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Cross-border regulation and tax issues hamper innovation and competition in the ETF market


The European Exchange Traded Funds (ETF) market is caught in the cross fire of conflicting regulations and the varying approaches of national tax authorities, according to a survey of more than 30 promoters and participants, representing 90% of the European ETF industry’s total assets by promoter.

Seventy-three per cent of sector participants said that ETFs have been unfairly caught by regulations aimed elsewhere. Although they are predominantly an institutional investment class, ETFs have long been subject to the retail investment rules, listings rules, European Market Infrastructure Regulation (EMIR) and currently look to be in scope for shadow banking regulation as well. As a result 72% of promoters are spending between 5 and 10 hours a week dealing with regulation.

Lisa Kealy, Partner in EMEIA Financial Services, Ernst & Young, says: “Europe’s market is fragmented; we have 21 exchanges compared to 3 in the US, which already makes Europe relatively expensive. Scale and momentum remain vital to making sustainable profits from ETFs and effective cross-border distribution remains critical to the success of ETFs. The variety of tax treatments and the weight of regulation is now a barrier to gaining significant cross-border scale in the market and as such has become a barrier to competition. Innovation is a vital source of differentiation which offers another route in for new entrants, but there is a sense that regulatory changes are also likely to limit the industry’s innovative zeal.”  

The survey shows that the industry is most concerned about the affect ESMA’s regulations could have on the efficiency of portfolio management techniques and the behaviour of secondary market investors. The two products the market expects to be most affected are actively-managed UCITs ETFs and Total Return Swaps.
Anthony Kirby, Executive Director in EMEIA Financial Services, Ernst & Young says: “At the moment, the ETF-specific regulations being brought in by ESMA are dominating the debate. ESMA’s proposals do go some way to addressing industry fears about the definition of an ETF being too narrow, or the labelling of some ETFs as complex products. However, there remains considerable uncertainty around the treatment of exchange-traded notes, and the industry has real concerns about the impact of the new regulations on physical ETF specialists and commodity ETFs.”

The industry is also divided on whether ESMA should set limitations on the use of leverage by enhanced beta ETFs.  

The survey highlights the market’s concerns that European regulatory changes do not always work in harmony; the goals of EMIR and UCITS VI seem to contradict ESMA’s focus on the systemic risks of physical securities lending. ESMA’s proposals for fuller disclosure of liquidity risks and stressed market scenarios are also beyond the aim of UCITS IV.

Respondents were also concerned that UCITS VI will roll back some of the changes to asset eligibility made by UCITS III, limiting the development of new ETF strategies, while the proposed EMIR is also expected to limit the use of derivatives by increasing the required collateral and costs. The European Commission’s proposals on shadow banking reform are creating additional problems for ETFs by treating them similarly to money market funds and adopting prescriptive approaches to stock lending and securitisation.

Anthony adds: “UCITS VI and EMIR and regulations on shadow banking, may hinder the emergence of new, complex ETF strategies and could limit the use of derivatives. However, what all of these regulations have in common is that they will push up costs. We know that most promoters do not intend to pass on these costs, which implies that regulation will accelerate the search for scale, increase barriers to entry, and encourage the biggest players to get even bigger.”

As the ETF market matures, tax is becoming an increasingly complex issue. The growing cross-border distribution of ETFs is creating investor reporting issues and the growing popularity of emerging market assets and increasing use of derivatives are making tax management at an investment portfolio level difficult. More fundamentally, determining the ultimate beneficial owners, a requirement in some jurisdictions, is a key problem and can impact a fund’s ability to access double tax treaties. The majority (73%) of promoters think that tax authorities do not always understand the tax implications of the nature of ETFs or are not fully supportive of the ETF market.

Nigel Nelkon, Executive Director in EMEIA Financial Services Ernst & Young, says: “That tax authorities may not fully understand or are not fully supportive of the ETF market is clearly unhelpful for the industry.  As promoters seek greater scale and smoother cross-border distribution the key tax issues are likely to escalate, and in the current climate, together with a lack of consistency of tax treatment across jurisdictions, this could cause reputational risk for ETFs. ”

Lisa concludes: “An industry that barely existed 10 years ago but that continues to gather assets steadily and enjoys more positive prospects than many other areas of asset management should not be hampered in innovation and growth by uncoordinated tax and regulatory policy.

“ETFs are coming of age at a highly opportune moment, as the wider asset management sector faces growing investment scepticism and pressure to reduce fees.  The industry needs to concentrate on educating regulators and tax authorities about ETFs; the better ETFs are understood, the more they are likely to enjoy continued growth without the risk of reputational damage or a backlash from the authorities.”

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