IOSCO publishes Good Practices for implementing its ETF Principles

On 11 May 2023, ISOCO published a Final Report, Good Practices Relating to the Implementation of the IOSCO Principles for Exchange Traded Funds (the Report).

The Report contains a set of eleven good practices, together with examples of how to implement IOSCO’s ETF Principles (the Principles) and other relevant standards and guidance.

Although the good practices are not formal IOSCO standards or recommendations, IOSCO encourages regulators, firms and trading venues to review and adopt them.

The good practices included in the Report fall under four headings:
• Effective Product Structuring
• Disclosure
• Liquidity Provision and
• Volatility Control Mechanisms.

The eleven measures which the Report contains are set out in full below.

What’s the background to the Report?

In June 2013, IOSCO published its Principles for the Regulation of Exchange Traded Funds, which cover a wide range of topics, including
• classification
• portfolio transparency
• costs
• strategies
• conflicts of interest and
• managing counterparty risks.

IOSCO’s review of the Principles

Noting the evolution and growth of the global ETF industry and markets since publication of the Principles, which has included new products exposed to less liquid and more novel asset classes as well as more complex investment strategies, IOSCO established a dedicated ETF workstream with a mandate to
• review a broad range of issues and new developments relating to ETFs and
• identify any gaps in the ETF Principles.

This work has included, among other things, surveying regulators and industry, engaging with industry stakeholders and academics, considering lessons learned from major market events affecting ETFs (such as the COVID-19-related market volatility in March and April 2020) and engaging with the Financial Stability Board (FSB).

As a result of the work undertaken, IOSCO has concluded that the Principles remain relevant and appropriate and that no major gaps have been identified in them.

IOSCO has, though, noted jurisdictional differences in how ETFs operate, how they are regulated and the markets in which they trade.

As a result, it has concluded that the Principles should be supported by a set of good practices, providing examples of how a jurisdiction could implement the Principles and highlighting issues for regulators, firms and/or trading venues to consider as to how they (and other relevant IOSCO standards and guidance) can be put into practice.

IOSCO’s Good Practices to support its ETF Principles

1. Effective Product Structuring

Relevant Principles: 4, 7, 8 and 9

Measure 1 - Regulators and responsible entities are encouraged to 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.
Measure 2 - Regulators are encouraged to 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.
Measure 3 - For jurisdictions that mandate the provision of iNAV, regulators and/or trading venues are encouraged to consider means to enhance the accuracy and usefulness of iNAV.
Measure 4 - Responsible entities are encouraged to:
(i) conduct due diligence on APs and MMs when onboarding them to the ETF, with a view towards having those that are capable of facilitating an effective arbitrage mechanism and providing liquidity
(ii) conduct ongoing monitoring on APs and MMs for the ETF regarding, amongst others, the functioning of the arbitrage mechanism and liquidity provision and
(iii) avoid exclusive arrangements with APs and MMs if they may unduly affect the effectiveness of the arbitrage mechanism.
Measure 5 - Responsible entities are encouraged to 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.
Measure 6 - Regulators are encouraged to consider whether the securities laws and applicable rules of securities exchanges within their remit and jurisdictions appropriately address potential conflicts of interests raised by ETFs.

2. Disclosure

Relevant Principles: 1, 2, 5, 6 and 7

Measure 7 - For ETFs, in particular those that invest in more complex or novel asset classes, or use more complex investment strategies, regulators are encouraged to 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.

Measure 8 - Regulators are encouraged to consider appropriate requirements for the disclosures of fees and expenses for investing in ETFs (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.

Measure 9 - Regulators and responsible entities are encouraged to consider appropriate disclosure requirements or disclosures to help investors to clearly differentiate ETFs from other ETPs / CIS, as well as appropriate disclosure for index-based and non-index-based ETFs.

3. Liquidity Provision

Relevant Principle: 9

Measure 10 - Regulators and/or trading venues, where applicable, are encouraged to monitor secondary market trading and market making activities of ETFs and have rules governing the orderly trading of ETF shares.

4. Volatility Control Mechanisms

Relevant Principles: 2 and 8

Measure 11 - Regulators and/or trading venues, where applicable, are encouraged to appropriately calibrate volatility control mechanisms 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.

What else does the Report contain?

In addition to the good practices themselves (which can be found in Section IV of the Report) and the examples of how to implement the Principles, set out in Appendices 3 to 6), the Report provides an overview of ETFs and a discussion of the major themes and recent developments in ETF markets which were explored in the course of IOSCO’s review.

(a) IOSCO’s product overview of ETFs

Section III of the Report provides a useful overview of ETFs and identifies a number of key differences between ETFs and unlisted open ended funds (OEFs), including
• the availability of intraday liquidity in the secondary market
• the Authorized Participant (AP) mechanism in the ETF primary market and
• the associated arbitrage mechanism.

The Report finds that

• an ETF is a product with distinct product characteristics, market structures and uses by investors compared to unlisted OEFs and other ETPs - investors can buy and hold shares of ETFs (as with unlisted OEF shares) or trade ETFs frequently as part of an active trading or hedging strategy.
• ETFs and their trading activities are subject to robust collective investment scheme regulatory frameworks applicable in different jurisdictions, along with additional regulatory requirements because of their unique characteristics and rules governing their secondary market trading
• differences in local ETF market structure may include (a) how relationships with Authorized Participants are structured, (b) the principal types of investors investing in ETFs, (c), the size, liquidity and structure of the markets in which ETF shares and underlying assets trade and (d) other factors that can contribute to the effectiveness of the arbitrage mechanism.
• while regulatory frameworks to which ETFs are subject in different jurisdictions typically have similar investor protection, market integrity and financial stability objectives, different jurisdictions can address concerns connected with ETFs in varying ways to achieve these objectives.

In addition to its ETF Principles, IOSCO points to its
• final recommendations (February 2018) to improve liquidity risk management practices of OEFs, including ETFs and
• recommendations (August 2018) to help trading venues manage extreme volatility and preserve orderly trading in secondary markets, including secondary trading in ETF shares.

(b) major themes and recent developments in ETF markets explored as part of IOSCO’s review

• ETF liquidity and the impact that ETFs might have on underlying markets have been the subject of extensive consideration by regulators and international bodies
• IOSCO concludes that overall, the ETF structure has remained relatively resilient, including in times of stress
• IOSCO and FSB exploratory work did not show ETFs negatively impact underlying markets or that they would significantly contribute to a liquidity shock or crisis
• observers generally noted that ETFs have structural features and tools to mitigate potential liquidity risks and that the ETF structure itself can provide an additional layer of liquidity
• others have noted the relative liquidity of ETFs when compared to underlying markets and that ETFs can provide an additional source of pricing information for the underlying portfolio assets.
• at the same time, though,
• some fixed income ETFs have shown more significant or more persistent discounts and spreads during times of stress (this was particularly so during the market volatility caused by COVID-19)
• some derivative-based ETFs with what the Report refers to as ‘more distinct features’ (such as investing in less diversified assets and/or adopting a leveraged/inverse strategy) also experienced more significant volatility and operational challenges during times of stress.