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European regulator warns it may limit ETF distribution

The European Securities and Markets Authority (ESMA) says it could issue warnings to retail investors about the risk of ETFs or limit the distribution of certain ones to retail investors.

ESMA chair Steven Maijoor says: “It may be necessary for ESMA to issue warnings to retail investors about the risks of ETFs or even to limit the distribution of certain funds to retail investors. In this context, ESMA may need to ask for appropriate powers for inclusion in the relevant sector legislation.”

The European Securities and Markets Authority (ESMA) has examined the possible measures that could be introduced to mitigate the “potential systemic risk” of ETFs.

In a discussion paper released on Friday, ESMA highlighted the potential systemic risk caused by these types of fund and their impact on financial stability. The regulator will use the feedback received to this paper, due by September 16, to develop draft guidelines for such funds.

ESMA proposes that the information provided to investors in the prospectus of synthetic ETFs should at least include information on the underlying investment portfolio or index.

It should also include the type of collateral that may be received from the counterparty and the risk of counterparty default and the effect on investors’ returns.

In terms of securities lending, investors should be informed about the policy in relation to collateral, like the permitted types of collateral and the level of collateral required by Ucits.

Another question is whether synthetic ETF providers should be required to hold collateral that closely matches the assets of the index an ETF aims to track.

ESMA chair Steven Maijoor says: “It may be necessary for ESMA to issue warnings to retail investors about the risks of ETFs or even to limit the distribution of certain funds to retail investors. In this context, ESMA may need to ask for appropriate powers for inclusion in the relevant sector legislation.”

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  1. The ESMA could start with a simple step like calling ETFs which are synthetic rather than holding the underlying physical instruments “SETFs”. If investors know an ETF is mostly replicting the index synthetically, much of the potential danger will evaporate. After that, how about a little caveat emptor? Not all investors are lambs to the slaughter, some are intelligent and sophisticated investors who are prepared to accept higher risk.
    It is the inexperienced investors who need most protection and advice and giving a clear and unambiguous name to the class of ETFs will help avoid them being misled.
    Hopefully ESMA won’t be as dense as some (you know who I mean) and want to call them “A”, “B” “C” etc.

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