What’s behind the CSA’s review of ETFs?

In early August, the Canadian Securities Administrators (CSA) began examining ETF regulation to assess the adequacy of the existing regime.

ETFs rarely catch regulators’ attention. While the mutual fund industry has had its share of misconduct — from portfolio managers front-running their funds’ trades to market-timing and high-closing scandals — investor protection concerns involving ETFs have been few and far between.

That changed earlier this year when the Ontario Securities Commission (OSC) imposed a temporary cease-trade order on an entire family of ETFs after Toronto-based Emerge Canada Inc. failed to file its financial statements. Emerge was later suspended amid a capital shortfall that included owing an estimated $5.5 million to its suite of six ARK ETFs, the Canadian versions of Cathie Wood’s high-profile tech funds.

However, the Emerge case doesn’t appear to have motivated the CSA’s review. Speaking on background because they weren’t authorized to comment publicly, regulatory sources indicated the review isn’t grounded in specific compliance or enforcement concerns involving ETFs, and it’s not designed to uncover suspected industry misconduct.

Jean-Paul Bureaud, executive director of investor advocacy group FAIR Canada, said he’s not aware of any ETF-specific investor protection issues that would prompt an enforcement review.

Rather, the regulators appear to be launching the review largely as a policy checkup to ensure that ETF regulation is fit for purpose. Bureaud noted the CSA previously completed an exercise to modernize mutual fund product regulation, “and this review may be in the same vein.”

Bureaud added: “It is good regulatory practice to periodically revisit the regulatory framework impacting different products [and] issuers to ensure they are continuing to have the intended impact and outcomes.”

Moreover, the accounting trouble with the Emerge funds wasn’t specific to their ETF structure, said Dan Hallett, vice-president of research and principal with Oakville, Ont.’s HighView Asset Management Ltd.“The same accounting standards and disclosures apply to ETFs and mutual funds,” he said. “The Emerge issue was a scale issue — one that arose because the sponsor was small and never raised sufficient [assets under management (AUM)].”

If there are similar issues at other firms, these should be easily detectable under the existing regulatory regime, Hallett said, given that fund managers are required to file audited annual financial statements with regulators for both their funds and the manager itself. Regulators could uncover issues by reviewing these financials and examining the assets owed to funds by their managers.

“If I was looking, I would zero in on smaller-AUM sponsors,” Hallett said.

However, that’s not the focus of the CSA’s review, which stems from the ETF category’s strong growth in recent years rather than concerns about the finances of small ETF managers.

A shift toward passive investing and growing sensitivity to investing costs has led to ETFs outselling mutual funds in four of the past five years, and the sector is grabbing an ever-growing share of the investment fund market. As a result, ETF AUM totalled almost $359 billion as of July 31 (compared with $1.9 trillion in mutual funds), accounting for roughly 15% of investment fund AUM in Canada.

This represents a doubling in market share since mid-2016, according to a report from the Canadian ETF Association. And that trend looks set to continue.

In Canada this year, ETFs saw $19.7 billion in net flows in the first six months, according National Bank Financial Inc. At the same time, mutual funds suffered $12.8 billion in net redemptions, according to the Investment Funds Institute of Canada.

As the ETF sector has grown and become more systemically significant, it has evolved beyond its original purpose of providing investors with cost-efficient access to broad index returns and now includes a range of more exotic strategies. As the complexity of underlying assets expands, so do the potential investor protection worries.

For example, regulators have flagged concerns with retail investors using inverse and leveraged ETFs. The advent of crypto ETFs — which Canada was one of the first jurisdictions to allow — only came after a landmark decision by an OSC hearing panel and protracted discussions between a fund manager and regulators amid concerns about liquidity and custody of the novel assets.

These same factors — the ETF sector’s growing share of investment assets and the increasing exposure to more novel and complex strategies — prompted a similar exercise earlier his year by the umbrella group of global regulators, the International Organization of Securities Commissions (IOSCO).

In May, IOSCO published the results of a review that concluded the global principles for ETF regulation, which were finalized back in 2013, remain sound.

“No major gaps have been identified, and no major regulatory issues were reported by IOSCO members or industry participants,” the report said.

The CSA indicated its review will examine some of the same areas IOSCO covered, including the process of creating and redeeming ETF units, the arbitrage mechanism that aligns an ETF’s trading price with the underlying value of its portfolio holdings, and the use of volatility controls (such as circuit breakers) in secondary-market trading.

IOSCO’s review also pointed to certain areas that may represent emerging concerns for regulators.

For example, IOSCO reported that while the ETF structure “has generally remained resilient” during periods of high market stress, certain fixed-income ETFs faced pricing and liquidity issues during the market strains that accompanied the onset of the Covid-19 pandemic in early 2020.

Certain niche funds (invested in less diversified assets or following more complex strategies) “also experienced more significant volatility and operational challenges” during that period.

While the affected funds represent only a small share of ETF AUM, IOSCO warned that the liquidity and operational risks, “if not properly mitigated, could potentially impair the product viability” of these sorts of funds.

IOSCO’s review also identified various sources of potential conflicts of interest specific to the ETF structure — such as possible conflicts between ETF managers, affiliated brokers, market-makers, index providers and derivatives counterparties.

The review also flagged differences in how the IOSCO principles are applied by regulators and in how local markets function.

For example, while some regulators require daily public disclosure of actively managed ETFs’ portfolio holdings, other regulators (including Canada’s) allow periodic, delayed disclosure.

In light of the differences in how various jurisdictions apply the global principles, IOSCO set out added guidance that identified “good practices” for both regulators and ETF firms to consider in four areas: product structure, disclosure, liquidity and trading volatility controls.

That new guidance from global regulators and the results of their review are a good starting point as the CSA evaluates the adequacy of its regime in the months ahead.