A Regulatory Framework for Exchange-Traded Funds, by Henry T.C. Hu & John D. Morley

by Guest Blogger — Wednesday, Apr. 4, 2018

The “exchange-traded fund” (ETF) is one of the key financial innovations of the modern era. Our article, A Regulatory Framework for Exchange-Traded Funds (forthcoming in Southern California Law Review, vol. 91, no. 5, 2018), is the first academic work to show the need for, or to offer a regulatory framework for ETFs.

The economic significance of ETFs is enormous. U.S.-listed ETFs now hold more than $3.2 trillion in assets and comprise seven of the country’s ten most actively traded securities. ETFs also possess an array of unique characteristics raising distinctive concerns. They offer what our article conceptualizes as a nearly frictionless portal to a bewildering universe of plain vanilla and exotic asset classes, passive and active investment strategies, and long, short, and leveraged exposures. ETFs are nearly frictionless in the sense that, throughout the trading day, they offer almost instantaneous access to and exit from investment exposures at prices that closely reflect the values of the assets an ETF holds. But this frictionless exposure depends largely on the effectiveness of a novel, theory-driven device that we refer to as the “arbitrage mechanism.” We believe the arbitrage mechanism to be the ETF’s defining characteristic: it is absent from the market microstructure of all other traded securities and from the ETF’s closest cousins, the mutual fund and the closed-end fund. This mechanism has sometimes failed catastrophically, even in very large and simple ETFs.

Despite their economic significance and distinctive risks, ETFs remain a regulatory backwater. The United States has neither a dedicated system of ETF regulation nor even a workable, comprehensive legal conception of what an ETF is. ETFs are subject to extensive regulation, but this regulation was generally not developed with ETFs in mind. A motley group of statutes divide similar ETFs into a plethora of different regulatory cubbyholes that were originally intended for older, fundamentally different vehicles such as mutual funds, commodity pools, and operating companies. Other regulations come from a process of discretionary review that allows the SEC to assess the merits of each proposed ETF on an ad hoc, individualized basis.

This regulatory state of affairs causes two basic types of problems. The first is that it introduces pathologies in the process of regulatory administration. It fragments regulation across a series of different statutes that impose disparate rules on functionally identical funds.  It also relies too much on discretion, allowing the SEC to approve or disapprove of individual funds through a process of review that is opaque, inconsistent, and unfocused, and incapable of being updated. The result is that otherwise similar funds can receive dramatically different regulation. New funds, especially, tend to suffer, often operating under much tighter requirements than older funds.

In addition to creating these pathologies in administration, ETF regulation also fails to properly address the ETF phenomenon’s distinctive characteristics, including the arbitrage mechanism. The arbitrage mechanism’s reliability is essential to the integrity of ETF trading prices and the ETF’s core investment premise as a nearly frictionless, nearly universal, financial portal. The arbitrage mechanism poses risks because, among other things, it relies entirely on market incentives to lead certain “authorized participants” to enter into just the right transactions at the just the right times with an ETF and traders in the secondary market so that the trading price of a share will be close to the share’s net asset value (NAV).

The arbitrage mechanism has sometimes failed catastrophically in times of market stress. On February 5, 2018, the shares of an arcane, “inverse volatility” ETF with about two billion dollars in assets the prior trading day closed at a trading price roughly eighteen-fold its NAV. Major problems have occurred even in ETFs that are least prone to failures. Most notably, early on August 24, 2015, the arbitrage mechanism broke down in a number of large, well-established ETFs offering simple passive long exposure to broad portfolios of highly liquid domestic stocks.

Rooted in a disclosure system originally designed for mutual funds, the SEC’s disclosure rules for ETFs fail to comprehend the significance and complexities of the arbitrage mechanism and sometimes require no public disclosure of major breakdowns in the mechanism’s workings. Using the SEC-mandated arbitrage mechanism performance scorecard, the country’s second largest ETF properly and accurately reported a perfect “100.00” percent performance for a period that included August 24, 2015, even though it suffered a major gap between its trading price and NAV early that day. ETF disclosure regulation also fails to properly respond to the model-based nature of the arbitrage mechanism, something especially surprising given the major model-related disruptions associated with the modern process of financial innovation.

Under our proposed framework, the arbitrage mechanism would be the organizing principle of ETF regulation. Under our proposal, all collective investment vehicles utilizing the arbitrage mechanism would constitute an “ETF” and come under the same regulatory umbrella. The ETF would begin to enjoy an independent legal status and regulation would comprehend the idiosyncrasies of ETFs and the underlying innovation process. Our framework includes a streamlined, transparent, and primarily rules-based system for creating new ETFs that would allow most ETFs to avoid individualized SEC review. At the same time, the SEC would have enough discretion to adequately address the most troublesome new funds, such as ETFs raising certain arbitrage mechanism or related structural engineering concerns, risky or complex ETFs not adequately addressed by suitability rules, and ETFs with large negative externalities.

We also propose rules governing the disclosure and substantive operations of all ETFs. We suggest that certain substantive elements of the Investment Company Act, which regulates most ETFs, be extended to cover other ETFs that currently escape that statute’s application. We propose quantitative disclosure requirements that would be granular enough to capture breakdowns in the arbitrage process such as the debacle of August 24, 2015. We also suggest, among other things, that all ETFs provide broader, more prospective information about the arbitrage mechanism and related structural engineering matters through a “Management’s Discussion and Analysis”-style approach that should provide a particularized assessment of a fund’s arbitrage mechanism and related engineering and an outline of the ETF’s ongoing efforts to monitor and improve the engineering.

ETFs are not the only pressing matter the SEC faces. But we believe that there are few, if any, subjects in financial regulation that are more important and for which the current rules are more outdated. ETFs have been a great success, but they also pose great risks. We applaud SEC Chairman Jay Clayton’s recognition that reforms are needed. The time has come for a legal regime worthy of this phenomenon and its fascinating and complex new challenges.

Henry 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. This post is based on their recent paper, available for download here.

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