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ETF Firms Hope For End Of Derivatives Review

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.

Regulatory Arbitrage?

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.

"If the '40 Act issues a share, and then redeems it, it can issue the share back out again. You can't do that with the '33 Act," Hyland said during a telephone interview. "There have been at least half a dozen or more occasions in the last five years where that actually has created a problem for a '33 Act ETF, where they have had an unexpected surge in the demand for shares."

The recent launch of five FactorShares ETFs that were registered using the '33 Act seems to have played into the question of whether registration under the '33 Act or the '40 Act is more appropriate. Some on Wall Street have wondered whether the spread-product funds launched by FactorShares would have been launched as '40 Act funds if the SEC had not begun its derivatives review a year ago.

While funds such as the FactorShares 2X TBonds Bull/S&P500 Bear (NYSEArca:FSA) would seem like a candidate for the '40 Act, FSA, as well as the other four ETFs FactorShares launched last month, all use futures to achieve their strategies, requiring the funds to be registered under the '33 Act.

That said, there does seem to be a divergence between the perceptions of what the SEC is attempting to do and what the Commission originally intended.

Shifting Perceptions

According to Andy O'Rourke, director of marketing at Direxion, each day that passes without resolution on the derivatives issue stymies innovation and even threatens to distort the commission's original message.

"Everyone seems to have assumed that the SEC thought there were too many leveraged and inverse products," O'Rourke said in a telephone interview.

What was originally an investigation into the use of complicated derivative products by ETFs has morphed into an indictment of derivatives in general, O'Rourke argued, saying that the total return swaps Direxion uses in its funds are "very transparent."

It's true that in the eyes of some in the ETF industry, the SEC investigation has expanded to include funds already that have already been put into registration by companies that have obtained exemptive relief.

That would be beyond the scope of the SEC's original announcement that it was putting on hold consideration of new and existing exemptive relief filings that describe use of derivatives in possible future funds.

'Ongoing' Review

The last official word from the SEC on the subject was a letter last summer from its office of legal disclosure addressing the Investment Company Institute, the mutual fund industry's trade group, highlighting some of the preliminary findings of its derivatives review.

Among the SEC's concerns was that some of the actual derivatives disclosures required on Form N-1A tend to be generic. As such, they "may be of limited usefulness for investors in evaluating the anticipated investment operations of the fund, including how the fund's investment adviser actually intends to manage the fund's portfolio and the consequent risks," the letter said.

Officials at the SEC declined to comment on shifting perceptions regarding what the review is all about, and how mentioning registration statements such as the N-1A in the letter last summer-as opposed to exemptive relief filings-might be fueling additional regulatory uncertainty.

SEC spokesman Kevin Callahan also said Donohue's departure in November, and, specifically, the two months that passed before his successor, Eileen Rominger, assumed her new responsibilities, hasn't slowed the derivatives review.

"The review is ongoing," Callahan said in a telephone interview, declining to say when it might be over.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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