Principles for the Regulation of

Exchange Traded Funds

Final Report

BOARD OF THE
INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS
FR06/13

JUNE 2013

Copies of publications are available from:

The International Organization of Securities Commissions website www.iosco.org
International Organization of Securities Commissions 2013. All rights reserved. Brief
excerpts may be reproduced or translated provided the source is stated.

ii

Contents
Relevant Definitions

Chapter 1 - Introduction

Chapter 2 - Principles Related to ETF Classification and Disclosure

1.

Disclosure regarding ETF classification

2.

Disclosure regarding ETF portfolios

3.

Disclosure regarding ETF costs, expenses and offsets

11

4.

Disclosure regarding ETF strategies

13

Chapter 3 - Principles Related to the Structuring of ETFs

14

1.

Conflicts of interest

14

2.

Managing counterparty risks

15

Chapter 4 ETFs in a broader market context

20

Appendix I List of Principles

21

Appendix II - Feedback Statement on the Public Comments received to the

Consultation Report Principles for the Regulation of Exchange Traded Funds

22

Appendix III List of Working Group Members

40

Appendix IV Broad Overview of ETF Structures and Regulation Across Three Key
Regions
41

iii

Relevant Definitions
Exchange-traded fund (ETF)

ETFs are open ended collective investment schemes

(CIS) that trade throughout the day like a stock on the
secondary market (i.e., through an exchange).
Generally, ETFs seek to replicate the performance of a
target index and are structured and operate in a similar
way. Like operating companies, ETFs register offerings
and sales of ETF shares and list their shares for trading.
As with any listed security (including some closed-end
investment companies), investors may trade ETF shares
continuously at market prices, but ETF shares
purchased in secondary market transactions usually are
not redeemable from the ETF except in large blocks
called creation units. 1
As noted in the definitions below, ETFs may be indexbased or actively managed, and may pursue their
investment objectives using a physical or synthetic
investment strategy.

Authorized Participant (AP)

Unlike other open ended CIS, ETFs generally do not sell or

redeem their individual shares (ETF shares) to and from
retail investors directly at net asset value (NAV). Instead,
certain financial institutions (known as authorized
participants or APs) purchase and redeem ETF shares
directly from the ETF, but only in creation units. Most
often, an AP that purchases a creation unit of ETF shares
first deposits with the ETF a purchase basket of certain
securities and cash and/or other assets identified by the ETF
that day, and then receives the creation unit in return for
those assets. The basket generally reflects a pro rata portion
of the ETFs underlying holdings. After purchasing a
creation unit, the AP may hold the ETF shares, or sell some
or all of the ETF shares in secondary market transactions.
The redemption process is the reverse of the purchase
process. The AP acquires (through purchases on national
securities exchanges, principal transactions, or private
transactions) the number of ETF shares that compose a
creation unit, and redeems the unit from the ETF in
exchange for a redemption basket of securities and/or cash
and other assets (or all cash).

Exchange-traded products (ETPs)

ETPs include a wide variety of different investment products

that share the feature of being traded on an exchange. They
include ETFs that are organized as CIS, exchange-traded
commodities (ETCs), exchange-traded notes (ETNs),
exchange-traded instruments (ETIs), and exchange-traded
vehicles (ETVs).

A creation unit may be defined as the block of ETF shares (the number of which the ETF specifies) that
an authorized participant can acquire or redeem, typically for a specified basket of securities or other
assets.

Index-based ETFs

Index-based ETFs typically seek to replicate the

performance that corresponds to that of an underlying index
or benchmark. Index-based ETFs may seek to obtain this
performance either by holding physical securities and other
assets, or entering into one or more derivative contracts with
a counterparty, as defined further below.

Physical ETFs

Physical ETFs seek to meet their investment objective by

holding physical securities and other assets. Physical ETFs
that are index-based obtain returns that correspond typically
to those of an underlying index or benchmark by replicating
or sampling the component securities of the index or
benchmark. A physical index-based ETF that uses this
replicating strategy generally invests in the component
securities of the underlying index or benchmark in the same
approximate proportions as in the underlying index or
benchmark. The transparency of the underlying index
typically results in a high degree of transparency in the
ETFs underlying holdings. In certain cases, it may not be
possible for an ETF to own every stock of an index (e.g.,
due to transactions costs, because the index is too large, or
some of its components are very illiquid, or where an
indexs market capitalization weighting would result in the
ETF violating regulatory requirements for fund
diversification). Where owning every stock of an index is
not possible, a physical index-based ETF may rely on
sampling techniques.
The physical index-based ETF
implements the sampling strategy by acquiring a subset of
the component securities of the underlying index, and
possibly some securities that are not included in the
corresponding index designed to improve the ETF's indextracking. Some physical ETFs, however, may be nonindexed based (or actively-managed). i.e., with a portfolio
selected at the discretion of the investment manager.

Synthetic ETFs

Synthetic ETFs seek to meet their investment objective by

entering into a derivative contract (typically through a total
return swap) with a selected counterparty. The swap
contracts can take two forms: (i) a so-called unfunded
structure; and (ii) a so-called funded or prepaid swap
structure. Synthetic ETFs tend to be concentrated in Europe
and in some parts of Canada and Asia. 2

Synthetic ETF unfunded structure

In this type of synthetic ETF structure, the ETF

provider/manager invests the cash proceeds from investors
in a so-called substitute or reference basket of securities
(which is typically bought from a bank). The basket's return

According to data elaborated by ETFGI, as of January 2013, 60% of the European ETF offer is
synthetic, compared to 20% of the offer in the Asia/Pacific region including Japan. Hybrid ETFs
(accounting for roughly 1% of ETF-managed assets globally according to ETFGI) are structures that
utilize both replication techniques purely as a mean to mitigate e.g., the occasional impact of market
closings (i.e., long public holiday periods in certain jurisdictions) or the temporary unavailability of
certain securities.

is swapped via a derivative contract with an eligible

counterparty (frequently, the derivatives desk of the same
bank) in exchange for the return of the index referenced in
the ETF's investment objective.
Synthetic ETF funded structure

In the funded model type, a synthetic ETF seeks to obtain a

return in line with the performance of its reference index by
engaging in a swap in exchange for cash (or for the entire
ETF portfolio) without the creation of a substitute basket.
In both models, derivative exposure is collateralized or
reduced through a collateral or portfolio management
process that may involve the services of a third party as
collateral agent (in the funded model) or is covered by the
substitute basket as assets of the ETF (in the unfunded
model). 3

Actively managed ETFs

ETFs where the manager typically exercises discretion over

the composition of the invested portfolio in an attempt to
outperform a chosen benchmark. The key difference
compared to passive ETF products is therefore a manager's
ability to adjust the portfolio without being subject to the set
rules of an index.

Leveraged & inverse ETFs

Leveraged ETFs seek to deliver multiples of the

performance of an index or benchmark over a specified time
frame. Inverse ETFs (also called short funds) seek to deliver
the opposite of the performance of the index or benchmark
over a specified time frame. Like other ETFs, some
leveraged and inverse ETFs reference broad indices, some
are sector-specific, and others are linked to commodities,
currencies, or some other benchmark. Use of leverage may
alternatively be embedded in an index itself, whereby the
index provider attempts to replicate the payoff to leveraged
investment strategies.
Inverse ETFs often are marketed as a way for investors to
seek to profit from, or at least hedge their exposure to,
downward moving markets. Leveraged inverse ETFs (also
known as ultra short funds) seek to achieve a return that is a
multiple of the inverse performance of the underlying index
over a specified time frame. An inverse ETF that references
a particular index, for example, seeks to deliver the inverse
of the performance of that index, while a 2x (two times)
leveraged inverse ETF seeks to deliver double the opposite
of that indexs performance.
To accomplish their objectives, leveraged and inverse ETFs
pursue a range of investment strategies through the use of

For further information on the differences between the two synthetic replication models, see Synthetics
under a Microscope, published by Morningstar ETF Research in July 2011; available at:
http://news.morningstareurope.com/news/im/msuk/PDFs/Morningstar%20ETF%20Research%20%20Synthetic%20ETFs%20Under%20the%20Microscope.pdf

swaps, futures contracts, and other derivative instruments.

Most leveraged and inverse ETFs reset daily, meaning they
are designed to achieve their stated objectives on a daily
basis. In general, the daily return of this type of ETF will be
a multiple, or inverse (multiple), of the daily return of the
stated index or benchmark. However, the weekly, monthly,
and annual returns of this type of ETF will generally not be
equal to the corresponding multiple, or inverse (multiple), of
the weekly, monthly, or annual returns of the stated index or
benchmark. This effect can be magnified in volatile
markets.
Tracking Error

Tracking error measures how consistently an index-based

ETF follows its benchmark underlying reference index.
Tracking error is defined by the industry as the volatility (as
measured by standard deviation) of the differences in returns
between a fund and its underlying reference index. The
tracking error helps measure the quality of the replication.

Tracking Difference

Tracking difference measures the actual under- or

outperformance of the fund compared to the underlying
reference index. Tracking difference is defined as the total
return difference between a fund and its underlying
reference index over a certain period of time.

Chapter 1 - Introduction
There is increasing interest in ETFs worldwide as evidenced by the significant amount of
money invested in these types of products. The dynamic growth of ETFs has also drawn the
attention of regulators around the world who are concerned about the potential impact of
ETFs on investors and the marketplace.
The IOSCO Committee on Investment Management (C5), in the course of 2008-2009,
decided to carry out preliminary work into the ETF industry. Responses to a questionnaire
sent to member jurisdictions and subsequent hearings with industry representatives confirmed
the value of further policy work to assist national regulators in addressing potential issues. In
2010, C5 sought the endorsement of the former IOSCO Technical Committee (TC) now the
IOSCO Board for a policy initiative to establish a common set of principles of value for
regulators, industry participants, and investors alike. The C5 proposal was adopted by the TC
in June 2010 and outlined a three-fold mandate:
1. Highlight the experience and key regulatory aspects regarding ETFs and related issues
across C5 members;
2. Identify the common issues of concern; and
3. If appropriate, develop a set of principles or best practices on ETF regulation.
In order to carry out its mandate, C5 established an ad hoc working group, co-Chaired by the
French AMF and the US SEC, and comprising the following C5 Members: the AMF of
Qubec, the Ontario Securities Commission, the Swiss FINMA, the German BaFin, the Hong
Kong SFC, the Italian CONSOB, the CSSF of Luxembourg, the Central Bank of Ireland
(CBI), the Spanish CNMV and the UK FSA.
Consistent with the mandate of C5, these principles address only ETFs that are organized as
CIS and are not meant to encompass other Exchange Traded Products 4 (ETPs) that are not
organized as CIS in a particular C5 Member jurisdiction. Accordingly, unless otherwise
noted, when used in this paper, the term ETF refers only to an ETP organized as CIS. 5
As ETFs are CIS, C5 notes that work done by IOSCO with respect to other areas of CIS
regulation are also applicable to the management and operations of ETFs. 6 Therefore, in this
paper, C5 chiefly identifies principles that distinguish ETFs from other CIS, reviews existing
IOSCO principles for CIS, and adapts those principles to the specificities of an ETF structure
where relevant. More general recommendations are made where concerns are not exclusive to
ETFs or to securities markets regulation.

Please refer to the definition in the above Relevant Definitions section.

In particular, we note that an entity that may be deemed to be an ETF organized as a CIS in one C5
member jurisdiction may be deemed a non-CIS ETP in another. For example, some synthetic products
regulated as CIS in Europe may not be regulated as CIS in the U.S. For the purposes of the principles
in this report, ETFs are understood in the U.S. to be those ETFs that are regulated under the Investment
Company Act of 1940 (Investment Company Act). See Appendix IV.

See Principles for the Supervision of the Operators of Collective Investment Schemes, IOSCO Report,
September 1997; available at:
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD69.pdf.

The aim of this report is to outline principles against which both the industry and regulators
can assess the quality of regulation and industry practices concerning ETFs. Generally, these
principles reflect a common approach and are a practical guide for regulators and industry
practitioners. Implementation of the principles may vary from jurisdiction to jurisdiction,
depending on local conditions and circumstances.
Box 1: ETF industry overview and emerging trends
As mentioned above, the global ETF industry is characterised by a rapid evolution and
strong growth. Below are a few of the more noticeable trends that may be relevant to
understand the context of the present policy work.

In terms of size, according to industry estimates released at the end of January 2013, the
assets managed under ETF structures amount to USD 1.9 trillion7, representing roughly
7% of the global mutual fund market, which is estimated to manage approximately USD
26.8 trillion; 8

Investor appetite expressed in terms of net new asset flows into ETFs has reached USD
243 billion by year-end 2012, compared to the corresponding year-end 2011 figure of
USD 161 billion. At year-end 2012, the lion's share in terms of the sought after exposure
was occupied by equity indices (USD 165 billion), followed by fixed income (USD 63
billion) and by commodities (USD 7 billion); 9

Although traditionally the largest ETFs have been those based on broad market, capweighted indices, over the last three to four years, index providers have begun offering
indices that are no longer cap-weighted. Instead, as a response to a low-yield
environment, providers have turned to offer alternatively-weighted indices, e.g., equalweighted indices, risk-weighted indices, sector-weighted indices, etc. that seek to deliver
higher positive returns; 10

The industry is consolidated and dominated by a few large players.

Other market trends are a reflection of the increased regulatory scrutiny that has gone into
ETF products, particularly in Europe:

The large ETF providers in some jurisdictions have substantially increased the disclosure
to investors regarding the collateral held and the use of securities lending, as well as the
management of counterparty risk;

Synthetic ETF providers have taken significant steps to increase transparency, minimize
counterparty risk, including over-collateralization and the implementation of safeguards
guaranteeing the minimum quality and liquidity of collateral;

In Europe, this latter trend was spurred by the action of ESMA, which in January 2012
outlined the contours of a future regulatory framework for European (UCITS) ETFs via a

Source: ETFGI: Global ETF and ETP industry insights (January 2013).

Source: ICI Worldwide Mutual Fund Assets and Flows (Fourth Quarter 2012).

Source: ETFGI: Global ETF and ETP industry insights (January 2013).

10

See Innovation drives next generation of indices, by Peter Davy in Financial News, Issue 842;
available at: http://www.efinancialnews.com/story/2013-03-18/innovation-drives-next-generationindices

consultation that ultimately has led to a final set of Guidelines on ETFs and other UCITS
issues published in December 2012. 11 As the Guidelines have introduced a series of
recommendations for (UCITS) ETFs to reduce their counterparty risk regardless of the
replication model that is used there is also evidence that certain providers have begun
reviewing their practices in terms of limiting the portion of an ETFs portfolio they agree
to lend out. 12 The debate around the merits of physical as opposed to synthetic ETFs has
settled and there is evidence that market players have begun competing actively on fees
in a way that proves advantageous for investors through the offer of more transparent
and cheaper products;

With regard to index replication techniques, physical ETFs occupy the largest market
share worldwide, with approximately 90% of all global ETF managed assets. A recent
trend in Europe has nevertheless seen established synthetic ETF providers make a
gradual shift to the physical replication model, either by converting their existing
synthetic ETF inventory or via new launches). These moves have been justified by the
relevant providers as a response to investors demand. 13

For an update on the regulatory changes in Europe or in the U.S., see Appendix IV.

11

See ESMA Guidelines on ETFs and other UCITS issues, published on 18 December 2012; available at:
http://www.esma.europa.eu/system/files/2012-832en_guidelines_on_etfs_and_other_ucits_issues.pdf
(for a summary, please see Appendix IV).

