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E-MailHenry T. C. Hu is the Allan Shivers Chair in the Law of Banking and Finance at the University of Texas Law School and John D. Morley is Professor of Law at Yale Law School of Law. This post is based on their recent article, forthcoming in Southern California Law Review.
Exchange-traded funds (“ETFs”) are among the most important financial innovations of the modern era. ETFs offer individual and institutional investors alike a unique investment opportunity. Throughout the trading day, the ETF can be viewed as providing a nearly “frictionless,” often low-cost portal to and from a bewildering universe of plain vanilla and arcane asset classes, passive and active investment strategies, and long, short, and leveraged exposures. But ETFs also entail distinctive risks, flowing in part from their reliance on a unique market microstructure for its shares, the central feature of which is a device we refer to as the “arbitrage mechanism.” This device has sometimes failed dramatically in times of market stress, even among the most plain vanilla ETFs. Certain ETFs may present complex risks not only to their shareholders but to the asset markets that the ETFs invest in. Despite the importance of ETFs and the distinctive risks they pose, the United States does not have a dedicated system of ETF regulation or even a workable, comprehensive conception of what an ETF is. This Article addresses the problem by assessing the SEC’s recent effort in this area in light of the recommendations we provided in prior research.
In March 2018, we offered the first academic work to show the need for, or to present, a comprehensive regulatory framework for all ETFs. On June 28, 2018, just prior to that article’s scheduled publication, the SEC issued a proposal to change the way it regulates certain types of ETFs. On May 20, 2019, the SEC issued its “Precidian” exemptive order, allowing for the first time “non-transparent” actively managed ETFs—an order that we believe has surprising, hitherto unexplored implications for ETF regulation.
This new Article thus considers the SEC proposal and the Precidian order in the context of our earlier article’s proposed regulatory framework, and also refines that framework. We provide additional rationales for the framework, relying in part on new empirical findings.
The SEC’s proposal does not seek to provide a comprehensive regulatory framework for all ETFs. However, the proposal is a commendable start to addressing some of the problems in the current ad hoc approach to ETF regulation, especially as to the substantive side of ETF regulation.
With respect to the substantive side of ETF regulation, the SEC proposes a more rules-based approach and, in doing so, helps deal with the central problem—the reliance on individualized exemptive letters. The reliance has resulted in a process of review that can be opaque, unfocused, and cumbersome, and often had the effect of allowing older ETF sponsors to operate under lighter regulation than newer sponsors. The introduction of innovative ETFs is not evaluated according to clear principles of general applicability.
However, the partial shift to a rules-based approach being contemplated only applies to certain ETFs that are organized under the Investment Company Act of 1940 and also leaves in place an anomalous set of individualized exemptions for several specific Investment Company ETFs, including those offering leveraged and inverse exposures. More broadly, the proposal does not address problems of SEC discretion pertaining to the underlying process of financial innovation in ETFs. The proposed rule also neglects to address the frequent need for individualized exemptions with respect to stock exchange listing requirements.
With respect to the disclosure side of ETF regulation, the SEC proposal again only covers Investment Company ETFs, but is even more incremental in nature. On the disclosure side, the central problem has been the material neglect of the ETF’s distinctive characteristics and the underlying process of innovation. Most importantly, rooted in a disclosure system largely designed for mutual funds—a product whose shares do not trade—the SEC’s disclosure mandates for ETFs fail to comprehend the significance and complexities of what we called “trading price frictions,” including frictions related to the arbitrage mechanism and bid-ask spread.
The SEC contemplates modest enhancements of disclosures related to trading price frictions. And, going the other direction, the SEC contemplates eliminating the primary source of information for retail investors on intraday values of ETF shares.
We welcome the SEC’s invitation for views on more fundamental disclosure reforms. We offer a refined version of the comprehensive disclosure approach advanced in our first article, and provide fresh rationales for such an approach, based in part on new empirical findings. This approach would apply to all ETFs and would be cognizant of the distinctive characteristics of ETFs and the subtle complexities introduced by the underlying innovation process. We propose a disclosure regime consisting of three core components. First, we urge the SEC to promulgate a “disclosure building block” consisting of two elements: (1) a comprehensive and “dynamic” definition of “ETF” rooted in the distinctive functional characteristics of exchange-traded funds (per criteria specified from time to time by the SEC); and (2) a requirement that all products encompassed by this nomenclature self-identify as an “ETF” in their names. These ETF classification and self-identification issues turn out to be surprisingly subtle and important, and we rely in part on the facts of Precidian to illustrate this. Second, we urge enhanced disclosures of a quantitative nature relating to trading price frictions, including certain intraday deviations from net asset value and bid-ask spreads. In particular, requiring only disclosure of at-the-close deviations from net asset value can lead to investor complacency. Third, we urge requiring periodic disclosures of a qualitative nature centered on the arbitrage mechanism, covering, as examples: (1) certain matters as to the “Authorized Participants” central to the mechanism’s functioning; and (2) consideration, as appropriate, of the impact of the liquidity of the assets in which the ETF is invested. Such arbitrage mechanism-centered qualitative disclosures would be in the style of the Management’s Discussion and Analysis found in periodic reports filed by ordinary public companies. Collectively, such new nomenclature/self-identification requirements and such enhanced qualitative and quantitative disclosures could help individual and institutional investors alike.
The SEC proposal is a material step forward. It is a commendable start to addressing some of the most important contemporary issues in America’s capital markets.
The forthcoming 2019 article is available for download here and the published 2018 article is available for download here.
