The Final Report highlights IOSCO’s view that the exchange traded fund (“ETF”) structure has remained resilient in historical stress events. No major gaps, structural issues or regulatory issues relating to ETFs were identified by, or reported to, IOSCO as part of its recent review of ETF markets. The Final Report sets out measures for good practices in the areas of effective product structuring, disclosure, liquidity provisions and volatility control mechanisms and the intention is that the measures for good practices will expand on and supplement the Principles. These measures for good practices are directed at regulators, responsible entities such as UCITS management companies, and/or trading venues alike.

The measures for good practices set out in the Final Report are detailed in the below table, along with some further insight from the Final Report. We have also set out the relevant entities to whom the measures are directed.

Of particular interest is IOSCO’s view that there are merits to different approaches to portfolio transparency, which may result in the Central Bank of Ireland (the “Central Bank”) reviewing its current requirement for daily disclosure of portfolio holdings by Irish ETFs.

Furthermore, in light of the Central Bank’s recent findings relating to the charging of undue costs and fees and its recent focus on the single fee structure, which is typically employed by ETFs, IOSCO’s views relating to the disclosure of fees and expenses for ETFs may prompt renewed focus on the ETF fee structure by the Central Bank.  

MeasureIOSCO CommentApplicability
Effective Product Structuring
1Range of Assets / Strategies for ETF Offering  

Consider the range of asset classes and investment strategies that may be appropriate for the ETF structure, taking into account their nature, novelty, and complexity, the effectiveness of the arbitrage mechanism for such assets and strategies.  
Given the unique features of ETFs, including the arbitrage mechanism and secondary market trading and the trend towards more complex strategies and novel asset classes in the ETF space, consideration should be given to whether an asset class or strategy is appropriate for an ETF offering.Regulators and responsible entities (such as UCITS management companies)  
2Various Means of Facilitating an Effective Arbitrage Mechanism

Consider requirements regarding the transparency of an ETF’s portfolio and/or other appropriate information provided to market participants so as to facilitate effective arbitrage.  
The provision of portfolio information, particularly full daily portfolio transparency, is generally associated with facilitating an efficient arbitrage mechanism. However, IOSCO has observed that different jurisdictions require a combination of portfolio information disclosure, all of which recognise the need to provide sufficient information to value an ETF in a timely and accurate manner and to determine whether arbitrage opportunities exist.  Regulators

For jurisdictions that mandate the provision of indicative net asset value (“iNAV”), consider means to enhance the accuracy and usefulness of iNAV.
Jurisdictions have differing experiences with respect to the usefulness of iNAV, with some noting benefits for retail investors and for facilitating secondary market trading in the absence of daily portfolio transparency and others noting quality issues with accuracy and reliability. IOSCO highlights the lack of consistency in terms of requirements of iNAV disclosure standards or calculation methodology and so encourages a review of the merits and limitations of iNAV and whether and how it can be used to support investors.  Regulators and trading venues
4Selection and Ongoing Monitoring of APs/MMs

·       Conduct due diligence on Authorised Participants (“APs”) and Market Makers (“MMs”) when onboarding them to the ETF, with a view to having those that are capable of facilitating an effective arbitrage mechanism and providing liquidity;

·       Conduct ongoing monitoring on APs and MMs for the ETF regarding, amongst others, the functioning of the arbitrage mechanism and liquidity provision; and

·       Avoid exclusive arrangements with APs and MMs if they may unduly affect the effectiveness of the arbitrage mechanism.
The effectiveness of the arbitrage mechanism and liquidity is largely dependent on the active/robust participation of APs and MMs. IOSCO notes that ETF managers typically have detailed practices for onboarding APs/MMs and policies for monitoring them, including dedicated oversight teams. IOSCO advises that due diligence on APs and MMs is conducted when onboarding them and that there is a process for ongoing monitoring. IOSCO provides examples of considerations and assessments that may be used in the due diligence and ongoing monitoring process.  