12

For instance, already in June 2012, one significant industry player introduced a 50% limit on the
amount of assets that one of its European ETFs can lend out to a third party, i.e., well below the
maximum permitted by current European regulations (i.e., 100%). In parallel, this company also
decided to provide an indemnity, so that investors will not face financial losses in the case of a default
by a counterparty to a securities lending transaction involving one of its ETFs. In the U.S., ETFs
generally may not lend more than one-third of total assets. In calculating this limit, the SECs staff has
taken the view that the collateral (i.e., the cash or securities required to be returned to the borrower)
may be included as part of the lending funds total assets. Thus, an ETF could lend up to 50% of its
asset value before the securities loan.

13

See statements by Thorsten Michalik, global head of db X-trackers and Alain Dubois, chairman of
Lyxor in the FTfm article Deutsche and Lyxor switch tactics dated 18 November 2012 where they said
respectively that Some clients have shown a preference for direct (physical) replication and we aim to
meet that demand, and Lyxor is diversifying its offering to include physically replicated ETFs to
fully address investors needs.

Chapter 2 - Principles Related to ETF Classification and Disclosure

1.

Disclosure regarding ETF classification

ETFs offer public investors an interest in a pool of securities and other assets as do other CIS
(such as Undertakings for Collective Investment in Transferable Securities - UCITS - or
mutual funds), except that shares in an ETF can be bought and sold throughout the day like
stocks on an exchange through an intermediary.
Disclosure standards for ETFs generally should be consistent with those required for other
CIS, but may require additional disclosures when justified by the specificity of funds'
exchange traded nature, for instance, disclosures explaining the peculiarities of the unit
creation/redemption mechanism, or explanations with regard to the numerous factors that
affect an ETF's intraday liquidity. In particular, appropriate disclosure is needed in order to
help investors understand and identify ETFs. Disclosure regarding classification that helps
investors distinguish ETFs from non-CIS ETPs and from other CIS, and understanding the
risks and benefits of each also would be helpful.
Principle 1:

Regulators should encourage disclosure that helps investors to clearly

differentiate ETFs from other ETPs.

Principle 2:

Regulators should seek to ensure a clear differentiation between ETFs

and other CIS, as well as appropriate disclosure for index-based and non
index-based ETFs. 14

Means of implementation:
ETFs have to comply with applicable CIS regulation, but other kinds of ETPs generally are
not subject to such requirements. In particular, despite the fact that, like ETFs, these are also
products that trade intra-day on an exchange platform, non-CIS ETPs are usually indextracking listed debt products that are characterised by very different diversification and risk
management requirements. Thus, in terms of seeking to help investors understand the
differences between ETFs and non-CIS ETPs, regulators should consider requiring ETFs to
describe the distinguishing characteristics and regulatory requirements applicable to ETFs in
a particular jurisdiction that are not applicable to other ETPs, including any requirements
related to diversification, underlying asset liquidity, or risk management. 15 Investors could
then compare the ETF's disclosure with disclosure by other products to understand the
different characteristics and regulatory requirements. The adoption by regulators of a
classification scheme, accompanied by the use of a common ETF identifier as already
adopted in certain jurisdictions, may represent a useful tool. 16

14

Index-based ETFs seek to obtain returns that correspond to those of an underlying index. Non indexbased ETFs represent a small category of ETFs that are generally actively managed.

15

Implementation of these principles is directed at disclosure by ETF providers.

16

See for instance the ESMA Guidelines on ETFs and other UCITS issues, published in December 2012,
introducing a specific UCITS ETF identifier for use across all EU Member States.

Regulators should seek to ensure that disclosures describe the specific ways in which an ETF
may be similar to and different from other CIS (i.e., an open-end CIS or mutual fund). In
particular, disclosure (including, where appropriate, sales literature) could make clear to
investors whether an ETF may sell or redeem individual shares to or from retail investors.
Whereas ETFs usually do not provide for direct redemptions, regulators may require that
retail investors be given the right to redeem their shares directly from the ETF provider in
exceptional circumstances (e.g., stressed market conditions) provided appropriate safeguards
are in place. In addition, disclosure should help investors understand an ETFs investment
strategy, such as if it is index-based.
2.

Disclosure regarding ETF portfolios

Principle 3:

Regulators should require appropriate disclosure with respect to the

manner in which an index-based ETF will track the index it references.

Principle 4:

Regulators should consider imposing requirements regarding the

transparency of an ETFs portfolio and/or other appropriate measures in
order to provide adequate information concerning:
i)

any index referenced and its composition; and

ii)

the operation of performance tracking.

Means of implementation:
The disclosures recommended by the above principles should be viewed in the broader
context of existing CIS regulation in Member jurisdictions and particularly of index-based
CIS. With regard to index-based ETFs, regulators could require an index-based ETF to
include disclosures in the prospectus, in offering documents, or in other disclosure
documents, with respect to how the performance of an index is tracked and to risks associated
with this method.
With regard to transparency of an index-based ETFs portfolio, one way in which regulators
might address these issues is to require that an ETF publish daily the identities of the
securities in the purchase and redemption baskets which are representative of the ETFs
portfolio. 17 Arbitrage activity in ETF shares is facilitated by the transparency of the ETFs
portfolio because it enables market participants to realize profits from any premiums or
discounts between the intraday price of the ETF and the NAV of the fund. Arbitrageurs
seeking to realize such profits apply opposing buy and sell pressure to the ETF in comparison
17

For example, in the United States, each day, the ETF publishes the identities of the securities in the
purchase and redemption baskets, which are representative of the ETFs portfolio. To be listed and
trading on an exchange, the ETF is required to widely disclose an approximation of the current value of
the basket on a per share basis (often referred to as the Intraday Indicative Value or IIV) at 15 second
intervals throughout the day and, for index-based ETFs, disseminates the current value of the relevant
index. In addition, the NAV is typically calculated and disseminated at or shortly after the close of
regular trading of the exchange on which the ETF is listed and trading. The NAV is required to be
disseminated to all market participants at the same time. If any of the aforementioned values is
interrupted for longer than a trading day or is otherwise no longer being disseminated, or if the NAV is
unevenly disseminated, the exchange listing and trading such ETF is required to halt trading in such
ETF until such values are disseminated as required.

to its underlying components that helps to reduce intraday premiums or discounts. 18 An

efficient arbitrage mechanism is therefore designed to ensure that the intraday value of the
ETFs shares is closely aligned (i.e., minimizes wide premiums and discounts) with the
ETFs intraday NAV per share. 19
In addition, index-based ETFs in certain jurisdictions may lack common standards for
assessing their performance. Noticeable differences have been noted by regulators in some
jurisdictions regarding the quality and consistency of performance reporting and tracking
error measurements. Regulators might therefore consider requirements regarding disclosure
in order to help provide adequate information to investors concerning the index and
performance tracking. Such disclosure might include:
i) Information on the index composition, its methodology and relative weightings (index
providers also may publicly announce the components and/or value of their indices,
which could assist investors in understanding any tracking error and permit investors to
reference the units intra-day performance). Such information should be provided in an
appropriate time frame. 20
ii) The past performance of the ETF measured through its realised tracking difference and
tracking error;
iii) The methodology used to measure tracking error as published in the investor disclosure
documents, as well as a policy to minimize tracking error, including what level of
tracking error may be reasonably expected; and
iv) A description of issues which will affect the ETF's ability to fully replicate its target
index (e.g., transaction costs of illiquid components).
18

For example, in France, specific rules fix continuous limits to the maximum possible discrepancy
between the intraday value of underlying index (iNAV) and the ETF share price. When the limits are
reached, a trading interruption (reservation) sets in leading to a subsequent auction. Thus, according to
section 4.1.2.3 of the Trading Manual for the Universal Trading Platform, and according to the
Euronext Rule Book, Book 1 of the Trading Manual, the French stock exchange stipulates that:
Reservation thresholds consist of applying a range above or below an estimate of the net asset value
(indicative net asset value, referred to as iNAV) for ETFs or a reference price contributed by the
selected Liquidity provider for ETNs and ETVs, as updated during the Trading Day according to the
movements of the underlying index or asset. The level of this range is set at 1.5% for ETFs, ETNs and
ETVs based on developed European equity, government bonds and money market indices and 3% for
all others. For products providing a cap or a floor-value, the trading thresholds resulting from the
above-mentioned rules shall not break the said cap or floor-value.

19

Trading activity in ETFs, including OTC trading, should be subject to regulation with respect to
reporting of securities transactions. In the U.S., for example, all trades (subject to some very minor
exceptions), on or off exchange, must be reported to the consolidated tape.

20

In this regard, IOSCO stresses the importance of disclosing information on the index composition and
weightings to market participants, although it is cognizant of the concerns expressed by certain
stakeholders as to the protection of proprietary information. Regulators should therefore consider the
appropriate level of disclosure relating to index composition and weightings that addresses these
concerns, while also accounting for the sophistication of concerned investors, local conditions, as well
as the overall efficiency of arbitrage activities. In terms of index transparency and quality, please also
refer to the IOSCO Principles for Financial Benchmarks, especially with regard to the recommended
disclosures around the contents of a benchmarks methodology. For further information on this
initiative, please consult the IOSCO website when the final document becomes available.

10

3.

Disclosure regarding ETF costs, expenses and offsets

ETF shareholders currently may pay a number of costs or bear expenses, some of which may
be more transparent than others. One type of ETF trading cost incurred directly by investors
is reflected in bid/ask spreads. 21 Another relevant factor may be changes in discounts and
premiums between the ETFs shares and the ETFs NAV. 22 As with other CIS, ETF
shareholders also incur fund expenses while holding ETF shares. There may also be indirect
costs borne by an ETF and its shareholders (e.g., trading costs incurred when a physical ETF
purchases its underlying securities). In some jurisdictions, indirect costs borne by synthetic
ETFs may be balanced by cost savings on the underlying assets, due to the fact that synthetic
ETFs do not need to buy all of the instruments in the underlying index. Moreover, an
investors particular portfolio strategy (i.e., buy-and-hold vs. active investing) also may
impact the total cost of investing in such a product, particularly with respect to commissions
and other trading costs.
Similar to other CIS, ETFs also may engage in securities lending activities. In the case of
index-based ETFs, such activities may result in returns that can partly offset the ETFs
management fee, helping the ETF to more closely achieve the performance of its reference
index and may, subject to the split of revenues from such activities with the securities lending
agent, which could be the same entity as or an affiliated entity of the ETF operator and the
ETF, therefore improve the ETFs performance.
Principle 5:

Regulators should encourage the disclosure of fees and expenses for

investing in ETFs in a way that allows investors to make informed
decisions about whether they wish to invest in an ETF and thereby accept
a particular level of costs. 23

Principle 6:

Regulators should encourage disclosure requirements that would enhance

the transparency of information available with respect to the material
lending and borrowing of securities (e.g,. on related costs).

Means of implementation:
The fee information disclosed by ETFs should be aimed at enabling investors to understand
the impact of fees and expenses on the performance of the product and describe the ETFs
cost structure (e.g., the management fee; operational costs; where relevant, swap costs; etc.).
If appropriate, regulators also may require disclosure on other types of fee and cost
information, such as disclosure regarding brokerage commissions, tax structure, and
additional information on revenues (including a breakdown) derived from assets held by the
ETFs that are likely to have an impact on performance. These disclosures may include
21

The bid is the market price at which an ETF may be sold and the ask is the market price at which an
ETF can be bought.

22

An ETF is said to be trading at a premium when its market price per share is higher than its NAV per
share and to be trading at a discount when its market price per share is lower than its NAV per share.

23

For more on best practices standards, see Elements of International Regulatory Standards on Fees and
Expenses of Investment Funds, Final Report, Report of the Technical Committee of IOSCO, October
2004; available at:
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD178.pdf.

11

additional information on rebalancing costs, on revenues derived from fund assets, and on the
way these are distributed between an ETF operator and the ETFs shareholders (e.g., such as
dividends of equity shares or coupon payments of fixed income securities).
Similar to other CIS, physical ETFs also may lend securities to other financial institutions in
exchange for a fee paid by the borrower. Securities lending can in some cases provide
relatively significant additional revenues to ETFs, particularly ETFs with comparatively
lower fees. The scope and scale of ETF securities lending activity differs across jurisdictions
and even among ETFs within the same jurisdiction. In some jurisdictions, there are
restrictions on the amount of securities that may be loaned. 24 In other jurisdictions, where a
significant amount of securities may be loaned, regulators could require specific disclosure,
for example, to help inform investors about conflicts of interest that could arise when such
revenues accrue (at least in part) to the ETFs operator. 25
In this sense, in those jurisdictions where there are not restrictions on the amount of securities
that may be loaned, such disclosure should be designed to help investors understand whether
revenues are received by parties other than the ETF or its investors (e.g., a lending agent). 26
Such disclosure arguably becomes even more significant where ETFs are marketed to retail
investors as having low (or no) management fees. If securities lending revenues represent a
significant source of return, another option, would be to require disclosure of gross returns
from securities lending from other sources of fund income. 27 This would allow investors to
assess how such revenues have contributed to the performance of the ETF and to assess the
efficiency of the ETFs operator in distributing such revenues to other service providers
involved (e.g., securities lending-agents). 28 Such disclosures would allow the ETFs operator
to inform investors about the major trade-offs the ETF may have to balance when handling
such revenues or how such revenues might be shared between the ETF and its operator. Such
additional disclosure might also be desirable when dividend management leads to specific tax
treatment and/or to risk-return trade-offs that may materially impact the ETFs performance
24

As stated previously, in the U.S., ETFs generally may not lend more than one-third of total assets. In
calculating this limit, the SECs staff has taken the view that the collateral (i.e., the cash or securities
required to be returned to the borrower) may be included as part of the lending funds total assets.
Thus, an ETF could lend up to 50% of its asset value before the securities loan.

25

In the U.S., if lending income is paid to the CIS operator as part of the advisory contract, such
compensation would be considered by the CIS board of directors as part of its process of approving the
advisory contract. Moreover, the CISs board approves any and all compensation paid to the lending
agent. Fees may be paid in connection with securities lending only for services rendered.

26

The amount of fees paid to a lending agent may not be the most important factor in assessing whether
to hire a lending agent. The least expensive lending agent may not have the best performance or be the
best match for a lender. In addition, for a discussion of issues relating to use of an affiliated lending
agent, see infra in Chapter 4.

27

In Europe, the ESMA Guidelines on ETFs and other UCITS issues of December 2012 for instance
foresee that a UCITS (as the majority of ETF structures in Europe are labelled) should disclose in the
prospectus the policy regarding direct and indirect operational costs/fees arising from efficient portfolio
management techniques that may be deducted from the revenue delivered to the fund. These costs and
fees should not include hidden revenues. The fund should disclose the identity of the entity(ies) to
which the direct and indirect costs and fees are paid and indicate if these are related parties to the
management company or the depositary.

28

This disclosure could be particularly helpful where, for example, the ETFs underlying equity index is
a price index (i.e., namely an index that, unlike total return indices, does not take into account dividend
reinvestment).

12

(e.g., when the ETFs operator manages dividends actively by using, for instance, dividend
options). In addition, it could help investors to assess counterparty risks to which they may
be exposed, especially when an ETF lends its assets in order to optimize its returns.
4.

