Given the rapid growth and evolution of the exchange-traded fund (ETF) sector, largely under rules designed for mutual funds, securities regulators are considering a series of potential reforms to address some unique features of ETFs.
The Canadian Securities Administrators (CSA) published a consultation paper Thursday that examines the existing regulatory framework for ETFs and considers a range of possible policy changes targeting the sector. These changes reflect differences in how ETF units are created, redeemed, administered and traded in secondary markets.
“We believe that a regulatory framework tailored to the unique ETF structure can enhance investor protection, promote investor confidence in ETFs and foster competition,” the CSA said in the paper, adding its recommendations aim to support the sector’s growth.
Among other proposals, the paper suggests requiring ETFs to adopt policies and procedures regarding the creation and redemption of units to ensure these activities are subject to adequate fund manager oversight, to mitigate potential conflicts of interest and to enhance competition among dealers involved in the creation/redemption process.
For example, the paper proposes requirements for fund managers to monitor liquidity provision and the operation of arbitrage mechanisms (which keep the trading price of ETFs close to the underlying net asset value [NAV] of their holdings). It also proposes requiring ETFs to disclose arrangements with dealers involved in the creation and redemption of units, and for funds to provide similar information to dealers to enhance competition.
Additionally, funds would be required to adopt policies on disclosing portfolio information to facilitate arbitrage and improve transparency to investors.
Enhanced disclosure
The proposals also contemplate enhanced disclosure requirements for ETFs to provide daily reports on their websites about arbitrage mechanisms and secondary market trading — disclosures intended to improve transparency and allow investors to better evaluate investment and trading decisions.
“This proposed disclosure seeks to increase investor awareness about ETFs that have significant and persistent deviations from [NAV], which may occur when the arbitrage mechanism is impaired,” the paper noted.
Alongside the CSA consultation, the Ontario Securities Commission (OSC) published results of a study on the ETF market that informed the paper.
The OSC found that while most ETFs are liquid, have tight spreads and narrow price deviations from their NAVs, these metrics “widened substantially during periods of market stress,” such as the onset of the pandemic.
It noted that newer, smaller funds were generally less liquid and traded at wider spreads, further from their NAVs.
While the study concluded that the ETF sector is working well overall and proved resilient during periods of extreme market volatility — such as the pandemic and the Russian invasion of Ukraine — it noted “not all ETFs behave the same,” particularly smaller, less liquid, lightly traded funds.
“Additionally, quoted spreads appeared to trend slightly higher since 2022 amid increased market volatility and global macroeconomic events,” the study said.
“This trend may require further market monitoring to ensure that it is not a result of deteriorating liquidity conditions,” it added.
Along with potential regulatory changes for ETF operations, the consultation also seeks feedback on the availability of U.S. ETFs and other foreign funds to Canadian investors. Investors can currently access these funds through full-service and discount brokers, exposing them to investment strategies not otherwise permitted in Canada.
The consultation asks whether investors would benefit from any regulatory measures in this area.
“ETFs are an increasingly important investment vehicle for Canadians, providing investors with access to a wide range of investment exposures and strategies and offering intraday liquidity. This consultation will provide the CSA with important insights into the unique regulatory considerations for these products,” said Stan Magidson, chair of the CSA and chair and CEO of the Alberta Securities Commission, in a release.
The paper is open for a 120-day comment period, ending Oct. 17.
If the CSA proceeds with any rule changes, they would still have to undergo the usual rule-making process.