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Senate Subcommittee Holds ETF Hearing

Thursday, October 27, 2011

Alex Kreonidis | Bloomberg Law Senate Subcommittee on Securities, Insurance, and Investment, Market Microstructure: Examination of Exchange-traded Funds (ETFs) (Oct. 19, 2011) The Subcommittee on Securities, Insurance, and Investment of the Senate Committee on Banking, Housing, and Urban Affairs held a hearing that sought to address whether market regulators are dealing effectively with the growth and risks of ETFs. Witnesses testifying at the hearing included (1) Eileen Rominger, Director of the Division of Investment Management, Securities and Exchange Commission (SEC); (2) Eric Noll, Executive Vice President and Head of Transaction Services, Nasdaq OMX (Nasdaq); (3) Noel Archard, Managing Director and Head of U.S. iShares Product, BlackRock, Inc. (BlackRock); and (4) Harold Bradley, Chief Investment Officer, Ewing Marion Kauffman Foundation (Kauffman Foundation). Rominger provided a useful overview of ETFs and recent SEC developments. Archard raised an interesting proposal for SEC consideration that would impose a new classification system on ETFs and other exchange-traded products (ETPs). Notably, Archard and Noll also addressed ETFs in the context of market volatility, while Bradley presented contrasting views on the risks that ETFs pose to small cap issuers and the market as a whole.

ETFs and Other ETPs Generally

In her prepared testimony, SEC Director Eileen Rominger noted that ETPs seek to provide investors exposure to a specific benchmark or investment strategy by investing in securities and other assets. The most popular ETPs are ETFs, which typically are registered as investment companies under the Investment Company Act of 1940 (Investment Company Act) and rely on exemptive orders that give relief from certain provisions of the Investment Company Act and the Securities Exchange Act of 1934. ETPs also can be structured as interests in trusts and other pooled vehicles, such as commodity pools, or as exchange-traded notes issued by bank holding companies or investment banks.

ETF Structure

ETF investors purchase an undivided interest in a pool of securities and other assets held by the ETF. As Rominger explained, ETFs combine features of an open-end fund (i.e., mutual fund), which allow fund shares to be purchased or redeemed at their net asset value (NAV) as of the end of each trading day, with the intra-day trading feature of a closed-end fund, which permits fund shares to be traded throughout the trading day at market prices that may differ from the fund's NAV. However, a key difference between ETFs and mutual funds is that ETFs do not sell or redeem individual fund shares directly to or from all investors. Rather, ETF sponsors enter into relationships with financial institutions, typically large broker-dealers (Authorized Participants), that permit them to purchase and redeem large blocks of shares (Creation Units) directly from an ETF. Creation Unit purchases and redemptions are typically in-kind, Rominger explained. To receive ETF shares from a fund, an Authorized Participant assembles and deposits a designated basket of stocks with the fund in exchange for the ETF shares. After receiving the ETF shares, the Authorized Participant can sell them to individual investors, institutions, or ETF market makers in the secondary market. To redeem ETF shares, the Authorized Participant buys a large block of ETF shares on the open market and delivers them to the fund, receiving in exchange a pre-defined basket of individual securities, or the cash equivalent. According to Rominger, ETFs are structured so as to create arbitrage opportunities that minimize the potential for ETF shares to trade in the secondary market at a significant premium or discount to their intraday NAV. Rominger illustrated the arbitrage mechanism as follows:
For example, with respect to a simple U.S. equity index-based ETF, if the price of the underlying stocks comprising the index is below the price of the ETF shares, a market maker who is an Authorized Participant can buy the underlying stocks and short the ETF. Then, at the end of the day, the Authorized Participant can buy shares of the ETF in-kind through the creation process using the underlying stocks purchased earlier in the day. In return, the Authorized Participant receives shares of the ETF that can be delivered against the short ETF position.

Leveraged, Inverse, and Inverse Leveraged ETFs

Leveraged, inverse, and inverse leveraged ETFs are a small subset of the ETF market, and recently have been the focus of regulatory scrutiny. Rominger explained that leveraged ETFs pursue a long strategy, seeking to deliver returns that are multiples of the performance of the index or benchmark they track. Inverse ETFs and inverse leveraged ETFs, on the other hand, pursue a short strategy, seeking to deliver the opposite, or a multiple of the opposite of the performance of the index or benchmark being tracked. According to Rominger, "[w]hile the portfolio composition for long leveraged ETFs generally includes a mix of stock or other assets, as applicable, including total return swaps, cash, and futures contracts, inverse leveraged ETFs' portfolios are generally composed entirely of total return swaps, futures, and cash or cash equivalent securities."