Disclosure regarding ETF strategies

Since they were first developed in the early 1990s, ETFs have evolved. The first ETFs (such
as the SPDR in the U.S.) held a basket of securities that replicated the component securities
of broad-based stock market indices, such as the S&P 500. In Europe, most ETFs also
initially replicated broad market indices but were structured as synthetic ETFs where
exposure is obtained through the use of a total return swap. Many of the newer ETFs are
based on more specialized indices, including sector/regional indices, indices based on less
liquid asset classes (e.g., bonds, commodities), and indices designed specifically for a
particular ETF. The investment objectives and techniques of index-based ETFs have also
become more diverse and complex, leading to the creation of a new generation of ETFs, such
as those that are leveraged through the use of futures contracts and other types of derivative
instruments, or that reference the inverse of an index's performance. With respect to the use
of derivatives, ETFs could consider making appropriate disclosure to provide investors with
meaningful information about the funds anticipated use of derivatives in light of the ETFs
actual or anticipated operations.
Principle 7:

Regulators should encourage all ETFs, in particular those that use or

intend to use more complex investment strategies to assess the accuracy
and completeness of their disclosure, including whether the disclosure is
presented in an understandable manner and whether it addresses the
nature of risks associated with the ETFs strategies.

Means of implementation:
Regulations should encourage adequate disclosure of the specificities of ETF investment
strategies and replication techniques, including any specific risk associated therewith.
Regulators might address this concern by, for example, requiring an ETF to provide
disclosure in its prospectus, in offering documents, or in other disclosure documents, that
reflects its material operations, particularly its use of complex investment strategies, use of
derivatives, or securities lending agreements. Regulation could also require that an ETF,
when updating its disclosure documents review its investment strategies, investments in
derivatives, and provide timely disclosures in reports to its shareholders in the event of
material changes identified ex-ante (e.g., organizational change).
Where ETFs engage in significant use of derivatives, the identification of a counterparty
(accompanied by further disclosures as appropriate) may be an important component for the
disclosure's completeness. In addition, regulators could require an ETF provider to explain
the nature and extent of its counterparty exposure, including information on the collateral
agreements to mitigate such exposure. 29 It should be kept in mind that many other CIS also
use complex investment strategies, derivatives and securities lending agreements and that
ETFs may not present unique risks.

29

See infra in Chapter 4.

13

Chapter 3 - Principles Related to the Structuring of ETFs

1.

Conflicts of interest

Due to the nature and structure of CIS, conflicts of interest may arise between the CIS
operator and the CIS shareholder. ETFs share many of the general CIS conflict of interests,
but also may be subject to specific conflicts arising from the ETF structure.
As noted above, recent innovations include ETFs that are based on indices designed
specifically for a particular ETF. A few of the index providers that compile and revise
indices that are designed specifically for a particular ETF are affiliated with the sponsor of
that ETF. These affiliated index ETFs raise the risk of the communication of material nonpublic information between the ETF and the affiliated index provider.
In some jurisdictions, intra-group affiliations in respect of authorised participants (APs) also
can lead to conflicts of interest; especially when there is a small number of APs. 30 The
affiliated AP, if it has the ability to exercise power over the ETF provider through the group
parent, has the ability to channel business through in-house trading desks, in order to gain an
order flow benefit. Moreover, the group parent may also have the ability to instruct the ETF
provider to authorize and de-authorize competitor APs.
This conflict may have
consequences for the fair pricing of the ETF shares on the secondary market and the ability
for investors to redeem ETF shares.
Synthetic ETFs also may raise potential conflicts of interests where affiliates are involved, for
example as the swap counterparty. 31
Principle 8:

Regulators should assess whether the securities laws and applicable rules
of securities exchanges within their jurisdiction appropriately address
potential conflicts of interests raised by ETFs.

Means of implementation:
Where a custom index is created by an affiliate, regulators should appropriately address the
conflicts that could arise. For example, when an index is created by an affiliate of the ETF,
ways to address the conflicts that could arise might include:
a)

Making publicly available all of the rules that govern the composition, inclusion
and weighting of securities in each index in an appropriate time frame;

b)

Limiting the ability to change the rules for index compilation and requiring
public notice before any changes are made; and

c)

Where appropriate, by establishing firewalls between the staff responsible for the

30

In the U.S., CIS are generally prohibited from conducting affiliated transactions and those prohibitions
would apply to an AP affiliated with an ETF provider.

31

As noted above, U.S. prohibitions on affiliated transactions generally would apply to a swap
transaction where an affiliate is the counterparty.

14

creation, development and modification of the index compilation rules; and the
portfolio management staff.
In the case of a synthetic ETF that obtains its return through entering into an asset swap with
an affiliated counterparty such as a bank affiliated with the management company of the
ETF, regulators also should consider requirements designed to address the potential conflicts
of interest raised by this type of arrangement, e.g., their disclosure and ensuring that both
entities are hierarchically separate.
Other measures could include fostering greater market transparency on the terms and
conditions for the services offered to an ETF, e.g., regarding fee structures. The
harmonization of ETF listing rules (e.g., particularly in terms of maximum spreads, offer
sizes, minimum time presence, etc.) could usefully complement these alternatives.
2.

Managing counterparty risks

Physical ETFs accomplish their investment objective either by purchasing the component
securities directly, or by indirectly selecting a sample of the index's component securities.
Synthetic ETFs that seek to track the returns of an underlying index do so through the use of
derivatives, typically through a swap. 32 Leveraged or inverse ETFs rely on a range of
investment strategies typically involving swaps, futures, and other derivative instruments to
magnify investment returns. In addition, ETFs may also engage in securities lending. The
use of derivative instruments for index replication purposes, or engaging in securities lending,
entails counterparty credit risk for the ETF and its shareholders. Counterparty credit risk is
the risk attributable to the downgrading and/or insolvency of a counterparty either in an OTC
transaction or in a securities lending arrangement.
Principle 9:

Regulators should consider imposing requirements to ensure that ETFs

appropriately address risks raised by counterparty exposure and collateral
management.

Means of implementation:
Although counterparty exposure and collateral management are not exclusive to ETFs and
may concern all CIS, they may be better appreciated in the light of the two main ETF-specific
replication strategies.
a)

Synthetic and other derivative-based ETFs

As described above, synthetic ETFs pursue a range of investment strategies partially or

wholly through the use of swaps, futures contracts, and other derivative instruments. Thus,
synthetic ETFs obtain their desired return, in whole or in part, by entering into derivative
transactions with one or more eligible counterparties. Overall, this strategy may reduce high
rebalancing costs and may help diminish tracking error generally associated with physical
replication. Despite the exchange of collateral, synthetic ETFs expose themselves to the risk
of a default of the swap counterparty. This issue is nevertheless not specific or inherent to
32

As explained in the Relevant Definition section, synthetic ETFs may be funded or unfunded structures,
with a consequence on how the collateral is held and who owns it. For example, the selected structure
may affect the timing of a potential liquidation of the assets.

15

synthetic ETFs, but to a broader scope of products embedding a swap derivative.

Concerns also have been raised that, with regard to these synthetic ETFs, in some
jurisdictions, there is no requirement for collateral to be of the same nature and quality of the
securities making up the referenced index. As the collateral, or the direct investments
belonging to the ETF in the unfunded model, together with any additional financial
guarantees that the ETF may receive, are intended to cover the counterparty risk borne by
ETF shareholders, they should be prudently valued (i.e., at least daily, independently, and
allowing for haircuts and discount rates to mitigate valuation uncertainties) and be
sufficiently liquid and of high quality. By satisfying these conditions, in the event of the
counterparty's default, the ETF may more easily find either a new counterparty to the swap
contract, or turn to physical replication, or liquidate the basket of collateral to return monies
back to investors at a limited discount. 33 Moreover, high standards for collateral partially
address potential risks consisting in the incentive that banks would have to post less liquid
securities to the ETF as collateral. 34 Additionally, periodic publication of ETFs
counterparties, the exposure, along with the amount and composition of the ETFs collateral
may also be required.
Regulators should appropriately address risks raised by synthetic ETFs in their jurisdictions.
In assessing alternatives, regulators should consider the ETF risk exposure from derivatives
investment and develop requirements to the extent that they do not already exist proportionate to the risks raised by the scope and scale of such activity and the structure of
each ETF. For example, ETFs that invest largely in futures may not be exposed to the same
counterparty risk as those that invest in OTC swaps. 35 As another example, in some
jurisdictions, ETFs may become subject to liquidity requirements, designed to ensure that
they are able to meet obligations resulting from exposure to leveraged derivative investments,
while continuing to satisfy redemption requests). 36
33

In Europe, when the synthetic ETF receives collateral to reduce exposure to the counterparty, this
collateral must comply with the relevant criteria in ESMA Guidelines on ETFs and other UCITS issues
as published in December 2012. Of the multiple criteria, the most relevant consist in requiring that
collateral other than cash be highly liquid and traded on a regulated market (or multilateral trading
facility), that it be valued at least on a daily basis and conservative haircuts applied where it exhibits
high price volatility, that it not be issued by the counterparty or exhibit a high correlation with it, that it
be diversified across markets, country and issuer with an exposure to a given issuer no larger than 20%
of the (UCITS) ETF's NAV, that it be capable of being fully enforced at any time, that non-cash
collateral not be sold, re-invested or pledged, that cash collateral be invested according to certain strict
conditions, and that stress tests be carried out under normal and exceptional liquidity conditions when a
(UCITS) ETF receives collateral for at least 30% of its assets. For more details, see paragraphs 41-47
of the Guidelines; available at:
http://www.esma.europa.eu/system/files/2012-832en_guidelines_on_etfs_and_other_ucits_issues.pdf .

34

The Bank for International Settlements (BIS) has exposed a potential risk consisting in the incentive
that banks could have to avoid the more stringent liquidity standards of Basel III by posting their riskier
and more illiquid assets as collateral to third counterparties, including to ETFs. In its view, a large
investment bank, that is at the same time authorised participant (AP) and swap counterparty to the ETF,
would be in a position to upgrade its asset inventory for the purpose of funding itself at better terms on
the repo market, whilst transferring lower quality assets off its balance sheet and into the ETF. See S.
Ramaswamy, Market structures and systemic risks of exchange-traded funds, BIS Working Papers
(No. 343), April 2011; available at: http://www.bis.org/publ/work343.pdf

35

Though, in many jurisdictions, regulatory reform requiring central clearing of certain OTC swaps may
mitigate this risk.

36

This is the case in the U.S. with regard to leveraged ETFs (the types of synthetic encountered in
Europe, Canada or in Asia generally do not exist as a CIS in the U.S.). In addition, funds and their

16

b)

Physical ETFs

Physical ETFs also may invest in derivatives as part of their investment strategy, and
regulators should consider requirements to address counterparty and collateral risks that are
implied by such activity. In assessing alternatives, regulators should consider the amount of
derivatives investment in which an ETF engages and develop requirements proportionate to
the potential risks raised by the scope and scale of such activity.
Further, physical ETFs may be exposed to counterparty credit risk to the extent that they
engage in securities lending. While the FSB noted concerns with regard to ETF securities
lending, this issue is not specific or inherent to ETFs, but to a much broader scope of
products and/or activities. 37 Moreover, as mentioned earlier, the scope and scale of ETF
securities lending activity differs across jurisdictions and even among ETFs within the same
jurisdiction. Such activities may raise potential counterparty risk if the default of the
borrowing counterparty results in that partys inability to return the loaned securities to the
ETF. Regulators should consider requirements to address such counterparty risks
accordingly. For example, they could limit the extent to which an ETF can lend securities
and require that loans be fully or over-collateralized, 38 with collateral requirements similar to
those for synthetic ETFs. Additionally, in jurisdictions where the amount of securities that
can be loaned is significant, regulators might consider requiring appropriate disclosure of
ETFs risk management policies with regard to securities lending, as well as of their lending
counterparties typically agree under master swap agreements to both post collateral equal to their daily
marked-to-market exposure under a swap, netted across all of the swaps between the two parties and
additionally agree on acceptable forms of collateral; usually cash and U.S. treasury and agency
securities, but other securities such as equities are sometimes permitted as well as an agreed-upon
haircut representing the negotiated relative risk associated with a particular type of collateral. See 16
May 2011 Letter to Secretariat of the FSB from the Investment Company Institute regarding Potential
Financial Stability Issues Arising from Recent Trends in Exchange Traded Funds (ICI Comment);
available at: http://www.ici.org/pdf/25189.pdf.
37

The European Central Bank expressed this view: it is worthwhile mentioning that the risks and
transparency issues raised [recently by financial authorities in connection with securities lending by
ETFs] are not ETF-specific and might also be relevant for certain types of mutual funds or the
underlying building blocks (i.e., swaps, securities lending) more generally. See Chapter III The
Euro Area Financial System at n. 5, Financial Stability Review June 2011, European Central Bank June
2011; available at:
http://www.ecb.eu/pub/pdf/other/financialstabilityreview201106en.pdf?dd351cc552a0033e8f96e09533
e3c85d.
See also comment letter of the Investment Company Institute on the FSB note, Many types of
collective investment vehicles, including mutual funds, hedge funds, pension plans, and collective
investment trusts, as well as other market participants, engage in securities lending. Thus, to the extent
there is concern about the impact of securities lending activities on the broader markets, it should not
be approached as an ETF-specific issue, 16 May 2011.

38

This is the case in the U.S. where ETFs may not lend out more than 33% of total assets, including the
collateral, or 50% of assets, excluding collateral. Fully collateralized in the context of securities
lending, means that the ETF must receive approved collateral equal to 100% of the market value of the
loaned securities, and the collateral must be marked-to-market daily. In practice, securities loans often
are over-collateralized up to 105% of the market value of the loaned securities (or more under certain
market conditions). Collateral generally is limited to cash, U.S. government or agency securities, or
bank standby letters of credit. In Europe, ESMA issued its Guidelines on ETFs and other UCITS
issues in December 2012, laying out strict collateral standards for collateral received from OTC and
securities lending/repo transactions.

17

agent(s). To promote compliance with such policies, they may also request the periodic
publication of the ETFs largest lending counterparties, the amounts of securities on loan,
along with the amount and composition of the ETFs collateral. In assessing alternatives,
regulators should consider the amount of securities lending activity in which an ETF engages
and develop requirements proportionate to the potential risks raised by the scope and scale of
such activity, including steps to mitigate possible operational risks.
c)

General counterparty risk

Finally, regardless of the chosen replication method, if an ETF is exposed to counterparty risk
through significant use of derivatives, or the loan of a significant portion of its portfolio
securities, regulators could require ETFs to adopt additional measures to the extent relevant
and appropriate. Ways of addressing risk might include:
i) Appropriate risk management procedures 39 regarding use of derivatives for which the
risk of counterparty default is not covered by a clearing agency; 40
ii) Limits with respect to an ETFs net exposure to counterparty risk posed by a specific
issuer; 41
iii) Additional limits on assets accepted as collateral;
iv) Diversification rules for the collateral basket (e.g., to limit concentrated exposure to
an issuer, sector or country); or
v) Other safeguards to mitigate potential operational and legal risks arising from
collateral management (e.g., conditions governing the re-investment of cash
collateral, restrictions designed to ensure that non-cash collateral not be sold, reinvested or pledged, etc.).

Regulators could finally consider requiring the periodic

reassessments of the value of any collateral and require
39

In jurisdictions authorising synthetic ETFs, regulatory frameworks have been devised to that end. One
may refer here in particular to the ESMA Guidelines on ETFs and other UCITS issues published in
December 2012; and to article 8.8 of the Section II of the Code on Unit Trusts and Mutual Funds of the
Hong Kong SFC; available at:
http://www.sfc.hk/sfc/doc/EN/intermediaries/products/handBooks/Eng_UT.pdf.

