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ETF market in Europe

What impact will MiFID II, MiFIR and other regulatory and tax developments have on the ETF market?


MiFID II brings with it positive developments for ETFs. Currently ETFs are not MiFID instruments and there are no legal requirements to make trading volumes public.

The introduction of MiFID II means that it will be easier to see the demand and liquidity within the European ETF market. MiFID II will require reporting of ETF trades for the first time. ETF issuers are one, of some might say, a small group of promoters who are looking forward to the implementation of the new post-trade disclosure rules. At the moment it is very hard to see the liquidity in European ETFs because the trading is done over the counter and trades do not hit the consolidated tape. The consolidated tape is an electronic program which will provide real-time data on volume and prices for exchange traded securities. This gives an incomplete picture of the demand and liquidity in the European ETF market. Once MiFID II is implemented, ETFs will be in scope of the new reporting obligations. It is anticipated that investors will be able to see the true depth of liquidity in European ETFs, which, based on current publicly available information, looks less liquid than the US market. ETFs trades do not currently have one home. MiFID II will enable investors to see all trading activity across the whole ETF market.

MiFID II’s general transparency requirements include pre-trade and post-trade disclosures of the details of orders submitted to and transactions conducted on a trading venue. Trading venues can be a regulated market (RM), a multilateral trading facility (MTF) or an organised trading facility (OTF)). The transaction reporting requirements means that the competent authority will have to be notified of the trade. The impact for ETFs will be the mandatory trade reporting for OTC trades and a consolidated tape. Across Europe there are 25 exchanges and ETFs are cross-listed over multiple exchanges. This means that shares on one exchange might be priced differently and it could difficult to see the total trading volume across the exchanges.

This new window into the liquidity in the ETF market will give investors a clearer picture of the market. As the liquidity of ETFs and the transparency requirements both become clearer, it is we believe very likely that ETFs will be used in a greater capacity by the securities lending market.

In the UK, the Retail Distribution Review (RDR) requirements ban payment of commission to intermediaries and supports the development of new and innovative ETFs which do not pay commission. RDR removes the incentive for an independent financial advisor to choses a financial product that pays commission. Like RDR the proposed ban on inducements under MiFID II could help considerably with the expansion of the ETF European market.

While MiFID II does bring with it positive development for ETFs it will of course bring challenges. Distributors will have stricter compliance obligations, they will have to complete target market suitability assessments and there will be increased requirements regarding the disclosure of costs.

As knowledge of ETFs increases we will see innovative products developed taking into account regulatory developments, the changing demographic of investors and their evolving risk appetite. We believe investors will become more familiar and comfortable with ETFs due to the MiFID II requirements. At the moment ETFs are used sparingly in securities lending and with the implementation of MiFID II there should be more borrowing of ETFs by the market as investors see the potential for extra income. This increased availability of non-cash collateral may be seen as an option for some investors willing to take on higher risk investments.

Is MiFIR a game changer for ETFs/ETPs?

The main objective of the upcoming MIFIR regulation, which enters into force on January 3rd 2018 after having been postponed for a year, is to increase investor protection. The legislators have various options on how to achieve this, but clearly, the most intuitive way is through the enhancement of the market transparency. The exchange traded funds and products constitute an important part of the modern market ecosystem, and hence are not immune to new regulations, such as MiFIR.

Besides the obligation to report ETF transactions to national competent authorities, which is introduced by MiFIR, one should not underestimate two other obligations related to ETFs, such as pre- and post-trade transparency. Their potential impacts on the trading activities and, consequently, on the overall attractiveness of the ETF market can be significant and should not be taken lightly. In short, these two obligations would require the market operators and the investment firms operating a trading venue to make public the bid-ask spread (pre-trade transparency) and the details of each transaction (post-trade transparency). However, there exists a number of waivers allowing a delayed publication in order to prevent, for instance, that large orders or infrequently traded instruments have a significant effect on the price formation.

The good news is that ESMA has defined the criteria to calculate the waivers. The less good news is that these criteria are defined for all equity-like instruments, and hence for ETFs, and they are being debated and questioned by the market players as not entirely suitable. There exists a risk that due to inappropriate calibration of the thresholds and unsuitable criteria, the market operators will not be able to use waivers where they should be used. As a result, the ETF market might experience significant price fluctuations, creating the waves in the financial ocean, and this is exactly what the legislators are trying to avoid. If the legislators, instead of putting efforts into the review the calculation criteria and thresholds, would look at other ways to deal with the ETFs, for example, by adding more regulations, the attractiveness of this type of financial instruments might diminish prompting the investors seeking for less volatility in the price formation to switch to other products. The first to leave the ship would be the pension funds who care more about the stability rather than high returns for any price. This would force them to offload huge volumes of ETF, which in turn would bring even more pressure on the prices. The vicious circle and the domino effect could be not so far away. Besides, shifting the attention to other instruments will have a direct impact on the ETF volumes, forcing the fund managers to rethink their strategies.

