ESMA’s review should not be limited to ETFs or even to UCITS. This work fits under the MiFID review and the PRIPs initiative, not under the UCITS Directive, and any rules should be horizontal, cross‐sectoral. Existing regulatory arbitrage should be reduced, not increased by further regulating the products that already provide the highest level of investor protection in Europe. Any approach to the marketing of UCITS to retail investors (including potential limitations) should be in line with MiFID and should apply also to similar products such as certificates and notes. Any specific risks should be subject to disclosure to investors for all financial products. A distinction between “complex” and “non‐complex” UCITS should not be drawn on the basis of categories such as synthetic ETFs or structured UCITS, but can be made only on a fund‐by‐fund basis. All UCITS are subject to the same strict rules, and in addition ETFs are also subject to listing rules. A definition of complexity should not be based on the use of specific techniques in a fund. We feel strongly that the “complexity” inherent in the structuring of a product that is designed to meet specific needs of investors should not be confused with risk. Seemingly complex investment techniques may be used to deliver straightforward and low risk investment strategies that could be easily understood by retail investors. Furthermore, ESMA should clarify whether potential restrictions are meant to apply only in case of “execution‐only” transactions or also in case of transactions with advice. 2. Do you think that structured UCITS and other UCITS which employ complex portfolio management techniques should be considered as ‘complex’? Which criteria could be used to determine which UCITS should be considered as ‘complex’? EFAMA disagrees with this approach as it would not, in our view, improve investment outcomes for Europe’s end‐investors, such as long‐term savers and pensioners. The definition of “complexity” should be fine‐tuned, as complexity is not equal to risk. For example, techniques such as derivatives used in structured funds might be complex to explain but result in investor protection, not an increase in risk. However, the use of such techniques should be


appropriately disclosed to investors, and investment managers should have adequate controls to manage risks arising from their use. A distinction has to be made between the financial product structure (i.e. portfolio management technique) and its payoff. From a retail point of view, product complexity should be linked neither to the portfolio management techniques, nor to the financial instruments used in the portfolio, but to the products’ payoff ‐‐ especially because the fund’s structure is well regulated under UCITS. If the payoff is relatively easy to understand for a retail investor, the product is not complex from the investor’s viewpoint. ETFs tracking plain‐vanilla indices should certainly be considered as non‐complex. Many EFAMA members argue that UCITS with a high level of capital protection or capital guarantee should also be considered as non‐complex, and access to products that reduce risk for retail investors should not be restricted. EFAMA considers that all UCITS should remain non‐complex under MiFID as they are very strictly regulated and provide a high degree of investor protection. UCITS are also very liquid, do not involve any liability exceeding the acquisition cost, provide a very high level of disclosure to retail investors (which will be further improved with the introduction of the KII under UCITS IV), are subject to stringent risk management rules and, above all, are designed to be well diversified. They therefore fulfil all the requirements of Art. 38 of the Level 2 MiFID implementing Directive. However, if ESMA deems it necessary to modify the existing status of UCITS as automatically non‐complex, it should avoid introducing rules pertaining solely to UCITS as a product category. ETF‐ or UCITS‐specific regulation would contradict the PRIPs initiative, and any MiFID rules (amended if necessary) should be applicable across all MiFID financial instruments, including UCITS. Furthermore, creating different categories of UCITS might undermine confidence in the global UCITS brand and damage its competitiveness, especially outside the European Union. 3. Do you have any specific suggestions on the measures that should be introduced to avoid inappropriate UCITS being bought by retail investors, such as potential limitations on distribution or issuing of warnings? The ESMA paper discusses financial instruments or techniques (such as derivatives or securities lending) which are used by all UCITS. They are useful and necessary for the entire investment fund industry, and they are not “characteristics” of a fund that could be unsuitable for some investors. Once again, EFAMA members disagree with the proposal to implement distribution measures targeted exclusively to UCITS, and with the idea that UCITS may be inappropriate for retail investors. UCITS marketing is currently governed by host Member State rules and EFAMA members are concerned by a growing trend towards divergence and less harmonization. EFAMA is not opposed in principle to harmonizing rules on distribution and/or warnings, but such harmonization should take place within the MiFID framework, otherwise the Single Market for UCITS will be further eroded.


In general, EFAMA considers that the clear disclosure of risk factors, strategies and techniques in fund documentation and marketing material is very important to help the self‐directed purchase of suitable UCITS. However, where advice is provided, it is the adviser that is responsible for ensuring that the recommended product is suitable. Only the adviser has direct knowledge of the investor’s characteristics and needs, therefore any sweeping restrictions applicable to distribution will harm investor choice and are not sure to help investors. Product providers could choose to limit distribution to specific investor categories, but they have no direct contact with the final client in most cases. Ultimately, the requirement to have clear and consistent investor documentation (including appropriate risk disclosure) is the most important step ESMA could take to advance investor protection and avoid investment by retail investors in “inappropriate UCITS”. 4. Do you consider that some of the characteristics of the funds discussed in this paper render them unsuitable for the UCITS label? No, EFAMA does not consider that the characteristics of the funds discussed in this paper render them unsuitable for the UCITS label. ESMA should also consider that if UCITS were not permitted to use the strategies discussed in this paper, investors may instead turn to less regulated products with less protection. 5. Are there any issues in terms of systemic risk not yet identified by other international bodies that ESMA should address? A very large majority of our members does not see any other issues. Please note that EFAMA addressed issues related to systemic risk in its reply to the FSB Note on Potential financial stability issues arising from recent trends in Exchange‐Traded Funds2 6. Do you agree that ESMA should give further consideration to the extent to which any of the guidelines agreed for UCITS could be applied to regulated non‐UCITS funds established or sold within the European Union? If not, please give reasons. Once again, EFAMA believes that any distribution guidelines should apply to all financial products under MiFID, particularly if ESMA believes that there are systemic risk issues. The issues analyzed in the Discussion Paper are not peculiar to UCITS ETFs or UCITS funds. Many EFAMA members believe that non‐EU ETFs listed on European Regulated Markets should also be covered by the rules.