40

As an example of appropriate risk management procedure, the ESMA Guidelines on ETFs and other
UCITS issues have introduced the requirement for managers to carry out a stress-testing policy where
the level of collateral received exceeds a certain percentage of a fund's NAV. This requirement applies
notwithstanding the type of transaction that is at the origin of the collateral exchange (i.e., no matter if
to cover OTC or securities lending risks).

41

It may be appropriate for such limits to account for the credit quality of the counterparty and, if
appropriate, the possibility of haircuts for counterparties with lower credit worthiness. Procedural
requirements also might address the liquidity of collateral posted in order to be possible in the event of
default for an ETF to sell collateral securities over a short period and at prices reflecting an
independent, pre-sale valuation based on frequent marked-to-market, reliable and verifiable valuation
of assets.

18

appropriate segregation with a third party custodian to

protect against counterparty bankruptcy or default.

19

Chapter 4 ETFs in a broader market context

The present report has focused primarily on aspects specific to the ETF product. Where
appropriate, aspects not exclusive to ETFs have been duly pointed out as well. This
concluding chapter touches upon a number of aspects that ETFs share with other financial
products and indicates useful references for regulators to bear in mind.
Concerning the marketing and sale of ETF shares, as for other CIS, regulators should
consider the importance of intermediaries disclosure obligations, conduct requirements,
including applicable suitability requirements vis--vis their clients. 42 The latter are defined
here as any requirement that a financial firm, when recommending a retail client to purchase
a particular financial instrument, make a determination of whether that investment is suitable
or appropriate for that particular client. IOSCO encourages regulators and the industry to
consider ETFs in connection with the guidance on the applicability of suitability obligations
to market intermediaries in the context of complex financial products set out in IOSCOs
recent report on Suitability Requirements with Respect to the Distribution of Complex
Financial Products 43.
As other financial instruments that trade on an exchange, ETFs have been cited in a number
of reports focussing on issues of market stability, particularly with regard to their potential
effects on the overall liquidity and their vulnerability as means of alleged market abuse.
Although the evidence gathered at this stage remains inconclusive, ETFs would be subject to
the same preventive controls (e.g., trading halts) as myriads of other financial instruments. In
this regard, IOSCO encourages regulators and industry practitioners to consider ETFs in
connection with recommendations developed in the IOSCO 2011 Market Integrity and
Efficiency Report.
In addition, as discussed above, for the purpose of informing investors regarding the different
characteristics of ETFs and non-CIS ETPs, regulators are encouraged to consider requiring
ETFs to describe the features, risks and regulatory requirements applicable to ETFs that are
not applicable to these ETPs. Moreover, in relation to the comments received regarding
disclosure of non-CIS ETPs, IOSCO notes that, although beyond the scope of this report,
disclosure of non-CIS ETPs is encompassed by other IOSCO work that global regulators or
regional standard setters may consider when evaluating non-CIS ETP disclosure within their
respective legal framework.

42

As stated in the IOSCO Methodology for Assessing Implementation of the IOSCO Objectives and
Principles of Securities Regulation of October 2011, Market intermediaries generally include those
who are in the business of managing individual portfolios, executing orders and dealing in, or
distributing, securities." According to the methodology, a jurisdiction may also choose to regulate as a
market intermediary an entity that simply provides advice regarding the value of securities or the
advisability of investing in, purchasing or selling securities. However, for purposes of this report, the
term intermediary in the U.S. securities sector refers to broker-dealers, not investment advisers.

43

See FR01/13 Suitability Requirements with Respect to the Distribution of Complex Financial Products,
Final Report, Report of the Board of IOSCO, January 2013; available at:
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD400.pdf.

20

Appendix I List of Principles

Principle 1

Regulators should encourage disclosure that helps investors to clearly

differentiate ETFs from other ETPs.

Principle 2

Regulators should seek to ensure a clear differentiation between ETFs and

other CIS, as well as appropriate disclosure for index-based and non indexbased ETFs.

Principle 3

Regulators should require appropriate disclosure with respect to the manner

in which an index-based ETF will track the index it references.

Principle 4

Regulators should consider imposing requirements regarding the

transparency of an ETFs portfolio and/or other appropriate measures in
order to provide adequate information concerning:
i)

any index referenced and its composition; and

ii)

the operation of performance tracking.

Principle 5

Regulators should encourage the disclosure of fees and expenses for investing
in ETFs in a way that allows investors to make informed decisions about
whether they wish to invest in an ETF and thereby accept a particular level of
costs.

Principle 6

Regulators should encourage disclosure requirements that would enhance the

transparency of information available with respect to the material lending and
borrowing of securities (e.g., on related costs).

Principle 7

Regulators should encourage all ETFs, in particular those that use or intend
to use more complex investment strategies to assess the accuracy and
completeness of their disclosure, including whether the disclosure is presented
in an understandable manner and whether it addresses the nature of risks
associated with the ETFs strategies.

Principle 8

Regulators should assess whether the securities laws and applicable rules of
securities exchanges within their jurisdiction appropriately address potential
conflicts of interests raised by ETFs.

Principle 9

Regulators should consider imposing requirements to ensure that ETFs

appropriately address risks raised by counterparty exposure and collateral
management.

21

Appendix II - Feedback Statement on the Public Comments received to the

Consultation Report Principles for the Regulation of Exchange Traded Funds
Feedback Statement on the Public Comments received by the Technical Committee on
the Consultation Report Principles for the Regulation of Exchange Traded Funds
Twenty-seven responses have been received in relation to the consultation report Principles
for the Regulation of Exchange Traded Funds, published by the Technical Committee (TC)
of the International Organization of Securities Commissions (IOSCO) on 14 March 2012.
The consultation closed on 27 June 2012. The majority of replies came from the asset
management industry and its numerous associations, followed by two main stock exchanges,
an index provider, a research institute, a foreign regulator and a private citizen. All responses
were of a non-confidential nature. In particular, comments have been submitted by the
following respondents:
1. International Securities Lending Association (ISLA)
2. Index Industry Association (IIA)
3. Amundi
4. Intendencia de Mercado de Valores Ecuador
5. Investment Company Institute (ICI)
6. Blackrock
7. State Street
8. Deutsche Bank
9. Canadian ETF Association (CEFTA)
10. Association of the Luxembourg Fund Industry (ALFI)
11. German investment and asset management association (BVI)
12. Union Bank of Switzerland (UBS)
13. Investment Management Association (IMA)
14. National Association of German Cooperative Banks (BVR)
15. Chris Barnard
16. Hermes Equity Ownership Services
17. NYSE Euronext
18. London Stock Exchange Group (LSE)
19. EDHEC-Risk Institute
20. French Asset Management Association (AFG)
21. Irish Funds Industry Association (IFIA)
22. European Fund and Asset Management Association (EFAMA)
23. Alternative Investment Management Association (AIMA)
24. Lyxor
25. Cicero Group (on behalf of ETF Securities)
26. Stoxx
27. International Banking Federation (IBFed)
General comments and high-level summary of the responses received
Respondents welcomed the objectives of the consultation and stressed the importance of
adopting a consistent approach for the regulation of ETFs compared to other investment
products. A large majority of replies underscored the fact that ETFs should be viewed as a
22

sub-category of collective investment schemes (CIS). According to these respondents, only a

few of the proposed principles would be specific to ETFs, thus raising the question of
whether the scope of the consultation should be broadened to CIS, or alternatively, whether
the scope should be narrowed to those few principles that are only specific to ETFs. One
respondent (EDHEC) opined that the proposed regulation of ETFs through ad hoc policy
principles would do little to promote a more level playing field across the fund or investment
management industry, despite the good intentions of regulators to address potential ETF risks
early on.
Concerning principles (1-8) and their related recommendations presented in Chapter 2 of the
consultation report - Principles Related to ETF Classification and Disclosure all
respondents welcomed the intention of regulators to establish a clear demarcation between
ETFs and other exchange-traded products (ETPs). The distinction, however, between
traditional and non-traditional ETFs met considerable reservations on behalf of some
industry members. On the other hand, the suggested principles to enhance investor
disclosures by explaining complex strategies, replication methods, portfolio and performance
tracking measures, fees and operating expenses, as well as securities lending programs, were
all positively received by industry players and their representatives. Some respondents
outlined minor exemptions that they believe ought to be taken into account for the fine-tuning
of selected principles and to reflect certain industry practices.
Principles (9-12) as outlined in Chapter 3 - Principles Related to Marketing and Sale of ETF
Shares - found the agreement of all respondents, although a large majority remarked that
rules relating to the marketing and sale of ETFs should be no different than the ones
governing the distribution of other financial products. Additionally, some cautioned that
recommending specific requirements for the distribution of ETFs may generate a negative
bias against them to the advantage of competing products.
Chapter 4 - Principles Related to the Structuring of ETFs presented two principles (13-14)
aimed respectively at addressing conflicts of interest, and improving the management of
counterparty risk for ETF providers. On conflicts of interest, the majority of respondents
welcomed a clearer identification of potential conflicts of interest between the ETF manager
and affiliated service providers (i.e., the index provider, the lending agent, the AP and a
derivative counterparty), albeit held that such conflicts are sufficiently addressed in existing
legislation. Most responses furthermore considered that regulatory intervention as suggested
in the consultation report would prove disproportionate, create inefficiencies (e.g., by
preventing customized index providers from being affiliates of the ETF tracking their index)
and, in certain circumstances, may even be counterproductive (e.g., demanding that an AP
not be affiliated to the ETF provider may lessen the former's commitment to provide liquidity
under adverse market conditions). Globally harmonized rules on ETF listing requirements,
greater disclosure and industry best practices to uphold an ETF's fiduciary duty vis--vis its
investors, regardless of a provider's affiliations, from the majority of the respondents'
viewpoint, would be a more practical and efficient outcome. Two respondents (Amundi,
AFG) also requested that the term affiliation be clarified.
On the necessary measures to ensure that ETFs manage their counterparty exposures and
receive adequate collateral, a large majority of replies stressed that these needs are not
specific to ETFs, but should apply to the broader CIS industry. 44 Replies emphasized that
collateral requirements should not be too prescriptive as the ultimate economic function of
collateral, in case of counterparty default, is for it to be promptly re-sold in the market. On
44

This view was also shared by a foreign regulator (Intendencia de Mercado de Valores of Ecuador).

23

the report's proposal to limit the proportion of an ETF's portfolio available for lending, the
majority of respondents disagreed, citing lower returns and reduced competitiveness. Finally,
a broad consensus emerged over the fact that exposures to OTC derivatives may be
aggregated with those arising from securities lending transactions, with some respondents
voicing that the treatment of counterparty risk would need to be addressed in the light of
other forthcoming regulatory measures (e.g., the European Market Infrastructure Regulation
EMIR in Europe, or the Dodd-Frank Act in the U.S.).
The final Chapter 5 of the consultation report - Issues Broader than ETFs intended to
address broader risks beyond the ETF/ETP industry. Principle 15 suggested that ETF
exchanges adopt appropriate measures to prevent liquidity shocks and mitigate the impact of
their transmission across correlated markets. Opinions ranged from those favoring trading
interruption mechanisms (e.g., trading halts), to those more cautious, placing a greater
emphasis on pre- and post-trade transparency. A general view among respondents however
remains that ETF trading is not the sole to be potentially responsible for liquidity shocks and
their propagation in the broader market. Regarding the risk of abusive behavior to the
detriment of market integrity, the few respondents, among which one major exchange (LSE
Group), suggested authorities request that exchanges implement appropriate monitoring
systems to capture abusive behavior.
The final section of Chapter 5 addressed broader financial stability concerns not exclusive to
ETFs. Respondents were invited to share their views on a series of questions, suggesting
possible further avenues of work at the FSB/Joint Forum level. Within this section, less than
half of the total respondents replied, believing potential financial stability issues to be either
negligible (given the relative small size of the ETF industry compared to other asset classes),
or to have been sufficiently addressed in the report, or in the existing regulation. Replies have
thus confirmed few inclinations to see the launch of new initiatives within the
abovementioned international fora.
Specific comments
CHAPTER 2 - Principles Related to ETF Classification and Disclosure
Disclosure regarding ETF classification (Principles 1-2)
The proposed principles are addressed to regulators with the aim to improve the quality of
ETF product disclosures, allowing end investors (particularly retail) to clearly distinguish
ETFs from other ETPs. Analogous requirements are intended to better differentiate between
ETFs and other CIS, as well as between index and non index-based ETFs (i.e., passively vs.
actively managed ETFs).
The vast majority of respondents supported both principles, arguing that greater clarity
between ETFs and other ETPs is warranted, where ETFs are clearly a sub-category of the
latter. They further recommend that such disclosures apply to all other ETPs. Another shared
opinion was that use of an ETF identifier should moreover be limited to those products
meeting a common definition of an ETF 45 and that non-CIS products should be barred from

45

According to the definition of a UCITS ETF given by ESMA in its Guidelines on ETFs and other
UCITS issues, published in December 2012, a UCITS ETF is a UCITS at least one unit or share class
of which is traded throughout the day on at least one regulated market or Multilateral Trading Facility
with at least one market maker which takes action to ensure that the stock exchange value of its units
or shares does not significantly vary from its net asset value and where applicable its Indicative Net

24

using the ETF identifier. 46 As to the difference between index and non index-based products,
the view was that this should be more appropriately explained in the prospectus or other precontractual documents. One respondent (EDHEC) maintained that even before proposing a
clear distinction between the passively and actively managed indices, the word index would
need to be given a legal definition and that regulators should decide on index transparency
and audit requirements. The adoption of these consolidated standards would, in the view of
EDHEC, furthermore slow current industry dynamics, i.e., the increasing shift of indices
from passive to active management. 47
Referring to disclosure standards in Europe, one respondent (Deutsche Bank) stressed that
these should remain consistent between ETFs and other CIS. To another respondent
(EDHEC), the difference between an ETF and a CIS would in fact be minor and should not
be exaggerated. ETFs would in this sense be only CIS that need to comply with the rules of
the exchange on which they trade. The need to not pit ETFs against CIS as two separate
investment products was reflected elsewhere in the replies to the report. 48
Further to ESMA's publication of its Guidelines on ETFs and other UCITS issues in
December 2012, seven respondents (IMA, LSE Group, EFAMA, AIMA, Lyxor, ALFI, BVR)
based in Europe replied that the proposed IOSCO principles have now been translated into
EU law for European regulators to apply, particularly via the UCITS (Key Investor
Information Document - KIID) and Prospectus directives' requirements. One respondent
(ALFI) mentioned that, apart from the distinction between ETFs and CIS, or between index
and non index-based products, it was important for providers to define risks (e.g.,
counterparty risk) deriving from certain ETF structures, from the varying liquidity conditions
on an exchange, and from the particular role of the AP. 49 A similar view was echoed and
further explained by other respondents (AFG), according to whom, the recommendations
should recognize the important distinction between the replication technique of an ETF and
its particular strategy in the pre-contractual disclosure documents (see infra).

IOSCO's response: IOSCO broadly agrees with the responses provided in the
consultation and has introduced language, where relevant, to indicate how ETFs
differ from other ETPs, as well as from other CIS products. These indications are to
be disclosed to prospective investors in the prospectus or other pre-contractual
documents.

