SPDR WOMAN: The Future Of ETF Regulation

February 01, 2013

Jared kizer
Kathleen Moriarty
Kathleen Moriarty is a partner at Katten Muchin Rosenman LLP

Kathleen Moriarty of Katten Muchin Rosenman LLP was involved with the creation of the very first ETFs—thus her "SPDR Woman" nickname—and she remains one of the most respected experts on SEC law as it applies to ETFs. ETF Report's Heather Bell recently spoke with her about current regulatory issues around ETFs and what they mean for investors.

What do you think were the major points in the Dec. 6 SEC release that addressed derivatives in ETFs?
I think there's only one point with regard to ETFs: the SEC has lifted the moratorium on regular derivatives for active transparent ETFs. Index ETFs could already use them in up to 20% of their portfolios. The SEC is not changing any of the basic concepts or rules with respect to senior securities or derivatives—it's just lifting the moratorium on considering new active transparent ETF applications that intend to use derivatives. Basically, it puts everyone back to where they used to be, so active transparent ETFs once again will be allowed to engage in the transactions and acquire derivatives that they could have prior to the commencement of the moratorium, except they now have to follow several conditions specified by the SEC. Index ETFs remain unchanged; they must stick to the 20% portfolio limitation. Also, the moratorium still applies to new applications for leveraged and inverse ETFs, and the SEC's Division of Investment Management is continuing its study of derivative use by all investment companies.

Is this going to cause more traditional active managers to be more eager to launch ETFs?
I don't know if this alone will change their minds, but derivatives are useful tools. Certainly if this had been the only issue preventing them from launching ETFs before, it would make a big difference. From that perspective, I think it puts active transparent ETFs and regular mutual funds on more of a balanced playground.

Did the dismissal of the ProShares lawsuit in September lay to rest any of the arguments about leveraged and inverse ETFs?
I don't think it laid the basic arguments to rest, but it may have laid to rest the idea that the sponsors who created these products were deliberately creating fraudulent products for people. But the use of leverage itself was never the problem—it was just a tool. People misunderstood that the leverage performance occurred only on a daily basis. They thought—or hoped—that the leverage factor would work differently than the way it actually did. So, for example, they thought that a 2x leverage factor would apply during the entire time that someone held shares of a leveraged ETF, when in fact it applied only for a day and then would reset the next day.

So I'm not so sure that the suit put an end to the arguments about whether leveraged ETFs are good or bad investments, but it may have put an end to everybody griping about it endlessly, thinking they could sue and collect a lot of money. I think the suit puts investors on notice that you do have to pay attention to the investments that you are acquiring, just as you do for anything else. If you buy a pesticide, you should use it for that purpose—that's what it's designed for. However, if you drink the pesticide, you are going to have a problem.



Do you think that we will ever get a standardized exemption for ETFs? Or will they always have this exemptive relief process?
You know, ETFs aren't the only investment products that require SEC exemptive orders in order to launch. Some products that we consider "plain vanilla" today were required to receive exemptive orders in the past. The best example is money market funds, which were originally created pursuant to exemptive orders because they, too, didn't fit into the 1940 Act regulatory scheme per se.

I could see the SEC eventually codifying the index ETF exemption orders because a good number of them covering a broad range of products have been issued, so that at least all ETFs that are "normal" index funds (as opposed to unusual ones like leveraged index ETFs) could eventually be established and operate under index ETF rules. The SEC has seen how index ETFs behave in the marketplace and how people invest in them. They are familiar with the methods that APs use to create and redeem ETFs and they have seen how the funds trade on stock exchanges. They have seen acquisitions of index ETFs, as well as their orderly closure and termination.

Therefore, I think that the commission will, at some point in the future, adopt an index ETF rule. The question is, When? During the last few years, the SEC has had a huge amount on its plate, such as writing and adopting a huge number of rules mandated by Dodd-Frank, dealing with various financial scandals, deconstructing the "flash crash," trying to rejigger the money market rules, and dealing with dark pools and high-frequency trading, to name a few. These and other issues have prevented the commission from finding the time or having the inclination to start paying attention to ETFs.

Are commodities futures position limits going to happen in a way that seriously affects commodity investors?
I think it will depend on a number of things, including how the SEC interprets certain things. But there is no question that the Dodd-Frank changes are going to affect people, in that many, many more things that used to be traded one way are going to be traded very differently.

Now, the CFTC and the SEC and the legislators hope that will make trading better and more transparent. It certainly makes it more costly. It makes it more time consuming and more difficult. And then, of course, swaps are massively affected. They now have to be subject to all these rules as well. And just the cost of implementing all the rules and bureaucracy means that the marketplace will be affected.

What about nontransparent active ETFs? Will those ever be allowed?
I don't know. That's a hard question. The issue that is really hanging everybody up right now is that, because of the way the SPDR S&P 500 ETF (SPY) was presented and because of the way it was constructed, the arbitrage function works really well—because everybody knows what is in the S&P 500 on a daily basis. The basic concern about active, nontransparent ETFs is that if you don't know what's in their portfolios—except the few times a year when their portfolio lists are published on a lagged basis—how can you assure that, when investors buy their shares on an exchange, their market price has some realistic relevance to their actual net asset value (NAV)? Several people have offered different solutions to address this issue, from Gary Gastineau, Tony Baker and others, but it's my understanding that applications for active nontransparent ETFs are still tabled at the moment.