2 See http://www.efama.org/index2.php?option=com_docman&task=doc_view&gid=1406&Itemid=‐99.


Some EFAMA members question how UCITS rules could be applied to non‐UCITS, as the AIFMD applies only to AIF managers, and contains no product rules. They also consider that any guidelines for AIFs should not apply to fund sales to institutional investors. 7. Do you agree that ESMA should also discuss the above mentioned issues with a view of avoiding regulatory gaps that could harm European investors and markets? If not, please give reasons. EFAMA strongly encourages ESMA to extend the discussion to all financial instruments falling under MiFID (including certificates and notes, as well as products issues by SPVs and non‐European funds), in order to avoid regulatory gaps and reduce the scope for regulatory arbitrage. To do otherwise would contradict the spirit of the PRIPs initiative and not meet ESMA’s stated policy objectives. EXCHANGE TRADED FUNDS EFAMA agrees with many of the ESMA proposals, but wishes to point out that the main source of confusion and possible consumer detriment is the lack of distinction between exchange‐traded funds and non‐fund products (“ETPs”), especially in view of the very different product characteristics and levels of investor protection. If requirements are imposed, they should also cover ETPs. 8. Do you agree with the proposed approach for UCITS ETFs to use an identifier in their names, fund rules, prospectus and marketing material? If not, please give reasons. Almost all EFAMA members agree with ESMA’s proposal that ETFs should use an identifier (such as “ETF”) in their names, fund rules, prospectus and marketing material. It could be very useful to create an “ETF” label that is well defined and protected. First of all, an identifier should help investors distinguish exchange‐traded funds from non‐fund structures (“ETPs”), one of the major sources of investor confusion. However, it is crucial that the criteria for the use of the identifier be clearly defined, similarly to the CESR’s definition of “Money Market Funds”, in order to avoid misuse and to avoid catching many UCITS and non‐UCITS funds which are listed or admitted to trading on Regulated Markets but are not ETFs. The ETF market and other markets for listed funds function differently, and the issue should be carefully analyzed by ESMA. Further information on this critical issue with an example about the Danish market is enclosed in Annex I. There are differences of opinion on the role and definition of an ETF identifier among EFAMA’s members. Some members consider that the use of the identifier “ETF” should be protected and reserved only to:


a. UCITS actively traded on at least one European Regulated Market, with at least one market maker, and b. exchange‐traded funds (from Europe or non‐EU) with equivalent regulation. “Actively traded” should be further defined to include only funds with real continuous trading, with small bid‐offer spreads and significant offered size. Market‐making is currently regulated only at the level of each stock exchange. Each exchange provides some regulation concerning minimum size of market making, maximum spreads and minimum activity. These regulations should be harmonized by ESMA. Other members, on the contrary, consider that the identifier “ETF” should be reserved to any exchange‐traded fund (be it UCITS or non‐UCITS), while excluding other ETPs. The identifier should serve the very important purpose of differentiating exchange‐traded funds from non‐fund ETPs.

9. Do you think that the identifier should further distinguish between synthetic and physical ETFs and actively‐managed ETFs? EFAMA believes that end‐investors should benefit from a high degree of transparency regarding financial products, whether they are provided by investment managers, banks or insurance companies. EFAMA agrees that ETFs should use an identifier. A majority of EFAMA members disagree that the identifier should distinguish between synthetic and physical ETFs for various reasons: 1) The right place for such distinction is the KIID, not the fund name

There is not enough space in the fund’s name: the name of the ETF must already include “ETF”, the name of the provider and the name of the index. The appropriate place for such information is the KIID or the prospectus (or both).

2) “Synthetic” or “physical” replication are difficult concepts that cannot be understood without

explanations (the same applies to “actively managed”). The KIID and/or the prospectus have enough space to explain these concepts.

3) This distinction would not accommodate mixed situations, which often occur in practice:

a. ETFs can use several techniques and switch from one replication to another, or use a combination of them, in order to optimize the return of the fund. For example, an ETF could own physically 90% of the shares of the index, proportionally to the weighting of the index, but use synthetic replication only for the remaining 10% of the index, by purchasing some other shares and swapping them with the rest of the index. A threshold would be necessary to allocate a “mixed” ETF in one category or another.

b. Physical ETFs sometimes invest in futures or in certificates on single stocks, instead of investing in the underlying stocks.


Some EFAMA members, however, believe that an identifier can be ascribed to a synthetic or physical form of replication by reference to the primary investment policy of the fund as opposed to efficient portfolio management or secondary investment techniques to replicate the index. Lastly, other UCITS funds which use derivatives as part of their investment policy do not have such requirements, and it is essential to ensure consistency across all UCITS. 10. Do you think that the identifier should also be used in the Key Investor Information Document of UCITS ETFs? Yes, EFAMA agrees. As stated in our reply to Q9, key information regarding the fund’s strategies and replication methodology (or methodologies) should be included in the KIID (in a simplified language), including the index being tracked. More information can be provided through references in the KIID to the prospectus or other documentation. INDEX TRACKING ISSUES 11. Do you agree with ESMA’s analysis of index‐tracking issues? If not, please explain your view. EFAMA welcomes the focus on disclosure and largely agrees, but we reiterate that ETFs should be treated like any other indexed UCITS. Any guidelines should be applicable to all indexed UCITS, not only ETFs, and should not be applicable to ETFs that are actively managed, non‐indexed funds. We wish to point out an error in the definition of tracking error in Para. 21 of ESMA’s consultation document. Tracking error is not the distance between the performance of the fund and the performance of the index. Tracking error is the volatility of the difference of such returns. Taking the “distance” between the two performances would not make sense. For example, a fund that tracks an index but that accepts some tracking error and therefore some risks in order to be able to outperform the index, may have a negative “distance” between the two performances, precisely because it accepts a significant tracking error. In reference to Para. 23 of the text, we wish to point out that the issue is not specific to synthetic replication. Dividend reinvestment and dividend tax issues apply both to synthetic and physical ETFs, and might lead to tracking error. A very large majority of EFAMA members believe that the choice to define a UCITS as “index‐tracking” should remain with the investment manager, as currently possible. One EFAMA member, however, believes that, in order to define itself as « index‐tracking», a UCITS should publish a target tracking error.