In short, serious considerations about the suitability of waiver calculation criteria and threshold calibration should not be overlooked. It is easier to say than to actually foresee how these new rules will affect the ETF market. This is why, once the MiFIR has entered into force, it is essential that the legislators closely follow-up the evolution of the ETF market and apply necessary corrections to criteria in order to avoid the perturbations. On the other hand, the private sector should not remain speechless and should actively voice their thoughts and observations to team up with the authorities in order to find the best possible set of rules for regulation of transparency obligations under MiFIR.

Other Regulatory Developments in ETFs

Benchmark regulation and the ETF Market

The final rules under the benchmark regulation are not yet finalised but will have an impact ETFs and their benchmarks. This proposed regulation seeks to prohibit the use in the EU of unauthorised benchmarks and this could impact ETFs. ESMA has finalised its technical advice to the European Commission on some of the key aspects of the regulation. The rules should come into force in January 2018 and the final technical standards should be published by ESMA by mid-2017. The proposed regulation seeks to stop the use of unauthorised benchmarks in the EU and set out the criteria for deciding when third country benchmarks can be used.

The European Union Fourth Anti-Money Laundering Directive is the European Union’s most recent response to the threat of the financial system being used for money laundering and terrorist financing purposes. It sets out a risk based approach and detailed framework which ETFs must comply with to effectively manage their money laundering and terrorist financing risks. It is increasingly common for ETF boards to undertake training on AML/CTF to ensure that they are aware of the requirements and responsibilities under this regulation. ETF boards will not be able to rely on third parties to conduct elements of customer due diligence, and will need to ensure and evidence effective on-going monitoring of investor transactions. EU member states must implement the directive into domestic legislation by June 2017.

The General Data Protection Regulation (“GDPR”) is directly applicable in EU member states and due to come into force in May 2018. It will both update and overhaul data protection law. The new regulation aims to remove red tape for businesses but also tighten privacy protections for online users. Practically speaking, this means that boards of ETFs and asset managers will have to proactively plan their strategies to deal with the new requirements and obligations under the GDPR. Fines of up to 4% of global turnover (or €20 million – whichever is higher) will be imposed for breaches. Boards and audit committees will need to understand new roles and responsibilities created, compliance requirements and privacy risks. They will have to ensure effective oversight of these areas is fully embedded into their governance structure.

Brexit, the impact of Brexit on the legal and regulatory ETF landscape is not yet know. Brexit will have a multi facted and multi layered, impact on the asset management industry. How the land will lie after the exit of the United Kingdom from the Europe is something that is unknown. UCITS ETFs typically have a local EU management company, which should shield the investment manager from any Brexit risk as the local management company should still be allowed to delegate investment management activities to a London-based manager. In Europe, an ETF may be established as a UCITS or an AIF however the majority of ETFs have been set up under the UCITS regime. UCITS ETFs benefit from the high level of acceptance of the UCITS framework by regulators worldwide due to the investment rules, investor protections and risk management safeguards.

Section 871(m)

The purpose of section 871(m) is to prevent avoidance of U.S. dividend withholding tax by non-U.S. persons who, by investing into derivative financial instruments, achieve economic exposure to U.S. source dividends without actually receiving such dividends. The perceived abuse was addressed by enacting section 871(m) as part of the broader FATCA initiative. In short, section 871(m) introduces taxation of previously untaxed derivative instruments. It does so by considering payments from derivative contracts linked to U.S. equities as “dividend equivalent” payments subject to the same reporting and withholding obligations as regular U.S. source dividends. The underlying rationale is straightforward: a derivative that is highly correlated to a U.S. stock is assimilated to that stock from a tax point of view and payments thereon are assimilated to U.S. source dividends and subject to U.S. dividend withholding tax.

In practical terms, ETFs and their managers will need to identify the transactions and instruments impacted by section 871(m), assess the financial and operational impacts thereof and develop the necessary processes and tools to avoid unnecessary withholding.

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