Today’s political climate has brought with it a discussion about the effects of regulation and growth. That discourse, like our politics, is polarized. However, in our most lucid moments as we step away from ideology, we know there needs to be a balance. The pendulum keeps swinging from too much regulation to periods of too little; we desperately need a proper balance.
So, what does this have to do with ETFs? Plenty!
The ETF industry is a highly regulated market. Our businesses do not survive—or at least do not function—efficiently without a relationship with the Securities and Exchange Commission. But a couple of recent SEC rulings could one day be a case study for the negative impact of regulatory rulings on the growth of an industry. I should note that I believe in regulation in the ETF space, because investor protection equals investor confidence, which underpins the success of our industry.
The denial of two bitcoin exchange-traded products in March and the liquidity rules for ETFs and mutual funds offer examples of how the SEC can undermine the growth of our industry and keep investors from having access to quality investment vehicles. A happy medium between regulation and innovation can produce opportunities for investors in a safe and protected environment, but there are times when the SEC does more to protect itself than investors.
The bitcoin products were denied because bitcoins are not traded on a regulated market. I have no problem with that statement and the SEC’s ruling. But I have concerns that it took the agency three years to articulate a basic component of bitcoin that could have been handled shortly after the first filing. The industry lost three years of development time for a basic tenet of ETF regulation. The potential issuers lost time and money, while lawyers made money. In the end, investors lost out because the industry has been delayed in being able to innovate and find solutions to the SEC’s well-founded reluctance. The bitcoin market will evolve, and one day will trade on a regulated market.
The SEC’s liquidity rules are even more disturbing to me. Once again, ETFs and some mutual funds are being blamed as a cause of—or potential cause of—market manipulation. According to SEC rules, funds must meet a minimum liquidity test and force fund boards to monitor liquidity thresholds. There is a belief that the buying or selling of the underlying securities of some funds can manipulate the small-cap market.
Let’s think about that for a minute. If the small-cap market can be easily manipulated by a creation/redemption order, is it the fund’s fault or the fault of the market structure for small-cap stocks? Clearly, it is the latter. The order to buy or sell a small-cap stock does not only come from an ETF or a mutual fund, but also from hedge funds and other active money managers who place an order to buy or sell small caps. Are they also manipulators, or is it just the funds?
The real problem here is the SEC’s lack of will to adjust the market structure for small-cap stocks in the age of electronic trading. “Regulation NMS,” the overarching market structure regulation set forth by the SEC in 2005, made market structure across all market capitalization sizes a standard regulation. That allows IBM to be traded the same way as a small community bank that trades a few thousand shares a day. Why would a small-cap stock need to be traded in under one second per the Reg NMS rules when only a few thousand shares trade per day? There’s no reason other than the SEC’s belief in one standard for the whole market.
The trading and investment community has been chasing after the SEC for its reluctance to address this issue. In October, the agency finally implemented a pilot tick size program that will allow small-cap stocks to trade in nickel increments rather than penny increments. Yet for some reason, it is ETFs that are at fault for alleged manipulation of some thinly traded stocks. It feels more like the SEC is using ETFs as a scapegoat for the agency’s own shortcomings in addressing this issue.
Investors should be protected from potential manipulation. But just because the SEC has a blind spot, it doesn’t make sense that some properly functioning small-cap ETFs could be closed. According to published reports, some leading ETF providers have sent letters to the SEC stating that some proposed rules—such as those pertaining to benchmarks needing a minimum number of equities that meet a target market value or trading volume—could force some ETFs to be out of compliance or shut down.
ETFs do not manipulate markets. If you are going to punish ETFs, what about hedge fund managers, small-cap portfolio managers and large mutual fund complexes? Proper market structure rules are what’s needed, not closures of certain ETFs.
I look forward, in the not-too-distant future, to a business school case study on how the SEC disrupted the growth of the ETF industry and potentially restricted investors from accessing market opportunities. Of course, I hope the conclusion of such a study would remark on the importance of finding a balance between regulation and innovation.
Richard Keary is the former head of ETF listings for Nasdaq and the founder of Global ETF Advisors, an independent consulting firm designed to help its clients launch new and innovative exchange-traded products.