Some EFAMA members believe that ESMA should define and publish a clear tracking error definition and a standardized calculation method to allow for comparability, while others do not consider such standardization is either necessary or useful for retail investors, and point to the fact that institutional investors have their own preferences in terms of calculation. Some members consider that increased index disclosure cannot result in a requirement for the full disclosure of index constituents, as it would not be practicable and would be of little use to investors. 12. Do you agree with the policy orientations identified by ESMA for index‐tracking issues? If not, please give reasons. EFAMA agrees, but many among our members do not believe that a maximum level of tracking error should be included in the prospectus, as it may not practicable to predetermine it and may have legal implications in case of extreme market conditions (such as those experienced during the financial crisis). One EFAMA member, however, believes that a target tracking error would be appropriate, as part of the management objectives of the fund. Some also mention that certain types of indices may naturally lend themselves to greater tracking errors due to the nature of the index methodology (some index methodologies are calculated using a theoretical method which cannot be tracked perfectly when trading the underlying investments). Given the individuality of each index, in their opinion it is therefore not possible to impose a single tracking error maximum level across all tracking funds. 13. Do you think that the information to be disclosed in the prospectus in relation to index‐ tracking issues should also be in the Key Investor Information Document of UCITS ETFs? Yes, but such information should be included in a simplified form in the KIID, with more details in the prospectus. Such requirements should apply to all index‐tracking UCITS. The above comment on the inclusion of the maximum level of tracking error also applies to the KIID. 14. Are there any other index tracking issues that ESMA should consider? 15. If yes, can you suggest possible actions or safeguards ESMA should adopt? EFAMA has no further suggestions. SYNTHETIC ETFS – COUNTERPARTY RISK 16. Do you support the disclosure proposals in relation to underlying exposure, counterparty( ies) and collateral? If not, please give reasons.


Almost all EFAMA members agree, but once again such provisions should apply to all UCITS using derivatives, not just synthetic ETFs. For operational and commercial reasons, some EFAMA members are not in favour of disclosures in the prospectus that change often. For example, the policy concerning the choice of the counterparty of derivatives should be disclosed, but it would be inappropriate to publish the names of the counterparties, at least when they change often according to a predetermined process, like an auction process. 17. For synthetic index‐tracking UCITS ETFs, do you agree that provisions on the quality and the type of assets constituting the collateral should be further developed? In particular, should there be a requirement for the quality and type of assets constituting the collateral to match more closely the relevant index? Please provide reasons for your view. A large majority of EFAMA members does not consider that provisions on the quality and the type of assets constituting the collateral should be further developed as proposed by ESMA. CESR’s Guidelines on Risk Measurement for UCITS (box 26) already provide for quite stringent collateral requirements for UCITS, and our members consider that they are sufficient. If fund assets comply with the liquidity, valuation, issuer credit quality, and diversification constraints, no further requirement for the quality and type of assets constituting the collateral to match closely the relevant index should be necessary. Collateral is provided to secure a claim and should not be confused with portfolio assets. It is in the best interest of investors to give the manager some flexibility regarding collateral (within the existing guidelines). For example, the manager may prefer, in some instances, in order to respect the counterparty limits at all times, to have some over‐collateralization, but some less correlated assets. In other cases, the manager may prefer to have well correlated asset, but to be closer to the counterparty limit. There is only one risk to having collateral that differs very much from the index portfolio: the risk of not respecting the counterparty risk limit. If the market moves in different directions very strongly, the counterparty risk limits (5% or 10% by counterparty) could be breached. Rules limiting counterparty risk already create an incentive for the ETF manager to request collateral that is well correlated to the index that is replicated, and a tendency to use collateral that is close to the index that is replicate can be observed in practice: equity ETFs have collateral equity, bond ETF have bond collateral. One EFAMA member suggests that if collateral rules were to be developed, the only requirement should be that the collateral should at least be of an equivalent or better quality than that of the index being tracked. In this situation, an ETF tracking an emerging market index could have collateral comprising the securities from the same index or developed market securities but at the same time