In terms of exclusive arrangements, IOSCO notes that there is a strong incentive for the engagement of multiple APs and MMs in ETFs due to open and effective competition between them contributing to efficient arbitrage and an active secondary market. However, IOSCO notes that in some jurisdictions, AP agreements have anti-competitive and/or exclusivity clauses and that such arrangements should be avoided if they affect effective arbitrage.
Responsible entities (such as UCITS management companies)
5Appropriate Arrangements for Facilitating Arbitrage  

Put in place appropriate arrangements to facilitate an effective arbitrage mechanism, including contingency plans to address the circumstances where the arbitrage mechanism of the ETF is impaired.  
As noted above, the effectiveness of the arbitrage mechanism and liquidity is largely dependent on the proper functioning of APs and so it is important to consider, at product structuring phase, the implementation of appropriate arrangements to support APs that seek to engage in arbitrage. IOSCO provides examples of such arrangements, such as primary market arrangements (having multiple APs, open AP architecture, widening the availability of APs, smaller creation/redemption basket sizes), additional disclosure of portfolio information, diversifying ETF key service providers to mitigate operational risks, etc.  Responsible entities (such as UCITS management companies)
6Conflicts Management

Consider whether the securities laws and applicable rules of securities exchanges appropriately address potential conflicts of interest raised by ETFs.  
ETFs may be subject to certain additional conflicts specifically related to their structure, for example, those arising from affiliation with APs, MMs, index providers and/or counterparties. IOSCO notes that while most jurisdictions rely on broader collective investment scheme (“CIS”) regulations and guidance to address these concerns, others have requirements specific to ETFs which are encouraged to be considered.  Regulators
7For ETFs, in particular those that invest in more complex or novel asset classes, or use more complex investment strategies, consider appropriate requirements for the adequacy and appropriateness of the disclosures regarding ETF-specific aspects, including whether certain disclosures are presented in an understandable manner and whether they address the nature of risks associated with the ETFs’ strategies.  IOSCO suggests that it is useful to provide disclosure in addition to what is otherwise required by the CIS regulations to help investors fully understand the particular features and risks arising from these distinctive features of ETFs, specifically relating to: (i) arbitrage and secondary market trading; and (ii) complex investment strategies or the investment in novel asset classes.Regulators
8Consider appropriate requirements for the disclosures of fees and expenses for investing in an ETF (including secondary market trading costs) 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.  The disclosure of fees and expenses should provide sufficient transparency to allow the investor to make an informed judgement of the investment. IOSCO suggests that in addition to existing requirements for the disclosure of fees and expenses, more detailed disclosure on trading costs in secondary markets and other types of fees (such as brokerage commissions), could be considered.  Regulators
9Differentiating ETFs from Other ETPs and CIS

Consider appropriate disclosure requirements or disclosures to help investors clearly differentiate ETFs from other exchange-traded products / collective investment schemes, as well as appropriate disclosure for index-based and non-index-based ETFs.  
Under the UCITS rules there is already a clear identifier for UCITS ETFs and so the disclosure requirements identified by IOSCO in the Final Report are not directly relevant in the EU. IOSCO notes that additional investor outreach and education to help provide greater clarity for investors should be considered.  Regulators and responsible entities (such as UCITS management companies)
Liquidity Provisions
10Monitor secondary market trading and market making activities of ETFs and have rules governing the orderly trading of ETF shares.  As noted above, MMs are generally considered to be important to facilitating an effective arbitrage mechanism and to an ETF’s liquidity and so, in certain jurisdictions, the secondary market liquidity of certain ETFs may heavily depend on MMs fulfilling their functions. IOSCO encourages the regular monitoring of MMs’ compliance with market making obligations and the secondary market trading of ETFs and the imposition of specific rules governing the orderly trading of ETF shares.  Regulators and trading venues
Volatility Control Mechanisms
11Appropriately calibrate volatility control mechanisms (“VCM”) applicable to ETFs, considering factors including their liquidity profile and volatility profile. Where an ETF is listed or traded on a number of trading venues, those trading venues are encouraged to consider communicating with one another as appropriate when VCMs are triggered.  There is a wide variety of VCMs, and the VCMs imposed by jurisdictions and trading venues vary, depending on the market structures in which ETFs operate. The evaluation as to whether the existing VCMs applicable to ETFs are appropriately calibrated, and a review of the merits of different approaches to enhance  existing approaches should be considered and encouraged.  Regulators and trading venues

If you would like to discuss these measures or IOSCO’s views described above, please contact your usual Arthur Cox contact.