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ETF regulation enters a new era

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As the ETF industry has evolved, so has the regulatory framework that underpins it. In this blog, Jane Heinrichs, associate general counsel, ICI explores a new era of regulation.

2019 will be remembered as a landmark year for the US ETF industry, with the arrival of the long-awaited modernization of the regulatory framework for ETFs. In September 2019, the Securities and Exchange Commission (SEC) finalized a rule giving ETFs their own set of regulations—no longer forcing ETFs into the regulatory framework established in 1940 for mutual funds. This new era of ETF regulation will level the playing field for ETF providers and ease many of the burdens associated with bringing an ETF to market.

Here’s a recap of what you need to know about the SEC’s new ETF rule, the streamlining of exchange listing rules, and approvals for the industry’s first non- or semi-transparent actively managed ETFs.

Streamlined approval

Prior to the adoption of the ETF Rule (Rule 6c-11 under the Investment Company Act of 1940), ETFs had to obtain exemptive relief from the SEC—because ETFs cannot comply strictly with the 1940 Act and are different from mutual funds in myriad ways—to operate. The ETF Rule instead enables ETFs that satisfy certain conditions to organize and operate without the expense and delay of obtaining exemptive relief from the Commission.

Not all types of ETFs—including ETFs organized as unit investment trusts, share class ETFs, leveraged and inverse ETFs, and non-transparent actively managed ETFs—are covered by the rule. But for most ETFs, the new rule will replace the existing patchwork of exemptive orders with a uniform set of conditions. ETFs have until December 2020 to comply with the new rule.

At the same time that it adopted the new rule, the SEC also issued an exemptive order that further harmonizes related relief that is necessary for ETFs and authorized participants to operate and interact with each other.

Custom baskets

Among the crucial, specific changes: the rule permits an ETF relying on the rule to use custom creation and redemption baskets (that is, non-pro rata baskets and/or baskets that differ from other transaction baskets on the same business day), a practice not uniformly permitted under the previous regime of exemptive orders.

"The ETF Rule enables ETFs that satisfy certain conditions to organize and operate without the expense and delay of obtaining exemptive relief from the Commission."

This practice benefits investors by helping the ETF meet its investment objective more efficiently, improving its tradability, and therefore allowing its investors to enjoy lower costs.

New disclosure requirements

In addition to daily portfolio disclosure (required by most current exemptive orders), the rule’s disclosure requirements will provide investors who purchase and sell ETF shares on the secondary market with historical information regarding the ETF’s premium and discounts and bid-ask spreads.

Important change at the exchanges

In response to the SEC’s actions, it appears the three ETF exchanges are working to streamline their operations as well. They have proposed new rules to establish “generic” listing standards for ETFs that are permitted to operate in reliance on the ETF Rule.

If adopted, these rules would harmonize exchange listing standards for all ETFs, even if they were previously listed under different requirements—such as provisions relating to minimum market value, minimum trading volume, minimum diversification, and the minimum number of index components.

This change would further untangle the web of regulations and delays that discourage ETF launches. Currently, ETFs must comply with the initial—and continued—listing requirements of the exchange where it will list its shares.

But, if a new ETF cannot meet an exchange’s preapproved generic listing or continued listing standards, then a process begins through the SEC’s Division of Trading and Markets. This process can delay the launch of new ETFs by more than a year, is frustrating to would-be providers, and deprives investors of new investment opportunities. Uniform listing standards for all ETFs that comply with Rule 6c-11 would greatly help accomplish the SEC’s goal to streamline the ETF market-entry process.

Non-transparent products have arrived

In 2019, the SEC also approved the first non- or semi-transparent actively managed ETFs. These types of ETFs will not be required to disclose portfolio holdings daily, but rather will make the same quarterly disclosure as mutual funds.

Despite the potential cost, tax, and trading benefits of ETFs, daily disclosure and an accompanying fear of potential front-running by other traders have been enough to keep many of the largest fund companies from using the traditional transparent ETF wrapper for their actively managed products. The SEC’s willingness to permit different styles and types of ETFs in the marketplace should foster greater innovation and competition, leading to more choices for investors.

Big changes, big impact

Some of the reforms mentioned above are still playing out, but this is clearly a watershed time that will significantly benefit the growing ETF industry and their investors. I look forward to talking more at Inside ETFs about the rule changes!

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