an ETF tracking a developed market index could not be backed by collateral comprising emerging market securities. Another considers that collateral eligibility requirements should also include the application of a minimum credit rating threshold. Another EFAMA member considers that provisions on the quality and the type of assets constituting the collateral should be further considered by ESMA, taking into account the size of the ETF market. ESMA should consider whether enforcement of existing provisions would be sufficient, before imposing new ones. However, should ESMA establish that action is warranted, a possible solution would be to require a certain percentage of correlation of the collateral with the index portfolio. Furthermore, ESMA could also examine issues such as quality of collateral and counterparty risk (limits and conflicts of interest). 18. In particular, do you think that the collateral received by synthetic ETFs should comply with UCITS diversification rules? Please give reasons for your view. No, a large majority of EFAMA members consider that collateral received by synthetic ETFs should comply with CESR’s Guidelines on Risk Measurement, but need not comply with UCITS fund diversification rules, as UCITS collateral rules already have qualitative requirements on collateral diversification. This should help maintain flexibility with respect to the provision of collateral and help ensure that any collateral provided is of high quality, rather than imposing an obligation to take collateral of lower quality simply to comply with specific diversification limits. It is important to note that collateral diversification rules and UCITS fund assets diversification rules have two distinct objectives, which should not be confused: the purpose of the collateral diversification is to reduce counterparty risks while the purpose of the fund assets diversification is to prevent excessive concentration of investments. Quality of collateral is much more important than diversification. We reiterate that there should be no difference between listed and unlisted index‐tracking UCITS in disclosure and in collateral requirements. SECURITIES LENDING ACTIVITIES 19. Do you agree with ESMA’s analysis of the issues raised by securities lending activities? If not, please give reasons. EFAMA agrees with ESMA’s analysis except for Para. 37 of the discussion paper. The systemic risk concerns raised by the FSB are not justified, as there are already provisions in place under the UCITS regime which prevent a market squeeze and protect investors in the event of increased redemptions (such as the right to suspend redemptions under Art. 84 (2) of the UCITS Directive). For ETFs such


risks are even lower, due to the additional liquidity supply by market makers which significantly reduces the impact of unit trades on the fund portfolio and hence prevents large‐scale recalls of on‐loan securities. EFAMA wishes to reiterate that securities lending is a technique widely used by funds and its benefits for investors should also be taken into account by ESMA. 20. Do you support the policy orientations identified by ESMA? If not, please give reasons. EFAMA agrees. Any proposals must apply to all UCITS, not only to ETFs. Many EFAMA members consider that the disclosure for securities lending activities should match the collateral disclosure requirements for synthetic ETFs. Some members believe that a detailed description of the impact on tracking error cannot be included, as it can be positive or negative. 21. Concerning collateral received in the context of securities lending activities, do you think that further safeguards than the set of principles described above should be introduced? If yes, please specify. No, EFAMA believes that current rules are sufficient. 22. Do you support the proposal to apply the collateral criteria for OTC derivatives set out in CESR’s Guidelines on Risk Measurement to securities lending collateral? If not, please give reasons. In principle yes, since collateral guidelines should be consistent across ETFs and other UCITS in Europe. Whilst it would not be appropriate to simply refer to the collateral criteria for securities lending in CESR’s Guidelines on Risk Management (as these relate to the management of OTC derivative exposure), EFAMA’s members would welcome a coordinated and consistent approach to the treatment of collateral through the development by ESMA of similar principles for securities lending. In line with our reply to Q18, UCITS diversification rules for fund holdings should not be imposed on the collateral for securities lending to maintain flexibility in respect of the provision of collateral and help ensure that any collateral provided is of high quality.


23. Do you consider that ESMA should set a limit on the amount of a UCITS portfolio which can be lent as part of securities lending transactions? No, EFAMA does not consider that such a limit is necessary, as long as the lending is properly collateralized. Putting restrictions would potentially reduce the return for the fund, penalizing investors. 24. Are there any other issues in relation of securities lending activities that ESMA should consider? 25. If yes, can you suggest possible actions or safeguards ESMA should adopt? A large majority of EFAMA members consider there are no other issues that ESMA should consider. However, some EFAMA members believe that ESMA should consider that there currently are no rules in the UCITS Directive limiting counterparty risk for securities lending operations, and regulation similar to that for derivatives should be introduced: counterparty risk should be limited to 5% on any counterparty, or 10% on a credit institution. This should be accomplished in their opinion via ESMA guidelines and, whenever possible, at Level 1 in the UCITS Directive. ACTIVELY MANAGED UCITS ETFs 26. Do you agree with ESMA proposed policy orientations for actively managed UCITS ETFs? If not, please give reasons. EFAMA agrees, but we point out that the calculation of the indicative net asset value (iNAV) is not part of a fund manager’s duties and is performed by an external service provider. Moreover, the iNAV is provided for all types of ETFs, not just for actively managed funds, therefore it is not clear why ESMA proposes to specify relevant calculation methods just for this ETF category. Some EFAMA members do not believe it would be practical or feasible to disclose how the indicative net asset value is calculated. 27. Are there any other issues in relation to actively managed UCITS ETFs that ESMA should consider? 28. If yes, can you suggest possible actions or safeguards ESMA should adopt? Almost all EFAMA members consider there are no other issues to be considered, but some among our members believe that ESMA should define “actively managed” UCITS ETFs, which should be clearly distinguished from passive index‐tracking UCITS ETFs and even be listed on a different stock exchange segment.


LEVERAGED UCITS ETFS 29. Do you agree with ESMA analysis of the issues raised by leveraged UCITS ETFs? If not, please give reasons. EFAMA agrees. 30.Do you support the policy orientations identified by ESMA? If not, please give reasons. EFAMA agrees, and many among our members would recommend that such ETFs use the word “Daily” or “Monthly”, as appropriate, in their identifier, as well as the level of leverage e.g. “2X”, in order to make it clear to investors which return is being tracked. 31.Are there any other issues in relation leveraged UCITS ETFs that ESMA should consider? 32. If yes, can you suggest possible actions or safeguards ESMA should adopt? No. SECONDARY MARKET INVESTORS Shareholder Redemption on the primary Market Under UCITS guidelines it is not permitted to restrict any shareholders from having access to the redemption process. While an investor must be approved as an AP to create on an ETF, there are no such restrictions on the redemption process. Typically, should investors wish to redeem on the primary market, for whatever reason, they will be required to complete a standard account opening process. Once complete they can place a redemption order. As the Administrator, the Transfer Agent or the depositary (depending on the jurisdiction) may not be able to confirm the shareholder’s status on the register, it may be required that the shareholder deliver the shares back before the redemption order is accepted. This delivery acts as confirmation of their holding and enables the fund manager to act to raise the necessary cash to meet the redemption placed without risk of having to cancel should the investor not be able to deliver. As the actual beneficial owner may be holding their shares in a nominee or omnibus account structure with the local CSD, they will have to arrange for this delivery to take place using the same infrastructure they used when they initially purchased the shares.


