BY BIBB STRENCH
January 17, 2018
Ten years after it tried to adopt an ETF rule, the SEC has once again announced that it will propose a rule allowing a firm to enter the ETF business without first obtaining an exemptive order. Perhaps more importantly, the new ETF rule will level the regulatory playing field for all ETF sponsors. While all of the ETF sponsors will be playing on the same field, it will be vitally important for the industry to provide the SEC with input through comment letters, meetings with its staff and other means so that level playing field has as few regulatory puddles and loose turf as possible. The SEC staff likely will look first to those exemptive orders when drafting the rule, which contain a number of granular restrictions and conditions that should be jettisoned to produce a more flexible rule that still protects ETF investors. The ETF industry also can urge the SEC to adopt a rule that clarifies what types of exchange-traded vehicles can call themselves “ETFs.”
“Plain Vanilla” ETF Rule
The Trump administration through the U.S. Department of Treasury’s Asset Management and Insurance Report released in October 2017 kick-started the ETF rule proposal. In the Report, Treasury recommended that the SEC implement regulations to standardize and simplify the approval process for ETFs by removing the need to obtain individualized exemptive relief from the SEC for “plain vanilla” ETFs. “Vanilla” was not defined. It is certain that it does not include non-transparent, actively managed ETFs and 3X leveraged ETFs. But there appears to be no compelling reasons for the SEC to exclude most of the other types of ETFs. It will be imperative for the ETF industry to voice the view that vanilla should be as broad as a flavor as possible to capture much of the current ETF spectrum, including ETFs that invest in derivatives. In other words, spare as many ETFs as possible from the lengthy exemptive application process.
Grading the Regulatory ETF Playing Field
Besides dismantling the cumbersome gauntlet that new ETF providers must navigate through, Treasury in its report stated that a rule in lieu of exemptive orders should “help reduce uneven treatment between ETFs.” The ETF regulatory field currently is not level: those ETFs complexes that received exemptive orders in the 1990s and 2000s are subject to less strenuous conditions and representations than ETF complexes that recently entered the business. For example, with respect to redemptions, an ETF with an SEC order in 2009 may redeem a basket of securities that generally resembles the basket of securities posted by the ETF for that trading day; while an ETF that received an SEC order in 2017 must redeem the identical basket in terms of names and quantities unless it can avail itself to one of the narrow exceptions in current orders. With respect to creations, an ETF relying on an older order when confronted with a difficult-to-find security for a creation is permitted to use a similar security but is not required to use the same security.
Simple Rules Are Superior to Complex Rules
ETF exemptive orders over the years have become longer and unnecessarily more granular. The ETF industry should recommend that the SEC’s Division of Investment Management use its rulemaking authority to stop this regulatory creep and return to the ETF regulatory regime of the early 1990s. The SEC can adopt a rule with general conditions in lieu of a laundry list of conditions that simultaneously protects investors without impairing the flexibility of the ETF product. Because the process to change rules once adopted is cumbersome, the SEC should adopt a rule that focuses more on exempting an ETF from the requisite provisions of the Investment Company Act of 1940 and less on regulating the day-to-day operations on an ETF. The latter can be adequately addressed through disclosure and reporting rules, SEC inspections and the ETF stock exchange rules and applications that the SEC’s Division of Trading and Markets administer.
Are ETFs a subset of ETPs (exchange-traded products) or vice versa? What about ETVs (exchange-trade vehicles) and ETNs (exchange-traded notes)? Some are regulated by the Investment Company Act of 1940 and Securities Act of 1933, some just by the Securities Act of 1933, some by the Commodity Exchange Act, and some by a combination of all of these Acts. Most are entities but some are not. The SEC in the past have adopted rules governing what an investment company can call itself (e.g., a fund may only call itself a “money market fund” if it meets the conditions of Rule 2a-7 under the Investment Company Act). By taking a similar approach in the proposed ETF rule, the SEC could minimize investor confusion. The larger 1940 Act regulated ETF industry also would sleep better at night without worrying about the fallout from the crashing of a non-1940 Act regulated, highly speculative crypto-currency fund that calls itself an ETF.
To Do List
The SEC Division of Investment Management’s 2018 To Do List includes drafting an ETF rule, publishing it in a Federal Register notice that invites public comment and convincing three out of the soon to be five SEC Commissioners to adopt it. Since there is talk that the rule is on the regulatory “fast-track,” it is time now for the ETF industry to put at the top of its 2018 To List conveying to the SEC its views on what should and should not be included in the ETF rule. That message should be: (1) vanilla includes all but the few exotic flavors; (2) a plain English and concise ETF rule will lead to greater regulatory efficiencies and industry flexibility; and (3) a uniform definition of what is an ETF will be highly beneficial to the SEC, industry and investors alike.