New Wrinkle To Marijuana ETFs

December 03, 2018

Earlier this week, Innovation Shares filed a registration statement for a new marijuana ETF that would use a broker-dealer instead of a bank to custody cannabis stocks.

For many investors, the difference may seem esoteric. But as ETF.com has extensively covered, custodial risk is one of the largest unresolved issues facing any existing or potential marijuana ETF.

If the approach is approved, it may potentially resolve the biggest hurdle that has prevented issuers from launching additional marijuana ETFs to compete with the market's sole offering, the ETFMG Alternative Harvest ETF (MJ).

What Is A Custodian?

An ETF's custodian plays an often-overlooked role: Custodians are in charge of holding a fund's portfolio securities and cash, as well as making and receiving payments on behalf of the fund with respect to its securities. Without custodians, ETFs can't exist.

Until recently, most big U.S. banks have declined to serve as custodians for marijuana ETFs, because holding stocks involved with a drug still outlawed by the U.S government could potentially run the bank afoul of federal banking laws (read: "Promise & Peril Of Marijuana ETFs").

That's true even though the majority of investable marijuana stocks are domiciled in Canada, where marijuana is fully legal. Though those companies may fall outside the jurisdiction of the U.S. Department of Justice, the custodian bank holding those stocks does not.

Because of this lack of willing custodians, no new marijuana ETF proposals have been filed with the SEC since last year, nor have any existing proposals been approved, despite the marijuana industry's explosive growth in 2018.

MJ's Custodian Trouble

The custodian issue first came to light through the unusual way in which the market's sole marijuana fund, MJ, came to launch.

Instead of the usual filing-to-launch process, ETF Managers Group (ETMFG) retrofitted one of its existing ETFs with a new index. Prior to Dec. 26, 2017, MJ tracked Latin America real estate, and carried the ticker "LARE" (read: "When An ETF Changes Its Exposure").

In so doing, ETMFG circumvented the need to find a new custodian for its fund or to get the SEC's green light for a totally new ETF. Despite the dramatic difference in indexes between LARE and MJ, the ETF had already been approved once and would not need to be reapproved. Neither did ETMFG need approval from LARE's custodian, U.S. Bank, before making the change.

Prior to MJ's index switch, U.S. Bank had demonstrated little appetite for a marijuana ETF, turning down multiple proposals similar to the fund from other issuers. Indeed, ETFMG's decision to transform LARE into a marijuana fund almost immediately sparked debate within the bank over whether to continue serving as custodian for the fund.

In September, ETFMG and U.S. Bank parted ways, and MJ switched custodians to Wedbush Securities, one of the largest investment banks in the Western U.S. Though Wedbush has all the same clearing and settling capabilities in-house that U.S. Bank does, it is a much smaller institution than its predecessor, with $2 billion in assets under management, according to its most recently filed ADV. (U.S. Bank has roughly $462 billion in assets under management.)

What's more, Wedbush Securities is a private company, meaning it need not meet the same federal regulatory guidelines as publicly traded companies. However, it is still subject to federal banking law and holds FDIC insurance (read: "Marijuana ETF Shifts Custody").

Broker-Dealer As Custodian

Innovation Shares is proposing a different approach. The proposed fund would use a broker-dealer for its custodian instead of a bank. (No custodian or transfer agent is listed in the Innovation Shares prospectus, but Innovation and its subadvisor confirmed to ETF.com that several broker-dealer firms have expressed serious interest. No names appear because the agreement has not yet been finalized.)

Most ETFs rely on banks to custody stocks, in part because of their existing custody infrastructure for other investment vehicles. Banks also offer one-stop shopping, often providing a fund with custody services, fund accounting and administration, and transfer agency all at once (read: "How The ETF Sausage Gets Made").

Yet a broker-dealer is also capable of holding stocks on behalf of a registered investment company, such as a mutual fund or ETF, making them a "perfectly legitimate custodian," says Kip Meadows, CEO of The Nottingham Company, which is listed as the proposed ETF’s administrator and is affiliated with OBP Capital, LLC, the listed fund advisor.

Furthermore, says Meadows, broker-dealers have more flexibility to hold marijuana stocks on behalf of their clients, because they have no need to satisfy federal banking laws.

"The broker-dealer community is more comfortable [holding cannabis stocks] because they already do so" in other contexts, said Meadows. "It would be a blatant hypocrisy for the SEC to say they can't custody stocks [for a '40 Act fund] that they've already approved under a '33 Act filing."

Higher Costs … Maybe

The downside of using a broker-dealer to custody stocks is that doing so may require an additional audit with the SEC, if that broker-dealer is a private entity.

Under the so-called custody rule, the SEC requires custodians for pooled investment vehicles (such as ETFs) to undergo an annual "surprise" audit of the assets within those funds, unless they are already subject to an annual audit by the Public Company Accounting Oversight Board. As such, publicly traded banks would be exempt from the surprise audit, but privately traded broker-dealers wouldn’t.

That can increase the costs of annual audit requirements by roughly 50%, says Meadows.

However, he added, "It's a manageable fund expense. We feel that we can save on other fund expenses to offset," including by splitting up custody services, transfer agency, fund accounting and administration across several smaller entities, including affiliates of Nottingham, to reduce cost.

But the audits are "just the cost of doing business, and the investor will either understand that or not," said Meadows, adding that ultimately the end investor may not even see much impact, given that many ETFs have an expense cap. (He did not specify whether the proposed marijuana fund would have an expense cap.)

It is unclear whether using a broker-dealer to custody stocks would make the Innovation Shares' proposed fund more or less expensive than the existing ETFMG fund. MJ costs 0.75% annually. No expense ratio is yet listed in the prospectus of the Innovation Shares filing.

Contact Lara Crigger at [email protected]

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