33. Do you support the policy orientations identified by ESMA? If not, please give reasons. Redemption from the fund is a fundamental tenet of UCITS and EFAMA does not consider that the proposed warning is appropriate. However, the prospectus should provide disclosures on redemption on the primary market. For operational costs reasons, ETFs should have the right to apply subscription and redemption fees on the primary market, some independent on the size of the order, in order to limit such subscriptions and encourage exchange trading as primary channel. Fees are acceptable for UCITS, so they may not be restricted for ETFs. There are several reasons why final investors should be encouraged to use the secondary market, mostly to protect existing investors that remain in the fund: a) The current creation redemption process limited to Authorized Participants, imposes large

minimum size orders (usually around 1‐3M€). If retail investors were allowed to create and redeem for small sizes, the fund manager will lose operational efficiency and it will greatly impact the tracking error of the funds, as small fractions of the index are not possible to trade (to the detriment to remaining investors in the fund).

b) Authorized Participants are investment professionals who ensure the liquidity of the ETF on the secondary market. If retail investors could create and redeem on the primary market, the profitability of the Liquidity Providers would be impacted, which in return will impact the intraday market spreads (which may be to the detriment to new and existing investors in the fund).

c) Creation and redemption costs may change as they correspond to the actual execution costs, and are billed to the funds, so that existing shareholders are not impacted by new entrants or redeeming shareholders. This mechanism requires a good understanding of the underlying market to anticipate execution costs, and may sometimes lead to the payment of a separate invoice after the settlement of the ETF transaction when execution is delayed by a market disruption event. Such mechanism may not be implemented with retail investors, and the role of Authorized Participants as intermediaries simplifies the process for these investors.

However, if the secondary market is disrupted for operational reasons, for example because the market maker is unable to operate, then the final investor can make use of his/her right to access the primary market. 34. Are there any other issues in relation to secondary market investors that ESMA should consider? 35. If yes, can you suggest possible actions or safeguards ESMA should adopt? Yes, the prospectus should provide clear disclosures on liquidity risks for the secondary market. Such disclosures are already industry practice for ETFs.


ETFs are protected by several rules related to their listings, as well as the Market Abuse Directive and MiFID. Many EFAMA members consider that market‐making regulations should be harmonized. EFAMA takes this opportunity to point out that it would be appropriate for the upcoming MiFID Review to include an extension to ETFs of equity transparency requirements, to show the full extent of trading. However, it must be ensured that such extension applies only to ETFs, not to all other UCITS that – depending on national trading models – may be admitted to trading on Regulated Markets. It is therefore crucial that the definition of ETF be correct (see our reply to Q8). 36. In particular, do you think that secondary market investors should have a right to request direct redemption of their units from the UCITS ETF? Yes, as ETFs are UCITS and their investors maintain the right to request direct redemptions under conditions set in the prospectus. However, EFAMA considers that non‐APs should be encouraged to use the secondary market where possible and would generally support steps to ensure shareholders use the best method available to redeem shares, particularly from an operational standpoint, to avoid detriment to new and existing investors in the fund as a result. This includes availing of secondary market liquidity when available. 37. If yes, should this right be limited to circumstances where market makers are no longer providing liquidity in the units of the ETF? Regulated Markets require that at least one market maker ensures liquidity for ETFs. The market maker has a contractual obligation with the exchange to provide liquidity in the units of the ETF, with minimum time presence and size, and (often) maximum bid‐spread requirements. If an ETF is delisted or secondary market is disrupted, secondary market investors should have the right to redeem directly. Some EFAMA members, however, consider that exceptional circumstances should include those cases where secondary market does not function properly while there is no dysfunction on other markets (i.e. primary market and underlying index markets). In order to accept direct redemptions from investors the UCITS, the ETF must be able to trade the underlying hedging on the index dedicated markets. If the fund cannot hedge its position (by adjusting the OTC derivatives, the substitute basket or the collateral assets), then no direct orders should be allowed. 38. How can ETFs which are UCITS ensure that the stock exchange value of their units do not differ significantly from the net asset value per share? Firstly, a comment on ESMA’s choice of language: ETFs have no influence on market price of units on secondary market, which is determined based on order matching rules in open order books that include a variety of different order types and quotes from official market makers, other market


professionals and investors. ETFs therefore cannot “ensure” that no significant variations from the calculated NAV occur. ESMA should note that the net asset value of a share is correct only at the moment when it was calculated. The price that the shares trade at on the exchange will not be the same as the NAV as it reflects the portfolio value at a different point in time and also depends to a large extent on the current level of the underlying market’s volatility. However, the primary market process for an ETF automatically ensures that the secondary market will always stay in line with the NAV of the fund. For example, at all times the AP/Market Makers for an ETF are monitoring the ‘Fair Value’ of an ETF against the current market price. This is calculated in real‐time by valuing the components of the NAV and adjusting for the cost of creation/redemption. In the event that the on‐exchange price moves outside this fair value, the AP will have an arbitrage opportunity. For example, if the on‐exchange price is at a premium to the fair value due to high demand, the AP can sell at the ‘premium’ price on exchange and create at the lower NAV price. This will introduce additional inventory into the secondary market therefore removing the demand impact on the price. This will bring the price back in line with the fair value. On Euronext for example, the iNAV is published every 15 seconds throughout the Paris trading session (09:05 – 17:40). Reservation thresholds are set giving a range of 1.5% on either side for indices covering European underlying (3.0% for all other geographical zones) of the fund units’ iNAV, as published by Euronext Paris. The iNAV data and the thresholds described above are good indicators and safeguards. However, some European Stock Exchanges (such as the London Stock Exchange for example) do not publish iNAV since it is not one of their listing rules. Some EFAMA members consider therefore that ESMA should harmonize listing rules in order improve investors’ information and protection. STRUCTURED UCITS ‐ TOTAL RETURN SWAPS 39. Do you agree with ESMA analysis of the issues raised by the use of total return swaps by UCITS? If not, please give reasons. EFAMA agrees, with two exceptions: • Regarding the following sentence in point 56: “While it may be considered that the composition