Asset Value. The majority of European ETF providers have supported this definition in the run-up to
the finalization of the Guidelines in December 2012.
46

In this respect, Blackrock has even suggested that for those leveraged and inverse products (intended
for short-term and institutional investors), the identifier "ETF" should not be used as a label.

47

For this purpose, EDHEC suggests measures to offer better (i) information on the type of index being
tracked and the implications for the quality of tracking; (ii) transparency, quality, governance, and
auditability of indices that can be used by index vehicles; and (iii) tracking performance and minimal
standards.

48

In this regard, the AFG has suggested replacing Principle 2 with the following language: Regulators
should seek to ensure a clear differentiation between index-based and non index-based ETFs through
appropriate disclosure requirements.

49

As for other respondents representing the European industry, these further matters are sufficiently
disclosed in the existing EU UCITS (KIID) and Prospectus legislation.

25

Disclosure regarding ETF strategy (Principle 3)

The proposed Principle 3 was for regulators to encourage the clear, accurate and complete
disclosure by ETFs of their strategies and techniques, including the risks associated
therewith, in their pre-contractual documents to investors.
Overall, the vast majority of replies supported the principle, but argued that it should not be
specific to ETFs, and that it should (where it does not already) apply to all CIS in numerous
jurisdictions worldwide. 50 More importantly, most replies emphasized the need to distinguish
the manner in which the investment is managed or structured, from the way it obtains its
economic exposure (i.e., the replication technique). These respondents further argued that an
ETF's degree of complexity ultimately depends on the manner in which the relative
risk/reward profile and pay-off profile can be understood by the investor. In the opinion of
one respondent (EDHEC), disregarding or de-emphasizing the main risk drivers and the
payoff profile generated by the investment strategy to instead focus on the techniques the
investment vehicle uses (or the instruments it holds) to generate this payoff, could create a
false sense of security vis--vis other mainstream products. On this basis, some respondents
(AFG, IFIA, Lyxor) suggest that the wording of the proposed Principle 3, particularly that
referring to "other complex techniques", be adjusted or deleted. These actors observed that
what ultimately counts for investors is that they understand the investment strategy, but not
necessarily the investment technique (however complex) that the ETF provider puts into
place to deliver the desired economic return. 51 Another reply (IBFed) stressed that
complexity does not equate to riskiness. On the contrary, some structured products could
enable investors to diversify risk more easily, bringing the respondent to caution IOSCO
against equating the complexity of the product with its riskiness for the investor.
In another reply, a respondent (ALFI) suggested that the principle on disclosures should be
more suitably addressed in the national/regional legislation on the marketing and sale of
investment products to the public. In its view, such rules are important for the sake of
guaranteeing a level playing field among competing products (e.g., ETFs, other CIS, etc.),
regardless of whether they may be deemed complex or not. In this sense, another respondent
(EDHEC) noted that IOSCO's approach to product disclosure via the emphasis on ETFs in
the consultation report would appear too vertical at a time where a more horizontal approach
would better serve the purpose of a level playing field. To this end, it invited IOSCO to
design principles harmonizing the marketing and sale of both CIS and non-CIS securities
(e.g., other ETPs).
In the view of one private citizen (Chris Barnard), disclosures should accurately inform on
whether a particular ETF strategy exposes the investor to additional "new" risk factors
compared with investing directly in underlying securities (e.g., counterparty risk, leverage,
etc.).

IOSCO's response: IOSCO agreed with the need to introduce a clearer distinction
between investment strategy and replication technique. Both deserve adequate
disclosures in prospectuses or in other pre-contractual documents, especially in

50

One respondent (ICI) mentioned that the proposed principle would already be satisfied under the
current U.S. disclosure requirements as implemented by the SEC (i.e., those of the 1940 Investment
Company Act). Important is that the same disclosures apply to other forms of ETPs.

51

In their replies to the consultation report, AFG and Lyxor observed that "complex techniques" should
not be confused with "complex strategies", i.e., techniques, like securities lending or the use of deltaone derivatives that are not in themselves changing the investment strategy of the fund.

26

explaining the nature and extent of counterparty exposures. In this sense, the purpose
of the disclosures should be no different than that foreseen for other CIS products.
Disclosure regarding an ETF portfolio (Principles 4-6)
Principles 4-6 were aimed at encouraging regulators to increase the transparency with regard
to the way in which an ETF tracks a chosen index and demand more disclosure on portfolio
components, index composition, and performance tracking.
As a premise to the three principles, two associations (ALFI, AFG) and one research institute
(EDHEC) pointed to the fact that the distinction in the consultation report between traditional
(or so-called physical replication) and non-traditional (or so-called synthetic replication)
ETFs could be misleading. According to these replies, indicating that synthetic ETFs are nontraditional with regard to their frequent use of derivative contracts to achieve their desired
exposures (and without any further distinction between plain and leveraged/inverse indices),
would introduce two orders of problems: (i) such a categorization could create confusion for
the end investor since in Europe for instance, synthetics are UCITS funds and subject to the
same stringent regulation that applies to the traditional, physically-replicating ETF category;
and (ii) that the notion of a non-traditional ETF in the report implies a bias against products
using derivatives to generate the desired exposure. Referring to the difference highlighted in
the previous section between the investment strategy and the investment technique (used to
obtain the desired economic pay-off), some of the respondents suggested that a distinction
should be made between plain ETFs (including physical and synthetic ones alike) and
leveraged/inverse ETFs. 52 The two categories therefore should be kept separate as they do not
have the same investment strategies and therefore the same risks.
Concerning all three principles, the majority of replies stressed that they should apply to all
CIS (where they do not already), as they are not specific to ETFs. Looking at the individual
disclosure requirements more in detail, respondents were divided along the following lines:
Relative to the disclosure requirements on the chosen replication method under Principle 4,
replies confirmed an overall support from all sides of the industry. Respondents particularly
welcomed the balanced approach suggested by IOSCO whereby both replication methods are
treated in the same way (i.e., physical vs. synthetic replication). Moreover, according to one
reply (UBS), such requirements should not restrict an ETF manager from switching from one
type of replication to another, depending on market signals. As confirmed by the majority of
replies, the principle should apply to all CIS (as for the European industry in the recent 2012
ESMA Guidelines) and not be solely limited to index funds, but also to actively managed
ones, regardless of whether they are exchange-traded or not.
On the publication of the index components, as suggested under Principle 5, index and ETF
providers deemed it impossible to implement as intellectual property issues would impede the
real time publication of the individual components, especially where the ETF is actively
managed and the components of the underlying are proprietary information. One major index
provider (STOXX) proposed changing the wording of Principle 5 i), suggesting that the
information to be disclosed should concern the index and "its methodology" (instead of "its
composition"). One association (AIMA) in this regard replied that an index calculation
methodology will comprise an intricate computer program that is expressed in thousands of
lines of codes. Describing it in words would simply not be practical and of no use to
52

One industry player (Amundi), underscored the importance of discerning synthetic ETFs (in the form
of CIS) from other "non-traditional" products such as ETFs based on specialised indices, leveraged
ETF, inverse and ultra-short ETFs, etc.

27

investors. 53 Alternatively, as most replies have advanced, there could be a focus on high-level
transparency and less on allowing investors to materially be able to track an index. An index's
components could thus be published only selectively (e.g., only the top 10 components
making up the chosen index), or with a certain delay. 54 Some providers also mentioned that
most ETFs publish their portfolio holdings on a daily basis (often accompanied by collateral
composition) on their website; hence, IOSCO should not consider additional requirements.
Others (AIMA) considered it sufficient to provide investors with holdings' information on a
semi-annual basis, whereas others (CEFTA) admitted that even shorter periods (i.e., monthly)
in their domestic jurisdiction where possible. For synthetic ETFs, one respondent (Hermes)
favored extending the required disclosures to explain the nature of the derivative or other
arrangement at the basis of the replication, as well as the name and nature of the counterparty
to the arrangement.
IOSCOs proposal to require disclosure to investors on performance tracking was broadly
supported. Certain associations (CEFTA) agreed with the proposed disclosure principles and
deemed them to be sufficiently implemented in their home jurisdiction. However, one major
industry player (Blackrock) noted that offering investor information on the quality of indextracking may run into a series of problems, especially where investors observe greater levels
of tracking difference and/or tracking error compared to an anticipated target. In this respect,
Blackrock observed that disclosed information should remain "meaningful" to the investor,
e.g., an ex-ante target threshold for "mis-tracking" should be offered alongside an alert for
potential risks and causes leading to "mis-tracking". Despite supporting the recommended
principle on the need to publish tracking difference and/or tracking error information, another
industry player (State Street) cautioned that these predictions should be regarded as a mere
prognosis with no legal/binding consequences. Agreeing with these positions, one reply
(ALFI) even suggested that IOSCO provide guidance on how tracking difference and/or
tracking error are to be calculated, possibly even through a uniform methodology. This latter
view was shared by another respondent (EDHEC), inviting IOSCO to impose the use of
standard formulae to compute performance measures, along with ex-ante (i.e., targeted) and
ex-post (i.e., realized) tracking error information. The research institute also expressed some
concern at the fact that until this day regulators have not provided a legal definition of
tracking, as well as standardized measures for the market to assess the quality of the
replication. 55
A majority of respondents expressed support for the facilitation of the use of arbitrage
activity under Principle 6, and welcomed any arrangement that would permit market
participants to accurately assess an ETFs underlying value throughout the trading day. Some
(Amundi, AFG) adduced that the harmonization of exchange listing rules would be beneficial
in this sense, as well as improve investor information. In their wording, it was suggested that
53

AIMA further observed that any standard indices cannot be tracked by (retail) investors in practice.
Highly diversified indices with a thousand or more components (e.g., Russell 1000 or 3000) are likely
to be much more difficult to track than an index of e.g., 25 components with daily rebalancing.

54

One European respondent (UBS) referred to the 2012 ESMA Guidelines addressed to index-tracking
UCITS. These should be extended to non-UCITS index tracking CIS, but with few reservations: they
would need to be high-level so as to not violate the proprietary information of the index provider or
undermine fee collecting from registered users.

55

In EDHEC's view, regulators should provide a formula for tracking error to be used across all index
tracking products, impose a maximum tracking error for a fund to qualify as a tracker (with different
limits to be applied according to different underlyings), and enforce initial and ongoing disclosure of
targeted and realized tracking difference and/or tracking error.

28

the principle would need to apply only to those passive index-tracking ETFs, thereby
excluding the actively managed ones for which portfolio components may not be disclosed to
facilitate arbitrage activity. 56 Further, most industry associations responding to the
consultation report shared the view that in this second case, the disclosure of the actual and
detailed portfolio composition should be limited to APs for them to provide liquidity and
guarantee tight bid-ask spreads on the secondary market. These indicated that full disclosure
of index constituents or weights for the purpose of facilitating arbitrage activity could
actually be detrimental to investors, as regular public availability of this information could
lead to front-running of a successful investment strategy. Also, according to one of them
(AIMA), this requirement would discriminate against ETFs compared to other funds, as the
latter would not have to publish their full holdings after each trading day. 57 One association
(CEFTA) mentioned that ETFs already publish on a daily basis the identity and weightings of
securities in their purchase or redemption baskets. In its view, such daily disclosures of a
sample of portfolio holdings are sufficient to facilitate arbitrage activity by the authorized
AP. Another association (ICI) stated that while a mechanism that allows market participants
to assess the value of the ETF relative to its holdings (e.g., transparency) is necessary for
efficient arbitrage, it is not sufficient. In its view, the arbitrage mechanism is also affected by
the size of the creation units. 58
One respondent (IMA) suggested including references to an important body of IOSCO work
on market timing and on the need for funds to have appropriate mechanisms in place to deter
arbitrage activity in fund units to the detriment of other fund investors. Finally, as for
Principle 5 above, some replies once again highlighted the difference between passively and
actively managed ETFs, where higher portfolio transparency to facilitate arbitrage would run
against the commercial interests of the active manager.

IOSCO's response: IOSCO agreed to revise the definition of "non-traditional" ETFs

as previously included in the consultation report. IOSCO was of the view that the
same disclosure requirements should apply both to index-based and non index-based
(i.e., actively managed) ETFs. These would concern the replication method, the index
and/or basket composition, and the operation of performance tracking. Whilst IOSCO
encouraged the disclosure of index composition and weighting as much as
practicable, IOSCO noted the concerns expressed by stakeholders on the protection of
proprietary information. Regulators should consider the appropriate level of
disclosure relating to index composition and weightings taking into account these
concerns, the sophistication of concerned investors, local conditions and the overall
efficiency of arbitrage activities.

56

According to another respondent (IMA), appropriate would be the reformulation of Principle 6 to

include the following reference (in bold): "[] the transparency of an index-tracking ETFs portfolio
[]".

57

In its contribution, AIMA succinctly described the mechanism that allows an AP to conduct its daily
arbitrage. In order to help arbitrage by APs, most ETFs provide a file including an indication of the
investments of each ETF. This Portfolio Composition File also sets out the cash element to be
delivered (a) by APs to the ETF the case of subscriptions; or (b) by the ETF to the APs in the case of
redemptions. The Portfolio Composition File is usually made available to APs by the investment
manager on each dealing day. With this information the APs will be able to evaluate arbitrage
possibilities.

58

In the ICIs view, very small creation units would allow retail investors to transact directly with the
ETF, while very large creation units could reduce the willingness or ability of APs to transact with the
ETF, impeding the arbitrage pricing discipline.

29

Disclosure regarding ETF costs, expenses and offsets (Principles 7-8)

The last two principles concerning ETF classification and disclosure invited regulators to
consider the disclosure of fees and expenses linked to ETF investing (Principle 7), to
understand their impact on performance and, more particularly, to adopt measures enhancing
the transparency of fees received/paid with respect to the borrowing/lending of securities
(Principle 8).
Among respondents, there was unanimous consent on the need to consider disclosure
requirements on these topics and on the overall fact that, again, these principles ought to be
equally valid for other CIS. Opinions however ranged from those suggesting that information
should not be too detailed (mentioning that what really mattered to investors was the global
cost of the product), to those supporting the publication of all cost structure details possibly in
a harmonized format (e.g., the KIID as required under EU legislation). Certain providers
(State Street) introduced an important caveat in this context, i.e., that relevant fees and costs
should not be confused with risks, considering for instance that spreads, discounts and
premiums, are more appropriately to be considered as risks associated with investing in an
ETF, rather than as costs.
As to securities lending, there was a broad agreement that the proposed disclosures should
apply to all CIS for the sake of consistency and not place ETFs at a competitive disadvantage.
One commenter (State Street) stated that due to local differences in regulations and disclosure
for securities lending in CIS, it is more important for ETFs to be consistent with local CIS
than for ETFs to achieve consistency across the globe. One association (ISLA) stressed the
importance of having costs and performance of securities lending transactions recorded and
disclosed as a separate line item in the total expense ratios (TERs) of the fund. However, it
insisted requirements should not be too detailed such that constant updates (with their
associated costs) will be required. Important to two respondents (Amundi, EDHEC) is also
that fee-sharing arrangements between lenders and borrowers be disclosed in prospectuses
and/or annual reports. One important industry player (Blackrock) fully supported both
principles, adding that for securities lending, ETP providers further had to disclose the fee
splits between themselves and any third parties involved (i.e., lending agents). 59 Moreover, it
suggested that all fees paid by a fund in connection with securities lending revenue, including
collateral management, administration or securities transfer fees borne by the lender, should
be disclosed. Finally, according to Blackrock, the lending program should allow transactions
with multiple counterparties and require over-collateralization with collateral that is highly
liquid and diversified. According to an industry peer (Deutsche Bank), the above disclosures
would go hand-in-hand with the regular publication regarding the identity of the securities
lent, the nature of the collateral received 60 and of the counterparties involved with respect to
the lending and borrowing of securities.
To offer investors a complementary measure to measure the total costs associated with ETF
investing, one research institute (EDHEC) proposed a "Total Return (pass-through) Ratio"
(TRR) that would capture the returns arising from securities lending operations. By
highlighting the share of returns that does not accrue to the investor, such a ratio would
59

With respect to the division of fee revenues from securities lending between fund and third party
lending agents, one industry player (UBS) cautioned that if in the future all benefits from securities
lending were to go into the fund, lending agents may no longer be willing to supply their services.

