SEC proposes rules for Exchange Traded Funds

6 July 2018

The SEC has unveiled a proposal which would lower the barriers to entry for the ETF market and make the process for approval more robust.

A ‘focus on the main street investor’ was cited as one of the SEC’s five core principles in the Division of Enforcement’s 2017 Annual Report. The Exchange Traded Fund market in the US is currently valued at $3.5 trillion with over 1900 available investment products, representing nearly 15% of total investment company assets. Because ETFs are part of millions of Americans’ savings and retirement plans, the SEC sees them as ‘too important to regulate through a patchwork of individual determinations’. The regulator’s view is that they should be under ‘rules-based framework that continues to provide the oversight and protections investors expect’.

In an effort to stay true to their core principles, boost competition and innovation across the market for ETFs, the SEC’s proposal would lower the barriers to entry for the ETF market and make the process for approval more robust. The SEC attempted to address the issue prior to the global financial crisis in 2008 but, for obvious reasons, turned their attention elsewhere. As part of the new proposal, the SEC also announced they would allow issuers to launch low-risk ETFs without requiring approval in advance, and allow them to operate as 40 Act funds.

The proposed change would set new disclosure standards on ETFs. ETFs operating as 40 Act funds would need to provide daily portfolio transparency on their websites and disclose historical information related to premiums, discounts and bid-ask separation. Under the new proposal, ETFs would also be allowed to use a ‘custom basket’ of holdings when creating or redeeming shares rather than a ‘pro-rata representation’ of the portfolio. Firms are only allowed to do this if they enforce policies and procedures that detail the parameters they use for custom baskets to show they are in the best interest of the ETF and its shareholders. These policies and procedures would need to be designed to prevent authorized participants that are central to the trading of ETFs from dumping or cherry-picking assets they deliver to ETF issuers.

More complex ETFs, such as those for thinly-traded market sectors, inverse and leveraged products are out of scope, as are unit investment trusts or a share class of a multi-class fund.

There is a 60-day comment period for the new rule, which will begin when the proposal is published in the Federal Register. After the comment period ends, the SEC and its commissioners will mark up and amend the proposal before a final vote.

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