The explosive growth of exchange-traded funds -- there are now more than 200 U.S.-based ETFs holding more than $300 billion in assets -- not only has fund families feverishly churning out new products, it also has regulators working overtime to approve them. With so much at stake, what does the Securities and Exchange Commission look for before greenlighting an ETF? Like the Food and Drug Administration approving a new drug, the SEC's top priority is to make sure the new ETF is safe for public consumption, according to attorneys Patrick Daugherty and George Simon. The pair are well-qualified to comment, because they used to work at the SEC before switching to the private law firm of Foley & Lardner. At the firm, they represent ETF providers seeking to get their funds blessed by the SEC and onto an exchange. The pair were instrumental in the introduction of the Rydex Euro Currency Trust ( FXE), the first ETF to track a currency, as well as State Street's streetTracks Gold Trust ( GLD), which now boasts more than $6 billion in assets. In a conversation with TheStreet.com, Daugherty and Simon discussed the difficulties in getting an ETF approved by the SEC, the problem affecting an oil ETF and what's holding up the proposed silver ETF. TheStreet.com: How difficult is it to bring a new ETF to market? George Simon: It's a multipronged problem because there are multiple divisions at the SEC that must approve a new financial product, and each has its own set of concerns. The reason we got in this business is because the gold ETF had stalled. They could not get it through the market regulation division, which approves the exchange rules that permit ETFs to trade. What do you mean when you say, 'they could not get it through'? Simon: When you list one of these products on an exchange, the exchange has to file rules enabling that to happen. And the SEC has to approve those rules. The SEC, especially the market regulation division, wants to discern whether or not an ETF is a suitable product to trade on an exchange. And the gold ETF raised some real questions because gold is an over-the-counter, loose market.
What was the turning point for you in getting gold through the SEC gauntlet? Simon: The turning point was when State Street, the World Gold Council, the specialist for the product, Bear Hunter, and ourselves went down to the SEC and talked to each of the commissioners. That process got people comfortable with the product and the underlying market. That turned it around. Barclays Global Investors was working separately to roll out a similar product, which became the iShares Comex Gold Trust (IAU), right? Simon: They piggybacked on
State Street's application. One of our biggest fears was that the delay would enable BGI to launch their product at the same time we did, even though they filed nine months after us. And, as you know, being the first to market is a significant advantage in this game. If BGI had a similar structure for its product, why didn't the SEC just approve both gold ETFs at the same time? Simon: Well I guess the SEC recognized that we were first in line and they got to our application first. Do you have any idea what's going on with the proposed silver ETF currently under review by the SEC? Simon: It's just a guess, because we are not involved with the silver ETF, but I think that the commission still remembers the terrible problem that occurred in the silver markets 20 years ago with the Hunt brothers. They are wary of a similar problem recurring. Note: Simon is referring to Nelson Bunker and William Herbert Hunt's attempt to corner the world's silver market in the late 1970s, a move that eventually led to a massive collapse. How does the SEC test ETFs? The FDA, for example, tests drugs before they hit drugstore shelves. What about the SEC? Patrick Daugherty: There is no lab or beta site. There is a comment process in which the SEC staff asks a lot of questions and the proponents of the new product answer them. Once the SEC is comfortable that all its issues have been addressed, then they cut you loose and let you try it in the real world. And what happens if it flops in the real world? Daugherty: Well, there haven't been any significant flops. But it's important to note that these products don't have many moving parts, so there is not much that can go wrong. Lately you have been doing a lot of work on currency ETFs for Rydex. I know you can't talk too much about the six currently in registration, but what comes next after currencies? What about oil? Daugherty: We have not been asked to consider an oil ETF yet, although we would love to take it on. Simon: The problem with oil is that it is a commodity that is heavily used. Gold, for example, sits in a vault, and currency sits in a deposit account. Nothing happens to it. It just sits there. And you would not want to do that with oil. Daugherty: It might be possible to do it, but not directly like gold. But we'll see.