WASHINGTON ( TheStreet) -- SEC Chairwoman Mary Schapiro, dogged by agency miscues, isn't about to take chances in letting the $1 trillion exchange traded fund industry expand into derivatives -- no matter what Nasdaq and other ETF providers request.Her cautious, bottom-up approach isn't a bad thing in light of derivatives' explosive role in the 2008 financial crisis. And it's likely to result in improvements both for investors and ETF providers. One result will certainly be SEC rules requiring increased disclosure about ETFs' complex derivative holdings and collateral, and more transparency on complicated fund fees. ETFs' derivatives exposure also could be limited. The rules, which could be a year or two off, also are likely to improve competition in the rapidly growing ETF market by streamlining reviews of fund applications and providing more consistent standards. Although the SEC hasn't yet stated its intent, Schapiro has hinted that changes may be in store. "The controls in place to address fund investments in traditional securities can lose their effectiveness when applied to derivatives," she said in August. "This is particularly the case because a relatively small investment in a derivative instrument can expose a fund to a potentially substantial gain or loss." The Securities and Exchange Commission is in no hurry to unfreeze its March 2010 deferral on allowing new ETFs to make significant investments in derivatives, which make up less than 5% of exchange traded fund assets in the U.S. Instead, the commission has tied any loosening of the policy to a comprehensive decision whether to change the way ETFs are regulated, a rule-making process that began in August. The SEC has invited public comments until Nov. 7 on whether it should change its regulatory regime for ETFs and mutual funds using derivatives. The agency will then decide whether to propose a new rule, and again invite public comment on more specific provisions before making a final decision. Nasdaq OMX, whose QQQ is one of the largest and most actively traded ETFs in the world, is arguing that the only change needed is to improve investors' understanding of these funds.
ETFs pose little market risk and do little to contribute to market volatility, Nasdaq OMX executive vice president Eric Noll told the Senate Banking subcommittee on securities last week. These funds "are of limited concern when evaluating them in the context of whether they are a potential culprit in future situational analysis of systemic risks to our financial system," he said. "We believe the regulatory community is well-positioned to monitor and discipline the growth and innovation." Noll contended that ETFs are already sufficiently transparent. A different view was voiced at the same hearing by Noel Archard, a managing director at BlackRock ( BLK), the world's biggest provider of exchange traded funds. "Any significant use of derivatives, including swaps, should be clearly disclosed," he said. "This is why having an ETF rule that sets forth consistent standards in the U.S. is so important." In April, a similar call for increased disclosure was made by the Swiss-based Financial Stability Board, an international body of financial regulators whose members include the U.S. Federal Reserve, the U.S. Treasury Department and the SEC. ETF providers "should make publicly available detailed frequent information about product composition and risk characteristics," the FSB said. It added that the impact of derivatives "on market liquidity and on financial institutions servicing the management of the fund is not yet fully understood by market participants, especially during episodes of acute market stress." The ETF, a kind of mutual fund that trades on an exchange like a stock, has soared in popularity. Introduced in 1993, there are now 1,335 exchange traded products with $969 billion in assets in the U.S., and over 4,000 such products with $1.4 trillion in assets globally. With popularity has come a proliferation of new and more complex products, including derivatives starting in 2006. ETF derivative sponsors include securities-, commodity- and currency-based leveraged, inverse and inverse leveraged products. Leveraged ETFs track an underlying index while seeking to deliver daily returns that are multiples of the performance of the benchmark tracked. They invest in derivatives such as total return swaps, futures contracts and options.
Inverse ETFs try to deliver the opposite of the performance of the index tracked. They offer a hedge against declining markets. Inverse leveraged ETFs seek a return that is a multiple of the inverse performance of the underlying index. ETFs that make significant use of derivatives have about $48 billion in assets, the SEC has said. Like mutual funds, most ETFs are regulated under the Investment Company Act of 1940, though as hybrids they don't fit neatly into the law's framework. As a result, the funds must individually seek exemptions from the SEC to trade on exchanges and to create and redeem shares only with broker-dealers and market makers. This process can take years, and SEC exemptions can differ for individual ETF providers. It took six years for the agency to approve the first ETF application for derivatives use in 2006. "The SEC has a corresponding interest in making sure that investors receive information about these products that permit them to make informed decisions," SEC investment-management director Eileen Rominger said last week.
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