The European Securities and Markets Authority (ESMA) has proposed wide ranging reforms and a tightening of the rules around how exchange traded funds (ETFs) operate in Europe.
In particular the regulator is probing how synthetic ETFs are marketed to retail investors.
Potential reforms include the use of warnings and limitations on the distribution of certain ‘complex' exchange traded products (ETPs).
"ESMA has reviewed the current regulatory regime applicable to UCITS ETFs and structured UCITS and considered that the existing requirements are not sufficient to take account of the specific features and risks associated with these types of funds," the paper states.
Synthetic ETFs are the focus of particular concern, but ESMA puts all aspects of ETPs under review. These include index-tracking issues, securities lending activities, cost, the quality and types of collateral held, secondary market investors and actively-managed and leveraged ETFs.
Retail investors need to be protected from what ESMA says is widespread confusion about the different types of ETPs, which can carry varying layers of complexity and levels of risk.
"ETFs are....often confused with other types of exchange-traded products such as exchange-traded notes and exchange-traded commodities. They may also be confused with listed closed-ended funds", the paper states.
However, investors seem content to invest in ETPs for the moment. ETFs account for almost $1.5trn of assets worldwide, up from just $410bn in 2005, though the majority of the money is from US investors.
But ESMA is also concerned this burgeoning market could be bedding down risks that could threaten the financial system as a whole.
For example, the role certain ETF structures play in allowing credit institutions to raise funding against relatively illiquid portfolios, and potential funding risks that arise for such institutions when acting as swap counterparties for synthetic ETFs.
The European regulator is the latest body to call for tighter regulation of the burgeoning ETF market. The Financial Services Authority (FSA), the Bank of England, the Financial Stability Board and the Serious Fraud Office have all fired warning shots at the sector.
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