SEC Backs Major ETF Rule Change

June 28, 2018

At an open meeting today, the Securities and Exchange Commission (SEC) voted unanimously to propose the long-expected "ETF Rule," which, if adopted, would greatly reduce the time and costs needed for issuers to bring products to launch.

Proposed Rule 6c-11 would allow ETF issuers to launch funds without having to first obtain from the SEC what is known as "exemptive relief" from stipulations laid out in the Investment Company Act of 1940 (also known as the 1940 Act). It would also rescind all previously given exemptive relief to ETFs that would otherwise be covered by the new rule (read: "SEC Considering Major ETF Rule Change").

The proposed rule, which would apply to any ETF structured as an open-ended fund, would cover passive as well as active ETFs. It would not, however, apply to unit investment trusts—the structure behind the SPDR S&P 500 ETF Trust (SPY), ETFs structured as a share class of a multiclass fund (e.g., Vanguard funds) or leveraged and inverse ETFs.

It also makes custom creation/redemption baskets available to all ETFs covered under the proposed rule, a level-setting change that could have significant benefits for newer entrants into the space.

A similar rule without the creation basket amendment was first introduced in 2008, but was shelved as the financial crisis began to pick up steam.

About the proposal, SEC Chairman Jay Clayton said at Thursday's meeting, "This is an excellent example of good government doing good work."

What Is Exemptive Relief?

Until now, ETFs have essentially existed as an exception to the rules. Each advisor that wishes to issue their own ETFs had to first apply with the SEC to be exempted from certain provisions of the 1940 Act that governs how fund shares can be bought and sold.

"The most important relief is from the requirement that shares of an open-ended fund be redeemable on any business day, upon the request of the shareholder," said Brian McCabe, partner at ETF law firm Ropes & Gray.

Instead, ETFs are only redeemable by special market makers known as "authorized participants" and in big bundles of shares known as "creation units." This creation/redemption process, as it is known, is key to how ETFs operate with such tax efficiency.

Before any ETF issuer may launch funds, they must first receive exemptive relief from the SEC. But "relying on exemptions is not without price," said Chairman Clayton at the meeting.

For starters, the process is time-consuming and expensive. Exemptive relief applications typically take four to six months to process and review, and sometimes longer for issuers seeking to launch more exotic products. New issuers generally spend on average $15,000 to $25,000 on filing costs.

Unlevel Playing Field

Furthermore, exemptive relief has been doled out on a case-by-case basis, meaning that the 100+ issuers in the ETF industry all operate by different orders. The SEC has issued more than 300 exemptive relief orders so far.

"It's a very bespoke process," said McCabe. "Standardization will make the market much more efficient."

As a result, some ETF issuers are allowed to take actions that others aren't, depending on how the SEC's attitudes toward certain products have shifted or evolved over time.

One example is leveraged/inverse ETFs. In the mid-2000s, firms like Direxion and ProShares were given approval to launch leveraged and inverse ETFs. But after several high-profile investor lawsuits, the SEC has significantly curtailed its approval for issuers hoping to launch those types of products.

The newly proposed rule does not cover leveraged and inverse ETFs, which must still follow the existing exemptive relief process.

Custom Creation Baskets

Another example of shifting SEC attitudes concerns custom creation and redemption baskets. Early on, the SEC allowed issuers to apply for the ability to generate custom creation and redemption baskets. That meant issuers could, for example, give authorized participants Microsoft if they were redeeming shares of an ETF, but demand that they deliver Oracle if they were creating shares.

By using custom creation baskets, ETF issuers could adjust their portfolio's holdings efficiently, spreading out the impact of big changes and minimizing capital gains from higher-turnover, active strategies.

In 2012, however, the SEC stopped issuing exemptive relief that permitted custom baskets—just as several higher-turnover, actively managed products came to launch. This hurt the ability of new entrants to be active while maintaining the tax efficiency of an index-based approach.

"Folks with the older orders have a lot more flexibility currently," said McCabe.

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