60

Regarding collateral, the reply from UBS also mentioned that, apart from type/quality and amount of
collateral received, its value relative to the value of the securities lent would also deserve to be
published.

30

permit an assessment of the true cost of asset management, beyond the information given by
the total expense ratio (TER).
On the other hand, certain providers (Amundi) and associations (ALFI, AFG) have cautioned
that certain costs may be difficult to disclose ex-ante, since they would sometimes be difficult
to assess unlike other fund fees (e.g., depend on the number of operations carried out by the
asset manager, the instruments used, operational costs when trading those instruments, legal
constraints and tax issues, etc.). For some (AFG), the best indicator for investors to gauge the
total cost of their investment (and to measure the fund's performance) remained the tracking
difference. Only very few replies referred to the proposed disclosures of additional
information on the treatment of rebalancing costs, on revenues derived from fund assets and
on the way the latter are distributed between an ETF operator and the ETFs shareholders
(e.g., dividend payments).
Another association (ICI) pointed to the ongoing work of the relevant work-stream under the
Financial Stability Board (FSB) with respect to shadow banking and to Section 984 of the
U.S. Dodd-Frank Act, requiring the SEC to increase the transparency in securities lending
operations available to brokers, dealers and investors. It encouraged IOSCO to take on board
the results of these parallel work-streams ahead of issuing final recommendations on
securities lending for the sake of consistency.

IOSCO's response: IOSCO agreed that the same recommendations for fee and cost
disclosures are broader than ETFs in general, even with respect to securities lending
and to the enhanced revenues that such activities accrue to the ETF. It remains
however important that investors are informed not only of the relative fees and costs,
but also of the perceived revenues from securities lending, especially where these
represent a significant source of return.

CHAPTER 3 - Principles Related to Marketing and Sale of ETF Shares

(Principles 9-12)
Viewed together, the proposed Principles 9-12 each introduced a series of parameters
addressed to market intermediaries responsible for the marketing and sale of ETF shares.
These range from the fairness of the information presented to investors in the marketing and
sales materials (Principle 9), to the requirement for regulators to calibrate disclosure
obligations to the entity (i.e., the producer or the distributor) that de facto has control over the
contents of the information to be disclosed (Principle 10); from the suitability test to be
administered by distributors when selling ETFs to investors (Principle 11), to the requirement
for intermediaries to establish a compliance function to ensure that client suitability standards
are upheld (Principle 12).
Overall, the majority of respondents observed that the proposed principles on disclosure are
implemented through varying degrees in existing legislation across developed jurisdictions. 61
Some replies (IMA) questioned if the purpose of Principle 9 was to separate marketing and
selling procedures from those envisaged for other investment products. If so, ETF providers
and their intermediaries should not be allowed to tailor their own disclosures for the sake of

61

On their part, many European industry players and their associations underlined the fact that the
distinction between complex and non-complex products, as well as the rules on financial product
selling practices, would already be sufficiently addressed in the existing EU legislation (i.e., in the
MiFID framework).

31

preserving consistency among other non-ETF financial products. 62 One respondent (ETF
Securities) suggested grading the ETF offer according to the discretion of the
advisor/distributor as a possible method to advise clients on the suitability of a specific
product. In its view, this would need to be accompanied by measures to improve investor
education. With regard to Principle 10, one association (ICI) strongly suggested that in
evaluating an intermediarys disclosure obligations, regulators should consider who has
control over the information to be disclosed.
With regard to Principle 11, European ETF providers (and their representative associations)
insisted that plain synthetic ETFs (i.e., those replicating a standard, recognized broad market
index) are not to be considered as complex products 63 (despite the replication technique
typically making use of swap derivatives) and that there should be no distinction among the
two different replication models (i.e., physical vs. synthetic) concerning selling rules. On a
different aspect, one important industry player (Deutsche Bank) suggested the principle
reflect also an intermediary's duty to act honestly, fairly and professionally, while taking
reasonable steps to manage conflicts of interest.
Some providers (Amundi) pointed out, with respect to Principle 12, that an intermediary
should not be placed in a position to provide a written justification of its advice; as such an
obligation would probably lead to abuses by unscrupulous customers. Moreover, other
respondents (State Street, BVI, EFAMA) suggested that this principle be applied
proportionately, depending on the intermediary or target investor. With regard to the former,
one association (BVI) noted that the requirement would for instance not be appropriate for
those individual advisers that are natural persons and that are not integrated in a corporate
distribution structure. 64

IOSCO's response: IOSCO acknowledges that concerns regarding marketing and

sales practices relating to ETFs are no different from those applying to other CIS
products.
Relevant conduct requirements, including applicable suitability
requirements that apply to other investment products are still applicable to the sales
and marketing of ETFs. As is the case with other investment products, intermediaries
that market and sell ETF shares also may have a role to play in addressing the
investor protection concerns related to ETFs. In this regard, IOSCO encourages
regulators and the industry to consider ETFs in connection with the guidance on the
applicability of suitability obligations to market intermediaries in the context of
complex financial products set out in IOSCOs recent report on Suitability
Requirements with Respect to the Distribution of Complex Financial Products.

62

In this regard, IMA noted that the KIID in Europe is already an example as to how pre-sale information
should be consistent.

63

One association (AFG) suggested replacing the reference in Principle 11 from "[] particularly a nontraditional ETF []" to "[] particularly an ETF that uses complex strategies []".

64

In its reply, EFAMA suggested rephrasing the principle along the following lines (additional wording
in bold): Where appropriate in view of the nature, scale and complexity of their business,
intermediaries should establish a compliance function and develop appropriate internal policies and
procedures that support compliance with suitability obligations when recommending any CIS.

32

CHAPTER 4 - Principles Related to the Structuring of ETFs

Conflicts of Interest (Principle 13)
Regarding the potential conflicts of interest inherent in certain ETF business models, the
consultation report identifies four different forms stemming from the intra-group affiliation of
the ETF with other service providers: (i) between the ETF and the index provider, where the
latter compiles and revises the index; (ii) between the ETF and a lending agent that facilitates
the borrowing/lending of securities; (iii) between the ETF and the AP charged with
buying/selling the ETF's shares on the secondary market; and (iv) between the ETF and a
swap derivative counterparty for the delivery of the desired index returns. From these
considerations, the proposed Principle 13 in the consultation report demands that regulators
verify that the applicable securities and exchange laws sufficiently address the above, and
possibly other, implied conflicts of interest.
All replies supported the need to manage conflicts of interest in principle, with one provider
(Amundi) recommending that IOSCO also define the notion of affiliate, e.g., on the basis of a
minimum holding threshold, to facilitate the implementation of the proposed principle.
However, a large number of respondents disagreed with some of the proposed means of
implementation to Principle 13 and particularly, where IOSCO suggested requiring that
service providers not be affiliated to the ETF. To these respondents, the proposed measures
would be disproportionate, and would not take into account the fact that ETF management
companies first and foremost need to adhere to their fiduciary duties vis--vis their investors
regardless of their corporate structure. Instead, most replies stressed that conflicts of interest
should be addressed via sound standards and principles applied not only to ETFs, but also to
other listed instruments. From a general perspective, one commenter (State Street) stated that
what is key with regards to conflicts is that there are processes in place to identify and
manage these conflicts and that these are disclosed in an open and transparent manner. One
association (BVI) noted that business relationships within corporate groups are already
governed by conflict of interest rules. If special ones were to apply, as advanced in the
consultation report, to e.g., affiliated providers of customized indices, the same would have to
be done for all customized index providers regardless of their affiliations. Concerning ETFs,
replies revealed a consensus over the need to harmonize rules on admitting ETFs (and similar
products) to stock exchanges worldwide. More particularly, on the more contentious points
advanced in the report as possible implementation measures, respondents expressed the
following concerns:
(i) Regarding the potential conflict between the ETF and the index provider, certain actors
(Amundi, Blackrock) noted that where the index provider is an affiliate of the ETF
management company, index maintenance and calculation is already performed with
appropriate safeguards, in line with the proposed implementing measures in the
consultation report under letters c) and d); e.g., operational and hierarchical separation,
information barriers/firewalls, etc. Another association (ICI) stated that ETFs that track
indices created by an affiliate of the ETF adviser receive exemptive relief in certain
jurisdictions, under which they have agreed to a series of terms that are designed to
prevent the communication of material non-public information between the ETF and the
affiliated index provider. Another association representing the index industry (IIA)
instead supported the full separation between index provider and ETF, but considered
some of the proposed means to avoid conflicts of interest to be untenable. For instance,
the means of implementation considered under letter e), whereby component securities
should not be changed (as a result of index rebalancing) more frequently than on a
33

specific periodic basis. To the IIA, this requirement would force those seeking to use an
index as an ETF's underlying strategy, but with a different rebalancing frequency, to
have to alter their investment objective. Always according to the IIA, limiting the scope
for changes to indices and to their rebalancing frequency would be counter-productive
for investors, as in certain market circumstances, the rules of an index would need to be
adjusted quickly to ensure that it continues to reflect the reference market originally
described to investors in the investment policy of the fund. A minimum rebalancing
interval would moreover hamper those strategies that respond to corporate events (e.g.,
IPO indices, alternative betas in hedge fund strategies, etc.) and lead to the reduction of
indices and investor choice. This view was also shared by a major exchange (LSE
Group), as well as by all associations and ETF providers. Furthermore, the LSE Group
did not agree that a conflict of interest could arise between the calculation agent and the
index provider as they are very often the same entity and by definition affiliated,
especially for custom indices. Mandating their separation, as envisaged among the
possible implementing measures, would therefore prove disruptive in the LSE Group's
view.
Two associations (ALFI, EFAMA) supported that the forced separation between the
custom index provider and ETF, as well as the imposition of a firewall between these,
would make the development of indices virtually impossible without the involvement of
the ETF portfolio managers, whose investment objectives and strategy form the
necessary basis for the index compilation. 65 An important industry player (Lyxor)
added that if regulators were to assume that an asset manager alters the index at its
discretion in violation of its rules, the fund should be simply treated and advertised as
an actively managed fund. Finally, from a competition perspective, another association
(BVI) raised the concern that the proposed standards for custom indices could have
prohibitive effects on the possibility of index creation by ETF affiliates, which may
curb competition and thus perpetuate the pricing powers of the existing large index
providers who charge high license fees on their products. Only one response (STOXX)
openly supported the need to mandate the full unbundling between index
providers/managers and fund managers (with references to the 2012 ESMA
Guidelines).
(ii) On the potential conflict between the ETF and a lending agent, one market participant
(State Street) disagrees with the proposal to obtain quotes from non-affiliated lending
agents on a continuous basis in order to ensure the fairness of fees. To State Street, this
option would not be practical and appear disproportionate. Instead, it suggests that
market conformity checks on transactions conducted ex-post should be sufficient to
ensure that fees charged for securities lending are fair and reasonable. State Street's
view is shared by another respondent (BVI). One association (EFAMA) observed in this
respect that the market for securities lending in its current shape would appear opaque
and is limited to a handful of agents. These agents, generally, would not be willing to
disclose their conditions for transacting without good business prospects.
(iii) Regarding the potential conflict between the ETF and the AP, most replies pointed to
the fact that stock exchange rules would already sufficiently address this issue in their
formalized contracts with an AP. An industry association (ICI) described the exemptive
relief in one jurisdiction that permits affiliations between an AP and an ETF provider,
65

According to EFAMA, fund management companies should even have the right and be encouraged to
create and manage indices themselves.

34

where affiliates are not treated differently from non-affiliates when engaging in
purchases and redemption of ETF shares, and where there is no opportunity for them to
engage in transactions that could be detrimental to shareholders. There was a consensus
among respondents that the proposal to require a primary AP to not be affiliated with
the ETF would be overly prescriptive. Moreover, according to these replies, a nonaffiliated AP would not necessarily present the best solution for investors, as the former
may be inclined to offer lower liquidity or less inclined to make a market under stressed
market conditions, which in turn may disrupt trades and complicate meeting investors'
redemption requests. 66 One ETF provider (Amundi) noted that requiring a minimum
number of APs would also oblige an ETF to "forcefully" work with other "unknown"
entities with which there is likely to be less homogeneity in terms of compliance rules,
risk controls, reporting formats, etc. Another problem in requiring a minimum number
of APs is that it would make listing difficult to achieve in narrow niche markets (e.g., in
the commodities space), as put forth by one association (AFG).
(iv) On the potential conflict between the ETF and the swap derivative counterparty, a large
majority of respondents saw no fundamental reason for regulation to prevent ETF
providers from transacting with affiliated swap counterparties, as long as both entities
are hierarchically separate and conflicts of interest are sufficiently managed.
Instead of rushing to separate affiliated entities, the large majority of replies proposed that
IOSCO ought to require proper disclosures of all affiliated transactions to investors, rely on
industry to develop best practices, apply to the extent possible existing legislation (which in
the opinion of the majority of respondents already goes far enough), and harmonize ETF
listing rules where necessary (particularly in terms of maximum spreads, offered size,
minimum time of presence and iNAV policy). These measures would need to go hand-inhand with appropriate disclosures. As one respondent (EDHEC) advanced, a more detailed
disclosure of current fees paid by the ETF provider to affiliated or non-affiliated parties for
the rendered services would ultimately enable stakeholders to assess whether the alleged
conflicts of interest can either be managed, or resolved through bolder regulatory measures.

IOSCO's response: IOSCO decided to avoid providing a narrower definition of the

notion of "affiliated" as beyond the scope of this report. IOSCO generally agreed that
requiring the mandatory separation of an ETF from its affiliated service provider
would be impractical and unnecessary to the extent that rules to manage conflicts of
interest are already in place and applied. As to securities lending activities, IOSCO
decided not to require ETF providers to obtain mandatory quotes from non-affiliates,
relying rather on cost/fee and revenue transparency allowing investors to compare
among providers.

Portfolio Strategies (Principle 14)

Principle 14 is aimed at ensuring appropriate regulation addressing an ETF's counterparty
credit risk exposure and mitigating it via proper collateral management practices.
Replies to the consultation report and feed-back to the proposed means of implementation
addressing counterparty credit risk, reflected a general agreement on the underlying principle,
with the reservation that it should apply to all CIS having counterparty credit exposures. In
particular, one association (EDHEC) observed that neither OTC derivatives nor securities
66

Two associations (BVI, EFAMA) noted that there would be no point in requiring a minimum number
of APs. In Europe, for instance, UCITS ETF investors would under certain circumstances have the
opportunity to also redeem directly from the provider.

