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ETFs and investor protection

Traffic_lightAfter 17 blissful years of unconditional love, the honeymoon period for exchange-traded funds (ETFs) finally ran out in 2011. The celebratory mood created by people praising the simplicity and cheapness of ETFs and similar exchange-traded products (ETPs) was soured after regulators, the media and some industry professionals started to question transparency and safety.

Although the critics’ main focus has been on synthetic products (those constructed from derivatives) other protagonists have drawn attention to risks associated with stock lending in physical products (those that are backed by real securities).

One of the industry’s main European players, ETF Securities, is now attempting to create order again by proposing a ‘traffic light’ system to categorise ETPs so that investors, particularly retail investors, can more easily see what risks and complexities each product contains.

Townsend Lansing, head of regulatory affairs at the firm, has proposed that ETPs be split into three categories: physically backed (green); collateralised (amber); uncollateralised (red).

The physically backed category is where the products, such as in specie ETFs and precious metal products, own 100% of the underlying assets and do not lend them out.

The collateralised category is where not all assets are owned and where collateral may be used to earn fees from stock lending or to reduce credit risk.

Uncollateralised products are where an unsecured risk to an issuer, bank or counterparty is present. This product range may include exchange-traded notes, structured products, warrants and certificates.

Lansing presents the proposals in an ETF Securities document produced this month called ‘Categorising exchange-traded products: A practical approach for investors’.

Lansing points out that ETF Securities has both a physically backed product – a gold ETP – and an uncollateralised product based on oil.

The sudden antagonism to ETFs this year may have stemmed from either regulators in panic or a mischievous segment of the active management industry. Certainly elements of the latter group have capitalised on it, and so may some have in the ETF world too. But as 2011 draws to a close, there is likely some reflection in the ETF market on whether criticism of one kind of ETP is bad for the market at large.

©2011 funds europe