Recent Regulatory Guidance and Initiatives

The SEC and the Financial Industry Regulatory Authority have issued guidance on the risks of holding leveraged, inverse, and inverse leveraged ETFs for a period lasting longer than a day. See Bloomberg Law Reports®—Securities Law, SEC Staff and FINRA Issue Investor Alert on Leveraged and Inverse ETFs (Aug. 20, 2009). Most of these ETFs, Rominger noted, are designed to achieve their investment objectives on a daily basis. Their performance over longer periods of time can differ significantly from the performance (or inverse of the performance) of the underlying index or benchmark being tracked during that longer period. In March 2010, the SEC staff also announced that it was deferring consideration of exemptive requests for new ETFs making significant investments in derivatives. See Bloomberg Law Reports®—Securities Law, SEC Evaluating the Use of Derivatives by Investment Companies; Certain ETF Exemptive Applications Are Being Deferred (Mar. 29, 2010). Rominger explained that this has affected directly the launch of leveraged and inverse leveraged ETFs seeking to register under the Investment Company Act given that that they often make significant investments in derivatives. The deferral is intended to give staff additional time to reevaluate SEC regulatory protections in light of the increasing complexity of derivatives and their growing use by funds. Moreover, in August 2011, the SEC issued a concept release seeking public comment on the use of derivatives by ETFs and all other funds regulated under the Investment Company Act. See Bloomberg Law Reports®—Securities Law, SEC Seeks Public Comment on Funds' Use of Derivatives (Sept. 8, 2011). Pending completion of this broader review, Rominger said that the SEC staff has determined not to issue any additional exemptive relief for ETFs seeking to make significant use of derivatives. Lastly, Rominger noted that staff "is currently engaged in a general review of ETPs in connection with, among others, the adequacy of investor disclosure, liquidity levels and transparency of underlying instruments in which ETPs invest, fair valuations, efficiency in the arbitrage process and the relationship between market volatility and ETPs."

BlackRock's Proposed Classification System

To enhance transparency and investor protection, BlackRock's Noel Archard called for a standard classification system with clear labels to clarify the differences among ETPs. As proposed, "exchange traded product" or "ETP" would be catch-all terms used to describe any portfolio exposure product that trades on an exchange. "Exchange traded fund" or "ETF," on the other hand, would refer only to a fund that is regulated as a publicly offered investment fund (e.g., registered under the Investment Company Act) and that can be appropriate for long-term retail investors. Leveraged, inverse, and inverse leveraged ETFs would not be able to use the "ETF" label. Other classifications would include (1) "exchange traded note" or "ETN;" (2) "exchange traded commodity" or "ETC;" and (3) "exchange traded instrument" or "ETI," for any other portfolio exposure product traded on an exchange. When asked to comment on BlackRock's classification proposal during the hearing, Rominger said that it "deserves serious consideration." Among other recommendations, Archard also called for the SEC to adopt an ETF rule, using as its foundation the ETF rule proposed by the SEC in 2008. Archard noted that the current ETF exemptive relief process can take years to obtain, and sometimes results in different relief for similar products.

Market Volatility, Capital Formation, and Settlement Issues

Nasdaq's Eric Noll testified that ETPs have not caused the "extraordinary trading environment" experienced over the last year. Instead, he attributed market volatility to the "unparalleled uncertainty that the market must process during the fast paced news and information cycle of every trading day." According to Noll, ETPs and other asset classes "are just trying to move within this turbulent atmosphere." Similarly, Archard testified that the "broad dynamics of market volatility are reflective of overall macroeconomic uncertainty." During periods of volatility, he continued, "market participants look for mechanisms to trade on broad economic and market news and ETFs provide an effective mechanism to do so." According to Archard this is why one sees increased ETF usage during volatile markets, but that does not mean that ETFs are causing the increased volatility. Harold Bradley of the Kauffman Foundation presented a much different view of ETFs, arguing that "ETFs have increasingly distorted the role of equities markets in capital formation, while posing systemic risks from potential settlement failures." According to Bradley, individual common stocks are behaving increasingly as if they are derivatives of frequently traded and interlinked ETF baskets, thereby driving the prices of underlying common stocks. This dynamic particularly has been pronounced with ETFs comprised of small cap stocks, Bradley noted. Small cap stocks "are the proverbial tiny boats being tossed around on the ETF ocean," Bradley said and "the reluctance to become such a little boat is an important reason why growing private companies may be avoiding the public markets." For example, Bradley explained that ETFs function properly only if Authorized Participants can purchase component equities in the index being tracked. But the popularity of ETFs like the small cap iShares Russell 2000 Index Fund (IWM) have overwhelmed an Authorized Participant's ability to buy component securities, Bradley continued, resulting in extreme stock price volatility that will persist. He also raised concerns regarding settlement failures involving ETFs. Bradley noted that in 2010, two of the largest ETFs, the SPDR S&P 500 ETF and the IWM, constituted 21 percent of the value of all settlement failures. He warned that "trading 'fails' in ETFs during times of market stress could domino into a greater systemic risk issue for our markets." DisclaimerThis document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.

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