of the physical assets held by a UCITS is not relevant to the asset diversification test, by virtue of the diversification provided through the swap, it is not clear that Article 52 of the Directive would allow for this interpretation.” We believe that a constant interpretation of most European regulators has been that diversification has to be implemented after derivatives, and only after derivatives. This is reinforced by a simple economic analysis: the purpose of diversification is to diversify the exposure of investors, and exposure is real only after derivatives. Furthermore, the


assets held by the UCITS are economically equivalent to collateral and there are no quantitative diversification requirements regarding collateral, only qualitative ones.

• Regarding the sentence in point 54: “While there are certain practices which are banned by the UCITS Directive, for example physical short selling and borrowing it is not entirely clear that a counterparty will not engage in these type of transactions are part of the investment strategy”: the UCITS Directive regulates the fund, not the counterparty. The counterparty can hedge itself (or not) how it wishes, without any restriction.

40. Do you support the policy orientations identified by ESMA? If not, please give reasons. EFAMA supports them, with the following exceptions: 1) Regarding the third bullet point in Para. 59, ESMA’s policy orientations, EFAMA disagrees with

the proposal to treat discretionary decisions relating to the underlying swap portfolio as delegation of investment management

If the counterparty had discretion on investments that have an impact on the performance/NAV of the UCITS, then the agreement could be deemed as a delegation arrangement, but if the counterparty has discretion only on the investment portfolio that is swapped, it would be inaccurate to treat it as an investment manager. As for any swap, the investment manager of the UCITS sets guidelines for acceptable collateral and the counterparty has discretion within these guidelines to choose the securities it gives as collateral. Furthermore, the manager can give to the swap counterparty some flexibility as regards the choice of the underlying of the leg of the swap where the fund pays the performance of the direct portfolio. The reason is that the composition of this underlying (which is also the composition of the portfolio directly owned by the fund) has no effect on the exposure of the fund. The position of the fund through this leg of the swap is exactly compensated, by definition, by the portfolio directly owned by the fund. The only relevant consideration for the manager is the net advantage of such structure and whether the portfolio gives a proper guarantee to the fund in case the counterparty should default. The manager of the fund can give a lot of flexibility to the swap counterparty: this is in the best interest of the investors, because that allows a better net remuneration for the fund. This operation is very similar to lending securities and earning the appropriate proceeds from securities lending. The manager does not have to choose the precise securities that will be lent, provided that this is on line with its guidelines. Obviously, such flexibility for the swap counterparty does not make the counterparty an investment manager. An investment manager is an actor whose decisions have an effect on the return of the fund, which is not the case here.

2) The first bullet point of Para. 59 states that “both the UCITS` investment portfolio, which is swapped, and the underlying to the swap, which the UCITS obtains exposure to, must comply with


the relevant UCITS diversification rules.” EFAMA does not consider that UCITS diversification rules should apply to the swap underlying. Instead, Box 26 of CESR’s guidelines should apply. TRS are financial instruments in the sense of MiFID and should be treated as such for the purpose of measuring market risk. It is essential, but also sufficient to adhere to the diversification rules with regard to the UCITS portfolio, as risks taken by investors are the real exposure of the fund, after the effect of derivatives.

UCITS diversification rules are meant to avoid the possibility that exposure to a given issuer would have too significant an impact on the performance of the fund. However, the portfolio swapped in a TRS has no impact on the performance of the UCITS, since it is swapped. Instead, the UCITS has counterparty risk on the counterparty to the TRS, and the risk is subject to a 10% limit. The investment portfolio should therefore be subject to Box 26 of CESR’s guidelines.

3) Regarding the last bullet point in Para. 59 (“the prospectus should include information on the

underlying strategy, the counterparty(ies) and, where relevant, the type of collateral which may be received from the counterparty(ies)”, some EFAMA members consider that only abstract information over the counterparties should be required, since (1) the specific counterparty is often not known when a fund is launched, and (2) of course, counterparties can be added or removed. It would then be very burdensome if such a change would trigger a prospectus change.

EFAMA considers that the policy orientations should apply to all UCITS, not just to “structured UCITS”. 41. Are there any other issues in relation to the use of total return swaps by UCITS that ESMA should consider? 42. If yes, can you suggest possible actions or safeguards ESMA should adopt? No. STRATEGY INDICES 43. Do you agree with ESMA’s policy orientations on strategy indices? If not, please give reasons. EFAMA agrees with the proposals, with the exceptions below. a) Adequate benchmark A large majority of EFAMA members agree with ESMA’s proposals. However, some EFAMA members disagree and consider that by suggesting that an index must be a benchmark for the market to which it refers, ESMA seems to restrict the scope of eligible financial indices to long only and beta financial indices not embedding any kind of strategy.


