Adobe stock / Yulia Prykina

This article appears in the 2023 ETF Guide issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.

The Canadian Securities Administrators (CSA) began a review of ETF regulation in August, citing the sector’s growth as the impetus. Assets under management (AUM) in Canadian ETFs totalled almost $359 billion as of July 31, accounting for roughly 15% of investment fund AUM in Canada. That’s double the market share in mid-2016, according to the Canadian ETF Association.

That growth has come with new product types as ETF manufacturers have expanded beyond their original purpose of providing investors with cost-efficient access to broad index returns. Some complex strategies, such as crypto funds and inverse and leveraged products, have raised investor protection concerns.

The CSA said the review will focus on dealers’ processes for creating and redeeming ETF units, secondary-market trading and liquidity, and the arbitrage mechanism that aligns ETFs’ trading prices with the value of their underlying portfolios.

The International Organization of Securities Commissions (IOSCO) reviewed global ETF regulation earlier this year and found no major gaps. It did, however, point to areas — such as the liquidity of niche funds and potential conflicts of interest among ETF managers, market-makers and index providers — that could emerging concerns for regulators. The CSA said it will consider IOSCO’s guidance. The review is expected to be completed next year.

Allocation to redeemers

ETFs must use a new methodology to calculate allocations to redeeming unitholders beginning with the 2022 tax year.

“In general, the new methodology introduced a formula that denies an estimated portion of allocated capital gains when ETF unitholders make redemptions. This will generally result in higher year-end distributions of capital gains to investors than under the previous methodology,” explained Jasmit Bhandal, chief operating officer of Horizons ETFs Management (Canada) Inc., in an email to Investment Executive.

She said the firm had “no significant implementation challenges” with the new methodology over the past tax year. Neither did many end-investors reach out with questions related to the new methodology, “but they may have contacted their advisors or the dealer they transact with instead.”

What does T+1 settlement mean for ETFs?

Canada is following the moving to a shorter trade settlement cycle on May 27, 2024. What does the transition from the current two-day settlement cycle (T+2) to one-day settlement (T+1) mean for ETFs?

The shorter period between trade execution and settlement is intended to limit exposure to unsettled trades and price movements in the underlying securities, a report from TD Securities Inc.said. Investors will also get access to cash from selling investments more quickly.

But the report noted challenges for the Canadian ETF industry in moving to T+1.

For one, there could be a mismatch in settlement for international ETFs, as many markets still operate under a T+2 cycle. This means some Canadian-listed ETFs will settle before the underlying securities can, causing “a mismatch in the creation and redemption process,” the report said. The consequences could include higher execution costs for market-makers and contribute to higher bid/ask spreads.

Collateral agreements may become more common between ETF providers and market-makers, TD said, and developing automated systems for T+1 settlement may also add to costs.

Mutual funds will have the option to move to T+1, but won’t be required to do so. “This could bring some interesting dynamics for funds with both an ETF and mutual fund series, if the fund manager decides to delay implementation on the mutual fund side,” the report said.