The SEC derivatives review is about a year old, and there’s no end in sight.
It’s been almost a year since U.S. securities regulators decided that the proliferation of mutual funds and ETFs using derivatives required a review before they gave any new firms permission to sell such products. Since then, issuers have reacted in different ways, including abandoning derivatives use.
Indeed, countless mutual fund firms that have lined up at the SEC in the past year to gain Securities and Exchange Commission approval to launch ETFs have amended their original filings to establish that any ETFs they bring to market won’t be using instruments such as swaps and options after all.
“Investors are afraid of derivatives,” said Richard Keary, president of Global ETF Advisors LLC, a New York-based firm that helps companies launch ETFs.
“So, if you come out and say there’s no derivatives in your product, you’re going to have a broader audience that will to buy your product,” he said during a telephone interview, adding that nixing derivatives also means potential fund sponsors will face less SEC scrutiny.
Other firms, such as Direxion, the Newton, Mass.-based ETF sponsor that already offers derivative-based funds that serve up triple or inverse exposure to their underlying indexes, are waiting patiently as the SEC deliberates. They argue that innovation in the ETF industry is being stifled by the review, and hope that it doesn’t drag on much longer.
No one knows for certain how much longer the review will last, but ETF industry sources are concerned the commission won’t act quickly, in part because the executive heading up the Division of Investment Management that’s running the review, Andrew Donohue, left in November. They worry that a changing of the guard has delayed progress and, possibly, lowered the priority of the review at the SEC. Officials at the SEC aren’t talking.
Frustrations with the yearlong wait have bubbled up in recent months in the form of talk that some ETF issuers plan to start registering ETFs under the Securities Act of 1933.
It’s questionable whether the use of the 1933 Act instead of the Investment Company Act of 1940 Act to bring exchange-traded products to market—“regulatory arbitrage,” to use the industry term—is actually going on, or whether it even makes sense from a business perspective.
As of yet, no products that would otherwise be appropriate for the ’40 Act have been launched under the ’33 Act. It’s unclear whether that will change in the future. Industry sources are divided on the point.
Some do say it’s already in the works, though they are at pains to point to actual ETFs or exchange-traded notes to illustrate their point.
One industry source, who requested anonymity, said that issuers would absolutely play the regulatory arbitrage game to bring products to market in any way they could.
The source said the SEC’s Division of Investment Management has gone beyond the purview of its initial announcement, even putting the freeze on the launch of derivatives-based ETFs using the ’40 Act that are already in registration.
Waiting And Wondering
Conversely, some argue that trying to get around the current uncertainty surrounding derivatives by bending the rules is a great way to court problems with regulators.
“If you just start circumventing the SEC for no other purpose than regulatory arbitrage, and not because you’re adding some value to your client, the business risk of that is just too great,” Global ETF Advisors’ Keary said.
John Hyland, head of United States Commodities Funds, the firm behind the largest futures-based oil and natural gas ETFs in the world, agrees that engaging in “regulatory arbitrage” would be foolhardy. Besides, the 1933 Act has its own drawbacks, Hyland said. His firm registered its funds under the ’33 Act, a function of the fact that they use futures to gain exposure to commodities.