35

lending are in anyway specific to ETFs, or even CIS, and suggested it would be preferable to
approach issues related to these practices in a horizontal manner spanning the finance
industry as a whole. A majority of responses confirmed that uniform guidelines should
preferably apply regardless to how counterparty credit risk is assumed, and focus on the
proper management of collateral. 67 Regarding collateral, most respondents stressed the
importance of ensuring it remains of good quality and liquid, while allowing managers to
maintain the necessary flexibility on these parameters.
Further, several respondents stressed that counterparty credit risk, particularly with regard to
derivative transactions, would be more appropriately addressed through dedicated legal
frameworks (e.g., the CESR 2010 Guidelines, the UCITS Directive, the European Market
Infrastructure Regulation EMIR - for EU jurisdictions; the Dodd-Frank Act in the U.S.,
etc.).
Considering synthetic and other derivative-based ETFs, the general opinion among
respondents was that prescriptive collateral standards, e.g., ensuring that collateral be of the
same quality as the instruments constituting the tracked index, would in reality be difficult to
implement. One respondent representing the U.S. industry (ICI) cautioned that the structure
and regulation of the use of derivatives is substantially different between Europe and the
U.S., quoting from the consultation report that the types of synthetic [ETFs] encountered in
Europe or Asia do not exist as CIS in the United States. It further argued that in the U.S., the
1940 Investment Company Act already sufficiently addresses the concerns highlighted on
counterparty risk and collateral management with respect to derivative transactions. 68
Considering physical replication, a majority of respondents considered that limits on the
proportion of an ETF's lendable portfolio, would limit the opportunities for ETFs to enhance
their returns via securities lending and possibly lead to reduced competitiveness vis--vis
other ETPs. 69 These recommended that decisions on how much to lend should rather be taken
by the ETF management board, based on the information received (at least monthly) from
custodian/lending agents.
One association (BVI) invited IOSCO to consider that collateral, no matter the chosen
replication method, is by definition intended to be sold promptly in case of counterparty
default, thereby allowing the ETF manager to repurchase those securities needed to carry out
the advertised investment strategy. Also, independent of the replication model, one industry
player (UBS) noted that as more and more market participants are moving towards over-

67

In this regard, EDHEC recommends with the report proposal to limit net exposure on counterparty risk
from a specific issuer, combined with an overall limit on net counterparty risk exposure, and
accompanied by diversification requirements for instruments received as collateral. The latter are to be
duly segregated with a third party custodian. Provided that counterparty risk arising from securities
lending is mitigated to the same extent as that arising from OTC derivatives transactions, it would
make little sense to pit physical against synthetic replication in its view.

68

In the U.S., ICI observed that usually collateral is limited to cash and U.S. treasury and agency
securities, with haircuts applied to other types where allowed. Other rules, as approved in the form of
SEC Guidelines, set forth the types of collateral that funds may accept, as well as a number of
conditions governing securities lending by the ETFs, e.g., that funds lending securities receive at least
100 % of the value of the loaned securities as collateral from a borrower, marked to market daily; or
that a funds board approve specific borrowers to whom the fund may lend shares.

69

One association (AFG) would reinforce this point by rephrasing the proposed principle as follows:
"Regulators should consider imposing requirements to ensure that ETFs appropriately address
counterparty risks and collateral management.

36

collateralization, a more prescriptive regulation on collateral standards would stifle this

positive trend.

IOSCO's response: On counterparty risks, IOSCO acknowledges that many other CIS
also use derivatives and enter into securities lending agreements, and that these risks
are not unique to ETFs. As for other CIS products, regulators should encourage ETF
providers to appropriately address their counterparty exposures and adopt adequate
risk management procedures, limits to counterparty exposures, collateral
management requirements (e.g., rules for collateral eligibility and diversification), as
well as other available safeguards.

CHAPTER 5 Issues Broader than ETFs

Risks arising on secondary markets - risk of shock transmission (Principle 15)
Taking into account broader financial stability and market integrity concerns, this Chapter
pointed to two issues that had been flagged by the regulatory community: (i) the risk of shock
transmission flowing from the degree of market interconnectedness; and (ii) the risk of
abusive behavior on behalf of certain market players, as facilitated to a great extent by
continuous innovation and rapid technological progress. The proposed Principle 15 addressed
the first fundamental issue by inviting those exchanges listing ETFs to consider measures
aimed at mitigating the occurrence of liquidity shocks and limiting their transmission to other
trading platforms. Among the implementing measures advanced in the consultation report, of
primary importance are trading control mechanisms (e.g., trading halts, volatility
interruptions, limit-up/limit-down controls, etc.) to confront volatile market conditions. For
the second issue of market integrity, IOSCO has made targeted recommendations in its
Market Integrity and Efficiency Report, published in October 2011. 70 This report was more
recently (April 2013) followed by a new IOSCO Report on the Technological Challenges to
Effective Market Surveillance Issues and Regulatory Tools to help market authorities address
the technological challenges facing effective market surveillance. 71
Regarding Principle 15, nineteen respondents confirmed their endorsement of the principle.
The overarching consensus is, again, that the danger of liquidity shocks and their
transmission is by no means exclusive to ETFs among a myriad of other financial
instruments. Trading controls should therefore be applicable to all securities traded through
an exchange and measures to enhance both pre- and post-trade transparency should be
welcome according to most respondents. Although supporting measures to confront liquidity
shocks, only two respondents (EDHEC, IFIA) proved to be outliers. The former judged that
trading interruption mechanisms may instead increase liquidity shocks and facilitate
transmission across markets, 72 whereas the latter only stated that these would not be the most
effective means and may actually distort the orderly functioning of the market. As to the issue
of settlement delays as raised in the consultation report, one respondent (BVI) suggested
70

See FR09/11 Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity
and Efficiency, Final Report, Report of the Technical Committee of IOSCO, 20 October 2011;
available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD361.pdf

71

See Technological Challenges to Effective Market Surveillance: Issues and Regulatory Tools,
published by IOSCO in 22 April, 2013; available at:
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD412.pdf

72

In its response, EDHEC does not go into further detail, although admits that there has been little
theoretical or empirical research on this issue and would advise caution.

37

introducing buy-ins (as under the EU's proposed Regulation on Central Securities
Depositories CSDs). Such tools, however, should more pertinently be provided by the
national/regional legislation on capital market infrastructures. A respondent (ICI) strongly
supported the establishment of limit up-limit down mechanisms to address extreme price
movements in stocks in other jurisdictions where ETFs are traded and supported a more
robust discussion and examination of the linkages and interdependency of the different types
of financial markets.
One major exchange (LSE Group) provided an overview of the forms of trading controls it
has implemented. These include (i) circuit breakers that are triggered by market volatility and
lead to auction calls; (ii) tariff structures that provide incentives for lower order-to-trade
ratios and are calibrated per instrument group; and (iii) real-time market surveillance that
monitors misleading behavior. The use of circuit breakers/price volatility interruptions would
be an effective method of operating trading halts. Moreover, the LSE Group, using the
example of circuit breakers, recommended that these function according to the same
parameters across markets, where regulators would be left to establish overarching guidelines
and upper limits for tolerance, while leaving the details to be more efficiently set by market
operators (i.e., market infrastructures).
In its comment to Principle 15, one market actor (ETF Securities) commented that it did not
see an inherent vulnerability of ETFs to liquidity shocks. A more important consideration for
investors when considering an ETFs' resilience to a liquidity shock, this actor suggested, is
the number of APs (whether affiliated or not), as these parties can significantly influence the
bid/offer spread, thereby aiding liquidity and determining the total cost for the investors
owning ETF shares.

IOSCO's response: IOSCO decided to delete this principle, although noted that ETFs,
as other financial instruments that trade on an exchange, have been cited in a number
of reports focusing on issues of market stability, particularly with regard to their
potential effects on the overall liquidity and their vulnerability as means of alleged
market abuse. Although the evidence gathered remains at this stage still inconclusive,
in this regard, IOSCO encourages regulators and industry practitioners to consider
ETFs in connection with recommendations developed in the IOSCO 2011 Market
Integrity and Efficiency Report.

ETFs and market integrity (risk of abusive behavior)

As mentioned above, IOSCO has made targeted recommendations to deal with forms of
market abuse in its Market Integrity and Efficiency Report, published in October 2011. Out of
the responses received, only a handful sought to provide comments on this second important
issue addressed under Chapter 5 of the consultation report. Among these, the LSE Group
agreed that regulators should oblige exchanges to have monitoring systems in place,
extending also to order entry and deletion (not just executed trades). Under LSE Group rules
on misleading acts, conduct and prohibited practices, instructions exist to member firms
around prohibiting the entry of orders into the auction or during continuous trading, with the
intention of deleting or otherwise amending them before execution, as this could give a
potentially misleading impression of liquidity in a security or the likely auction uncrossing
price. The exchange does monitor this activity and take action against firms acting in breach
of these rules. The LSE Group however remains concerned about forms of market
manipulation, e.g., large orders aimed on one side of the book to move the bid/offer and then
to trade against it. Overall, the Group is wary of the fact that market manipulation can be an
ETF issue.

38

Risks to financial stability and avenues for future FSB/Joint Forum work
Taking stock of the observations and the conclusions of the FSB April 2011 note, 73 the third
and final section of Chapter 5 in the consultation report presented three questions on a series
of broader financial stability implications not exclusive to the ETF industry and indicating
areas where further work by the FSB or Joint Forum would be worthwhile.
The first question sought replies as to whether there are particular financial stability concerns
linked to ETFs that have not been addressed in the consultation report, in particular the issue
of securities lending and counterparty risks. In this regard, all replies agreed that all issues
had been covered in the report. Also, one association (AFG) found the advantages of ETFs to
have been understated in the consultation report. Accordingly, ETFs would be simple
products that have reached an unprecedented degree of transparency. Such transparency, in
its view, would benefit the public and, ultimately, the broader financial system.
A second question asked whether there were specific counterparty risks raised by ETFs and
whether further policy work from either the FSB or the Joint Forum would be warranted.
Again, almost all respondents agreed that there would be no ETF-specific counterparty risks
outside those identified in the consultation report and that at this stage there was no need for
either the FSB or the Joint Forum to carry out further work, particularly on issues like
securities lending where the FSB is expected to deliver broader policy recommendations in
the context of its broader shadow banking mandate. One association (IMA) suggested that
further scrutiny should be devoted to other competing non-CIS ETPs issued by banks, or
possibly by insurance companies. Another actor (Hermes) welcomed the question and
believed that the interactions between collateral treatment and new Basel III rules would
deserve additional attention and consideration.
A third and final question raised in the consultation report was whether the FSB or the Joint
Forum should seek a mandate to further study issues like the impact of ETPs on the price
formation of the underlyings. On this issue, an industry association (BVI) replied that an
ETF's extensive transparency and overall passive investing strategy makes its trading
predictable and thus less relevant in determining the price in one or more markets,
particularly in niche markets where only positive liquidity effects would be expected.
Another industry actor (ETF Securities) held that although ETFs would contribute to liquidity
and price formation, they would not "drive" it. Liquidity and the pricing of an ETP would
ultimately always be controlled by investor interest in the reference underlying. The one
research institute to reply (EDHEC) would however welcome IOSCOs consideration of
further academic studies and enforcement cases upon concerns related to potential liquidity
shocks, market integrity, and upon the financial stability issues highlighted in April 2011 by
the FSB.

73

See Potential financial stability issues arising from recent trends in Exchange Traded Funds (ETFs),
Financial Stability Board, 12 April 12, 2011; available at:
http://www.financialstabilityboard.org/publications/r_110412b.pdf

39

Appendix III List of Working Group Members

C5 Member jurisdiction

Organization

France

Autorit des Marchs Financiers (AMF) - Co-Chair

United States of America

Securities and Exchange Commission (SEC) - Co-Chair

Canada (Qubec)

Autorit des Marchs Financiers (AMF)

Canada (Ontario)

Ontario Securities Commission

Germany

Bundesanstalt fr Finanzdienstleistungsaufsicht (BaFIN)

Hong Kong

Securities and Futures Commission (SFC)

Ireland

Central Bank of Ireland

Italy

Commissione Nazionale per le Societ e la Borsa (CONSOB)

Luxembourg

Commission de surveillance du secteur financier (CSSF)

Spain

Comisin Nacional del Mercado de Valores (CNMV)

Switzerland

Swiss Financial Market Supervisory Authority (FINMA)

United Kingdom

Financial Services Authority (FSA)

40

Appendix IV Broad Overview of ETF Structures and Regulation Across Three Key
Regions
UNITED STATES
1. Main features of ETF structure
As of the end of 2012, the total number of U.S. ETPs organized as CIS was 1,194 with total
net assets of over $1.3 trillion, most of which are index-based ETPs. 74 The vast majority of
assets in these ETPs are in ETFs that are registered with and regulated by the U.S. SEC under
the Investment Company Act of 1940. At year-end 2012, 9% of assets were held in ETPs
that are not registered with and regulated by the U.S. SEC under the Investment Company
Act of 1940; these ETPs primarily invest in commodities and currencies. 75
2. Applicable regulation
In the United States, ETF shares are approved for listing and trading on a national securities
exchange (i.e., an exchange that has registered with the U.S. SEC under the Securities
Exchange Act of 1934). The registered national securities exchanges promulgate and
administer listing standards that govern the securities that may be traded in its market. The
rules of national securities exchanges, including listing standards, also are subject to review
by the U.S. SEC. ETFs accordingly are subject to the listing standards of the exchange on
which their shares are listed and traded. For example, the NYSE Listed Company Manual
currently includes generic listing standards for ETFs based on U.S. stock indices, non-U.S. or
global stock indices, fixed income indices and indices consisting of both equity and fixed
income securities. ETFs listed pursuant to such generic standards must be traded in all other
respects under the exchanges existing trading rules and procedures that apply to ETFs and
are covered under the exchanges surveillance programs for equities. ETFs in the U.S. can be
traded on or off exchange. All trades in ETFs (subject to a few minor exceptions), on or off
exchange, however, must be reported to the consolidated tape. The index underlying the ETF
also must meet a variety of conditions set forth in such standards, including requirements
related to the nature, liquidity, and diversification/weighting of securities in the index and
requirements with respect to index methodology and index value dissemination.
2.1 ETFs regulated under the Investment Company Act of 1940
In the United States, ETFs are registered with the U.S. SEC and are organized either as
open-end investment companies or unit investment trusts (UITs). Open-end CIS have
investment portfolios that are subject to active management by investment advisers
(operators) and are overseen by a board of directors or trustees. A UIT does not have an
74

The total number of these ETPs that are actively managed at the end of 2012 was 44, with more than
$10 billion in assets, excluding ETP funds of funds, which are ETPs that hold and invest primarily in
shares of other ETPs. At year-end 2012, there were 45 ETP funds of funds. Source: ICI 2013
Investment Company Factbook, (http://www.ici.org/pdf/2013_factbook.pdf).

75

Source: Ibid.

41

operator (or a board of directors) because its investment portfolio is not subject to active
management. A UIT is organized under a trust indenture, contract of custodianship or
similar instrument. ETFs in the United States generally meet the definition of investment
company in the Investment Company Act because such entities issue securities and are
primarily engaged (or propose to primarily engage) in the business of investing in
securities. ETFs generally are subject to the same provisions as other mutual funds.
Namely, ETFs generally cannot engage in affiliated transactions and their ability to use
derivatives generally is limited. To the extent that an ETF uses futures or swaps to
generate synthetic exposure to an underlying asset or index of assets, its operator may
also be regulated as a commodity pool operator as defined under the Commodity
Exchange Act if the ETFs use of futures or swaps exceeds certain de minimis trading
thresholds.
2.2 Commodity ETPs
ETPs that are not based on securities and whose portfolios may consist of physical
commodities, currencies, futures, or swaps are created and redeemed by APs and traded
on a national securities exchange in a manner similar to ETFs, but the entities offering the
ETPs are not registered or regulated as investment companies under the Investment
Company Act. These include ETPs that invest primarily in commodities or commoditybased instruments, such as crude oil and precious metals or futures thereon (commodity
ETFs). Commodity ETPs typically are organized as trusts or, in the case of commodity
pools, as limited partnerships, and issue shares that trade on a securities exchange like
other ETFs. An offering of shares in a commodity ETP is registered under the Securities
Act of 1933 (Securities Act) and the issuer is subject to the periodic reporting
requirements of the Securities Exchange Act of 1934 (Exchange Act).