In its advice of January 2006 (Ref: CESR/06‐005), CESR stated that in order to be recognised as being an adequate benchmark for the market to which it refers, the index “must measure the performance of a representative group of underlyings in a way that is meaningful and useful”. Strategy indices can be designed with a view to satisfying this condition. There are numerous strategy indices meeting that requirement that have been approved by the supervisory authorities across the EU over the last decade and in connection with UCITS products. It is also worth noting that some of those strategy indices have become benchmark indices themselves. UCITS funds providing an exposure to strategy indices have been raising and are still raising subscription proceeds amounting to billions of Euros, which is per se already a strong indication that there is demand for those UCITS funds and that they have been delivering a performance deemed as being a competitive one in comparison with other types of UCITS funds and other investment products. It would be helpful to obtain a clarification of the reasons for the perceived ESMA belief that strategy indices are not appropriate for UCITS funds. b) Sufficiently diversified EFAMA agrees with the proposal, but ESMA should clarify the meaning of “impact”. c) Rebalancing Traditional indices have a rebalancing policy which is, in general, quarterly. However, there is a lot of innovation in the world of indices these days and we do not see why having a more frequent rebalancing, even intra‐day, would be in itself a problem in terms of public policy. It depends also on what is defined as "rebalancing". If rebalancing is defined by changing the weights, traditional indices are rebalanced every second, because the weight of each constituent depends on the market price of such constituent. If we define rebalancing by the number of units of the constituents, traditional indices do tend to rebalance quarterly, but in this case, an index which is equally‐weighted would be seen as rebalancing every day, in order to keep its weight constant. We do not see any convincing reason to limit indices to monthly rebalancing. ESMA mentions two issues: costs and transparency. EFAMA fully agrees on disclosure of the rebalancing frequency. Investors should clearly be informed that rebalancing can happen intra‐day, but the costs are not necessarily significant, since the underlying concerned can be very liquid (futures etc.). Also, the rebalancing can affect only a small part of the portfolio so that would not be significant in terms of costs. The costs, however, can only be estimated, as the transaction costs are not known in advance: a general statement indicating that costs increase when rebalancing frequency increases is sufficient. Ultimately, the rebalancing has to be adequate to the market the index seeks to represent, and, if such market suggests an intra‐day rebalancing, it could be harmful to the industry and to the investors to limit the rebalancing frequency.


Transparency may be an issue, but the frequency of rebalancing is not the issue. An index can be rebalanced quarterly and be completely non transparent. An index can be rebalanced intra‐day and be very transparent. We believe there is no absolute relation between the two. What is also important is the fact that the index is rebalanced according to a model. It does not matter very much that it is rebalanced intra‐day, if such rebalancing is purely model‐based. On the contrary, a rebalancing that would happen every month, for example, but on a purely discretionary basis, should be prohibited. A large majority of EFAMA members agree with the disclosure of the rebalancing frequency in the prospectus. d) Published in an appropriate manner Strategy indices are based upon proprietary methodologies of index providers for which index users usually pay considerable fees. It is not appropriate to require public disclosure of this proprietary information and we fear that hardly any index provider would be willing to comply with the extensive disclosure standards proposed by ESMA which would result in an effective ban for ETFs and other UCITS in terms of utilization of such indices. It must be also noted that the level of transparency required by ESMA would constitute a major problem for nearly all index providers, not only for strategy indices. Moreover, timely publication of comprehensive index data could result in enhanced front‐running or prompt speculative trades against the index. Furthermore, it is unclear why the eligibility of an index should depend upon the (retail) investors’ ability of replication as suggested in Para. 69. The average retail investor will not be able to replicate even standard blue‐chip indices like MSCI World, FTSE 100 or DAX 30. Besides, investors in actively managed UCITS are generally not able to acquire knowledge of the fund holdings on a daily basis. Hence, the decisive criteria should be the replication ability of a fund manager and his continuous adherence to risk limits. Both elements are fully warranted also in case of daily rebalancing strategy indices. Some well‐known and recognized financial indices (e.g. the S&P GSCI) allow for some discretion, though constrained through their index committee, and some other indices do not disclose commercially sensible information (which would allow an investor aiming at replicating the index to arbitrage it). It seems to us that the right criteria as regards transparency should be that investors must be able to assess which market is exactly represented, what the objectives of the index are and how the rebalancing methodology works. e) Hedge fund indices Some EFAMA members disagree with the extension of eligibility criteria for HF indices to all financial indices as they have been developed for a specific market sector. If at all, application of guidelines 1‐3 could be envisaged.


f) Conflicts of interest The issue is sufficiently dealt with by general Conduct of Business rules for UCITS managers. The suggested “independent” assessment should also allow for valuation by internal business units provided the existence of Chinese walls or other segregation arrangements in relation to fund management. 44. How can an index of interest rates or FX rates comply with the diversification requirements? Some EFAMA members consider that ‐‐ provided that most of interest rates or FX rates indices are achieved through bonds portfolios ‐‐ it should be possible to comply with the mentioned diversification requirements. However, specific attention should be brought in the ETF regulatory and marketing documentation, since both investment management techniques and associated risks have to be disclosed in an appropriate manner. Other EFAMA members believe that interest rate derivatives and FX derivatives should be disregarded for the sake of diversification of indices, i.e. their notional should not be constrained by a diversification limit. There is no proper way to take them into account and they are already disregarded for the computation of diversification of assets held directly by UCITS according to article 52 of the UCITS Directive. The reason is that such derivatives do not have an "underlying" according to article 51(3) paragraph 3 of the UCITS Directive. Here is an example with an FX derivatives: we assume that an index provider wants to create an index "quanto", for example a quanto S&P 500 in EUR. This index would be made of the S&P 500 in EUR, but protected from the variation of the USD/EUR rate. The index would be made of the 500 shares of the S&P 500, plus a swap USD/EUR for a notional amount equal to the index. Such index would however be properly diversified, in spite of the fact that its EUR/FX swap has a notional equal to 100% of the value of the index. There is no underlying security of such swap that has to be taken into account. However, we believe that an FX position has a diversification feature in itself, e.g. a portfolio having an index exposure and FX positions might be better diversified than a portfolio exposed only to the index. As a consequence, when evaluating the exposure of an index to a given asset, managers should be given the option to include the FX exposure gained through FX future contracts used for investment purposes (as opposed to hedging purposes) in the calculation. Other members are of the opinion that the relevant diversification requirement should not be applicable to indices comprising interest rates or FX rates for two reasons:


1) recognised rates such as “Eonia” are computed as a weighted average of a number of overnight

unsecured lending transactions in the interbank market, i.e. they are already diversified, and 2) if a derivative linked to interest rates or FX rates is directly acquired for the account of a UCITS,

no diversification rules (regarding the underlying) apply in that respect. Therefore, no diversification rules should apply if an index derivative (linked to interest rate(s) and/or FX rates) is acquired.