One type of commodity ETP is based on a physical commodity and uses its assets
to buy and store the physical commodity itself. The products price is based on
the traded spot or cash market price of the physical underlying commodity (e.g.,
gold, silver, platinum, palladium).

A commodity ETP based on a physical commodity typically is not regulated as a

commodity pool as defined under the Commodity Exchange Act, as amended
(Commodity Exchange Act). The sponsor and the trustees of this type of
commodity ETP also may not be subject to regulation by the CFTC as a
commodity pool operator or a commodity trading advisor.

Another type of commodity ETP is based on futures and other swaps. These
products hold futures contracts (i.e., agreements to deliver a certain commodity at
a certain date in the future for a price paid today) that trade on exchanges and do
not require storage like a physical commodity does and may be cash-settled (as
opposed to physical settlement). Commodity futures contracts are regulated under
the Commodity Exchange Act administered by the CFTC. Commodity ETPs
based on futures or swaps typically are used for exposures which cannot be
physically stored or which represent a basket of commodities. The price of such
commodity ETPs is based on an index level which is derived from underlying
futures contracts (e.g., agriculture, energy, industrial metals, livestock).

A commodity ETP based on futures may be organized as a limited partnership that

42

is a commodity pool subject to the Commodity Exchange Act and whose general
partner is registered as a commodity pool operator with the CFTC. Alternatively,
such a commodity ETP also may be organized as a trust that is a commodity pool
subject to the Commodity Exchange Act and whose manager is registered as a
commodity pool operator with the CFTC.
3. Other Exchange Traded Products
Other ETPs include exchange-traded notes (ETNs) which, unlike interests in ETFs, generally
are unsecured debt securities, issued by public companies, in most cases by financial
institutions. ETNs also are exchange-traded securities that can provide the investor with
investment exposure to certain market benchmarks or strategies. As ETNs are debt
obligations of the issuer of the security, the ETN does not provide the investor with any
ownership interest in the referenced security or securities in the referenced index. In addition,
an investor in an ETN is exposed both to the market risk of the linked securities or index of
securities and the credit risk of the issuer. ETNs do not share the same fund-like or trust-like
structure as do other ETPs, and are not registered or regulated as investment companies under
the Company Act. An issuer that publicly offers ETNs is required to register the offer and
sale of the ETNs under the Securities Act and the issuer is subject to the periodic reporting
requirements of the Exchange Act.

43

EUROPEAN UNION
1. Main features of ETF structure
Whereas in the US almost all ETF assets are managed via physical replication structures as
defined above, in Europe, approximately one-third of ETF assets are managed through
synthetic structures
2. Applicable regulation
In Europe, the majority of ETF structures, regardless of the chosen replication method, are
authorised under the Undertakings for Collective Investment in Transferable Securities
(UCITS) Directive (2009/65/EC). As UCITS funds, among other requirements, European
ETFs are subject to strict diversification requirements at the level of their investment
portfolio and are obliged to respect precise limits in terms of leverage (no larger than twice
the value of their NAV) and of counterparty exposure (a limit equal to 5-10% of NAV). More
recently, in December 2012, important aspects of the UCITS Directive have been clarified
and broadened by the ESMA Guidelines on ETFs and other UCITS issues. Most
recommendations apply to all UCITS-authorised funds, whereas the remaining ones are
aimed specifically at UCITS ETF structures, regardless of their chosen model.
The Guidelines firstly provide a clear definition of a UCITS ETF through a single identifier
that bars any UCITS from branding itself as an ETF or exchange-traded fund where it does
not meet the prescribed definition. A second important feature of the Guidelines is an
extensive catalogue of required disclosures, ranging from the detailed description of the
chosen index to the replication method chosen, from the explication of the tracking error to
that of the eventual recourse to leverage (or inverse leverage) and implied risks, from the
illustration of redemption procedures (including direct redemption under certain
circumstances) to the justification of using financial derivatives and other efficient portfolio
management techniques, etc.
A second important section of the ESMA Guidelines, dedicated to all UCITS CIS, specifies
important requirements to be met when engaging in efficient portfolio management
techniques (i.e., investment in money market instruments, repo and reverse repo operations,
securities lending, etc.), including those relating to risk and liquidity management. These are
followed by analogous prescriptions relating to the use of financial derivatives. Collateral
management and quality requirements that are to accompany any of the above operations
emerge as one of the most innovative features of the Guidelines. At all times, the UCITS
must receive collateral that meets specific liquidity characteristics, is valued on a daily basis,
displays low correlations with issuers, is sufficiently diversified and enforceable at any time,
with no further possibility of being sold, reinvested or pledged, if of a non-cash nature. Stress
tests for collateral are required above certain thresholds and an appropriate haircut policy
takes into account the classes of assets received, their credit quality, price volatility and
outcome of stress tests. Finally, completing these Guidelines is an important section on the
eligibility of indices, laying out a series of conditions for indices to meet if they are to
become benchmarks for any UCITS CIS.
With regard to EU rules applying to sale and marketing of ETF products, these are
respectively disciplined by the requirements of the Markets in Financial Instruments (MiFID)
Directive (2004/39/EC) and of an implementing EU Regulation (No. 583/2010) to the UCITS
Directive on key investor information.
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3. Other Exchange-Traded Products

Regarding the other non-CIS exchange-traded products (ETPs) referenced in the above
sections of the report, these in Europe are generally distributed in Europe via the EU-wide
passport recognised by the Prospectus Directive (2003/71/EC) for products that are admitted
to trade on a regulated market and offered to the public. Generally qualifying as structured
products, compared to ETFs (which in Europe are typically UCITS funds), ETPs like notes
(ETNs) or commodities (ETCs) are for instance not subject to comparable diversification or
credit risk management rules. Moreover, investors in these products are less protected in
terms of the custody requirements that apply to the referenced underlying assets, compared to
the corresponding depositary regime under current UCITS rules.

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ASIA
CHINA
1. Main features of ETF structures
The first ETF in the mainland China market was issued in 2004. Since then China's ETF
market experience net inflow of capital every year. By the end of 2012, the ETF space had
expanded to 49 products with AUM of RMB 160.8 billion. The ETF market continues to
grow rapidly, new products such as gold ETF will likely be launched in 2013, while foreign
currency, leverage and inverse ETF products are also being studied.
In terms of product type, the mainland China market currently has equity ETFs, bond ETFs
and across jurisdictions ETFs. Equity ETFs replicate various major domestic indices as well
as investment indexes based on sectors, themes and investment strategies. The two cross
jurisdiction ETFs are equity ETFs that invest in the Hong Kong stock market.
In terms of product structure, all ETFs are structured as open-ended contract funds. Investors
could purchase creation units using a basket of equity and debt securities and/or cash,
investors could also redeem creation units for the redemption basket of securities. The
current range of ETF products serve as substitutes for basic index funds, which could be
understood by the general investor base. There are currently no synthetic, leveraged, inverse
and commodities ETFs and other ETVs and ETPs.
2. Applicable regulation
According to the Securities Investment Fund Law, all ETFs, whether it is equity, debt, cross
jurisdiction or commodities, require CSRC's approval prior to its offering. Apart from the
Securities Investment Fund Law, ETFs must follow regulations issued by the CSRC. ETF
investment, listing and operations must follow the Measures for the Administration of
Securities Investment Fund Operations. ETF distribution is governed by Measures for the
Administration of Securities Investment Fund Distribution. Currently, all ETFs are listed on
either the Shanghai or the Shenzhen stock exchanges. The exchanges have each issued its
own Securities Investment Fund Listing Rules to regulate the listing and exchange of ETFs.
HONG KONG
1. Main features of ETF structures
In Hong Kong, all exchange traded funds (ETFs) are collective investment schemes (CIS)
authorized by the Securities and Futures Commission (SFC) under section 104 of the
Securities and Futures Ordinance. ETFs that seek SFC authorization are required to comply
with the disclosure and structural requirements as set out in the SFC Handbook for Unit
Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted Structured
Investment Products (the Handbook), in particular, the Code on Unit Trusts and Mutual
Funds (i.e., Section II in the Handbook) (the Code). SFC-authorized ETFs are passively
managed and open-ended CIS, with an objective to track or replicate the performance of an
underlying index or benchmark. The index must have a clearly defined objective and be
broadly based, investible, transparent and published in an appropriate manner. Hong Kong
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has ETFs tracking different asset classes including equities, fixed income securities,
commodity futures as well as physical gold, silver and platinum, and ETFs focusing on
regional, single-country and sectoral indices.
SFC-authorized ETF must be listed on the Stock Exchange of Hong Kong Limited (the
SEHK). The structures adopted by SFC-authorized ETFs in Hong Kong are similar to those
found in US and EU. Hong Kongs ETFs broadly falls into two categories, physical ETFs
and synthetic ETFs. Physical ETFs track the index using full replication strategy and/or
representative sampling strategy , while synthetic ETFs use financial derivatives instruments
(such as funded swaps, unfunded swaps and/or performance-linked structured products) to
replicate index performance.
The operation of the primary market creation and redemption and secondary market trading
of ETF units is very similar to that in the US and Europe. In Hong Kong, creation and
redemption of ETF units in the primary market are usually conducted through participating
dealers (PD) in creation/redemption unit size. The function of PDs is similar to that of APs in
the US. PDs create or redeem ETF units in creation/redemption unit size in return for a
basket of securities and/or other assets. The basket generally reflects the contents of the ETF
portfolio and is equal in value to the aggregate NAV of the ETF units in the
creation/redemption unit size.
The creation/redemption unit size is typically much larger than the trading board lot size of
the ETF units on SEHK. Therefore, the capital investment required for primary market
creation and redemption is much higher. Investors (mostly retail investors), who do not have
the required capital investment, usually buy or sell ETF units in the secondary market via a
broker on the SEHK. ETF units on the SEHK are traded at market price, which may be
higher or lower than NAV of the units.
As most retail investors have to rely on the secondary market to exit their ETF investments,
secondary market liquidity is of paramount importance in the context of ETFs in Hong Kong.
SFC-authorized ETFs are expected to have at least one market maker to provide liquidity to
facilitate the trading of the ETF on the SEHK.
2. Applicable regulation
The SFC is the primary authority for regulating ETFs in Hong Kong and is responsible for
the authorization of ETFs and their offering documents. Hong Kong Exchanges and Clearing
Limiteds (HKEx) role in ETF regulation is primarily to ensure a fair and orderly market for
the trading of ETFs. Besides, HKEx also oversees the listing of SFC-authorized ETFs,
supervises the conduct of the listing process and monitors continuing compliance with the
Listing Rules, in each case in accordance with the applicable rules of the HKEx.
Generally, ETFs are subject to the same provisions as other unlisted open-ended CIS under
the Code, such as the requirement for an up-to-date offering document, ongoing disclosure
requirements, the requirements for a regulated manager and safekeeping of assets by
trustee/custodian.
SFC-authorized ETFs are also subject to the rules of the HKEx among others, those rules
relating to listing, trading, market making, and clearing and settlement. For example, in
conducting market-making activities, ETF market makers are subject to a set of market
making obligations, such as the maximum bid/ask spread and minimum quote size under the
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rules of the SEHK.

To mitigate counterparty risk, synthetic ETFs are subject to full collateralisation and prudent
haircut measures. In addition, collateral has to be sufficiently liquid and must not include any
structured products. It has to be marked to market daily, appropriately diversified and must
be held and readily accessible/enforceable by the trustee/custodian of the ETF. To further
enhance product transparency and better product differentiation, synthetic ETFs are subject to
specific name annotation requirements.
3. Other Exchange Traded Products
Apart from ETFs, other non-equity products traded on the SEHK in Hong Kong include fixed
income/debt instruments, derivative warrants, callable bull/bear contracts, and market access
products. The listing of these products is subject to the Listing Rules of SEHK. Futures and
options products are traded on Hong Kong Futures Exchange.
These other ETP products are generally unsecured debt securities and, unlike ETFs, are not
CIS. They are not subject to authorization by the SFC. In general, investors of these
products are subject to a direct exposure to the credit risks of the product issuers.
JAPAN
1. Main features of ETF structures
As with any listed security, investors may purchase and sell ETF shares continuously at
market prices. However, in fact retail investors cannot redeem their individual ETF shares.
Certain financial institutions (known as designated participants or DPs) purchase and redeem
ETF shares directly from the ETF, but only in large blocks called creation units.
Most often, a DP that is to purchase a creation unit of ETF shares, first deposits with the
management company (MC) of ETFs a purchase basket of certain securities, and then
receives the creation unit in return for those securities, which are managed as corpus by trust
banks. The basket is generally composed of portfolio whose value is designated to link to
specific indices and is equal in value to the aggregate NAV of the ETF shares in the creation
unit. After purchasing a creation unit, the DP may hold the ETF shares, or sell some or all of
the ETF shares in secondary market transactions. The redemption process is the reverse of
the purchase process. The DP acquires the number of ETF shares that comprise a creation
unit, and redeems the unit from the MC of ETFs in exchange for a redemption basket of
securities. An investor holding fewer ETF shares than the amount needed to constitute a
creation unit (e.g., most retail investors) may dispose of those ETF shares by selling them on
the secondary market. The investor receives market price for the ETF shares, which may be
higher or lower than the NAV of the shares, and pays customary brokerage commissions on
the sale. The ability of DPs to purchase and redeem creation units at each days NAV creates
arbitrage opportunities that may help keep the market price of ETF shares near the NAV per
share of the ETF.
2. Applicable regulation
In Japan, ETFs most commonly have a legal form of investment trusts which are regulated
under the Act on Investment Trusts and Investment Corporations. When a MC is to enter into
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an investment trust contract with a trust bank, the MC shall notify the JFSA of the basic terms
and conditions of the investment trust contract. The activities of a MC correspond to the
Investment Management Business and the activities of a DP correspond to the Type I
Financial Instruments Business (e.g., dealing in public offering of securities, etc.),
respectively, in the Financial Instrument and Exchange Act (FIEA) and they shall be
registered and regulated under the FIEA.
ETF shares are approved for listing and trading on a Financial Instruments Exchange licensed
under the FIEA. The exchanges promulgate and administer listing standards that govern the
securities that may be traded in its market. The rules of the exchanges, including listing
standards, are subject to examination on the application for license and the amendment of
them requires the authorization by JFSA. ETFs accordingly are subject to the listing
standards of the exchange on which their shares are listed and traded.
3. Other Exchange-Traded Products
ETNs are also traded in Japan, although they are currently eligible for listing only in the form
of depositary receipt (Japan Depositary Receipt, JDR). JDRs are the beneficiary certificates
of a beneficiary certificate-issuing trust issued in Japan as entrusted securities which are
foreign securities under the Trust Act. Their transaction volume is quite small in comparison
with that of ETFs.

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