Standard counterparty OTC limits would still apply. 45. Are there any other issues in relation to the use of total return swaps by UCITS that ESMA should consider? Yes. The situation of “indices of indices”, that is indices that contain some other indices among their constituents, should be clarified. Indices of indices should be analyzed using the framework of the Directive for diversification purposes: an index that includes in its assets some sub‐indices should not take into account the sub‐indices for the sake of diversification, to the extent that the sub‐indices are themselves indices according to the UCITS Directive and to ESMA guidelines. For example, if a sub‐index is itself an index according to the UCITS Directive and ESMA guidelines, the sub‐index is itself properly diversified. The weight of the sub‐index should therefore be allowed to be higher than 35%. For example, we propose that it should be possible to have an index that would be made of 4 constituents, each of them for 15% of the index, plus a compliant sub‐index for 40% of the index. As a constituent of the index, the sub‐index can represent more than 35% of the index. 46. If yes, can you suggest possible actions or safeguards ESMA should adopt? ESMA guidelines should include a paragraph mentioning indices that include other indices as constituents. It should mention that when an index includes as constituent another index (the “sub‐index”) and when the sub‐index respects European regulations as an index, the exposure to such sub‐index can be higher than 35% of the index. [11‐4062]


Annex I Definition of “ETF” – Exclusion of non‐ETF UCITS with listing and trading on Regulated Markets – Characteristics of the Danish fund market EFAMA reiterates the importance of a correct definition of “ETF”, in order to avoid misuse and to avoid catching many UCITS and non‐UCITS funds which are listed or admitted to trading on Regulated Markets but are not true ETFs. Unfortunately, such features as ‘creations shares’ or ‘iNAV’ are not used by all ETFs, and there are issues with definitions suggested so far by CESR or the European Commission. The proposed expansion of the definition of “admission to trading” by the European Commission might bring many non‐ETF UCITS into scope. For example, as of 30 April 2010, 3148 funds and sub‐funds were listed in Ireland, and a listing on the ISE is considered an admission to trading although most funds do not typically trade their shares. Of the above funds, only three true ETFs are listed (and one of them traded) on the ISE. UCITS are also listed/traded on a variety of other markets (although maybe not formally admitted to trading) and such trading is usually marginal compared to primary market activity (that is to direct redemption and subscription of shares/units). Denmark represents an exception and a special case, as almost all UCITS aimed at the retail market are traded on a tailor‐made marketplace (see www.ifx.dk) on Nasdaq OMX This secondary market is the main channel for retail investors’ purchases. Investors can buy fund shares in all Danish retail funds even though their bank does not have a cooperation agreement with all the fund groups. This is beneficial for competition between the funds. There are 420 funds traded on the Copenhagen Stock Exchange. Most of them are actively managed funds, and a minority are index‐tracking funds, but none are ETFs. However, trading of Danish funds on the Stock Exchange has some unique characteristics, which result from a stronger involvement by, and obligations on the fund Management Company. For ETFs the calculation of the iNAV is not part of a fund manager’s duties and is performed by an external service provider. This is not the case in Denmark, where the fund group’s calculation of NAV, subscription price and redemption price is guiding the prices in the secondary market. Danish fund managers are obliged to supply this information to the Stock Exchange at least three times a day according to the official rules of the marketplace.Market makers enter into agreements with the fund managers and must quote bid and offer prices inside the boundaries set by the subscription and redemption prices (provided by the fund manager according to the rules in the prospectus). This means that investors will always trade at prices in the secondary market that are at least as good as (or better) than subscriptions and redemptions directly with the fund. This method ensures that no significant deviations from the calculated NAV can occur. Every investor’s fund shares are registered by name with the Danish CSD (VP Securities), and investors can always redeem their fund shares directly with the fund company if they wish to do so. This is rarely the case, because investors can sell at better prices through their bank on the secondary market


The market maker acts as an ordinary investor having the same rights as every other investor in the fund. Ownership of the fund shares can change directly from investor A to B, or from investor A to market maker, which later trades with investor B. The market maker’s role is simply to set bid and offer prices on the basis of his own holdings and thereby ensure that the market can be active to the benefit of investors. There is also no liquidity risk for Danish funds on the Exchange, as the market maker can always subscribe new fund shares or redeem existing fund shares during the day at the latest subscription and redemption prices set by the fund manager. This mechanism ensures that the market maker can always set his bid and offer prices within the boundaries set by the fund manager and that he can fulfill every client order during the day. Furthermore, transparency for investors is better when they buy or sell on the secondary market, as investors can be informed about the exact buying or selling price at the time of the transaction. Listed Danish funds should not be included in the scope of the definition of “ETF” because the fund manager ‐ acting under the UCITS Directive ‐ has a central role in ensuring liquidity and ensuring attractive prices for investors. The secondary market is only functioning when the fund manager plays this role.

11-4062 efama reply esma discussion paper etfs and … · 2012-06-20 · 3 efama reply to esma...

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