Article | Securities Law
The SEC and Regulation of Exchange-Traded Funds:
A Commendable Start and a Welcome Invitation
by Henry T. C. Hu & John D. Morley*
From Vol. 92, No. 5 (July 2019)
92 S. Cal. L. Rev. 1155 (2019)
Keywords: Securities, SEC, Regulation, Exchange-Traded Funds (“ETFs”)
Exchange-traded funds (“ETFs”) are among the most important financial innovations of the modern era. And yet they still have no coherent regulatory system. This Article addresses the problem by assessing the SEC’s recent effort in this area in light of the recommendations we provided in prior research. In March 2018, we offered the first academic work to show the need for, or to present, a comprehensive regulatory framework for all ETFs. On June 28, 2018, just prior to that article’s scheduled publication, the SEC issued a proposal to change the way it regulates certain types of ETFs. On May 20, 2019, the SEC issued its “Precidian” exemptive order, allowing for the first time “non-transparent” actively managed ETFs—an order that we believe has surprising, hitherto unexplored implications for ETF regulation.
This new Article thus considers the SEC proposal and the Precidian order in the context of our earlier article’s proposed regulatory framework, and also refines that framework. We provide additional rationales for the framework, relying in part on new empirical findings.
The SEC’s proposal does not seek to provide a comprehensive regulatory framework for all ETFs. However, the proposal is a commendable start to addressing some of the problems in the current ad hoc approach to ETF regulation, especially as to the substantive side of ETF regulation. In proposing a more rules-based approach, the SEC helps deal with the central problem of current substantive ETF regulation—the reliance on individualized exemptive letters. However, this partial shift only applies to certain ETFs that are organized under the Investment Company Act of 1940 and also leaves in place an anomalous set of individualized exemptions for several specific Investment Company ETFs, including those offering leveraged and inverse exposures. More broadly, the proposal does not address problems of SEC discretion pertaining to the underlying process of financial innovation in ETFs. The proposed rule also neglects to address the frequent need for individualized exemptions with respect to stock exchange listing requirements.
With respect to the disclosure side of regulation, the SEC proposal again only covers Investment Company ETFs, but is even more incremental in nature. The SEC contemplates modest enhancements of disclosures related to “trading price frictions” of such ETFs. And, going the other direction, the SEC contemplates eliminating the primary source of information for retail investors on intraday values of ETF shares. We welcome the SEC’s invitation for views on more fundamental disclosure reforms. We offer a refined version of the comprehensive disclosure approach advanced in our first article, and provide fresh rationales for such an approach, based in part on new empirical findings. This approach would apply to all ETFs, and would be cognizant of the distinctive characteristics of ETFs and the subtle complexities introduced by the underlying innovation process. Collectively, a disclosure regime consisting of a “dynamic” SEC-specified ETF nomenclature and required ETF self-identification (which nomenclature and self-identification we refer to as the “disclosure building block”), fuller quantitative disclosures of trading price frictions (such as those related to the arbitrage mechanism and bid-ask spreads), and periodic Management’s Discussion and Analysis-style qualitative information centered on the arbitrage mechanism (including, as appropriate, consideration of the impact of the liquidity of the assets in which the ETF is invested) would help individual and institutional investors alike.
*. Professor Hu holds the Allan Shivers Chair in the Law of Banking and Finance, University of Texas Law School. Professor Morley is Professor of Law, Yale Law School. We much appreciate the insights of Cary Coglianese, Jill Fisch, Itay Goldstein, Joseph McCahery, David Musto, Steve Oh, Landon Thomas, Jr., executives and counsel at a number of major ETF sponsors and other entities involved with ETFs, the library assistance of Scott Vdoviak and Lei Zhang and the research assistance of Jacob McDonald and Helen Xiang. We thank conference and workshop participants at the Wharton Finance Department/Institute of Law and Economics (University of Pennsylvania Law School) Finance Seminar (Sept. 20, 2018), the Nasdaq-Villanova Synapse 2018 (Nov. 9, 2018), the ETP Fall 2018 Forum (Nov. 29, 2018), and the Tilburg University Law and Economics Center Seminar (Feb. 6, 2019). Professor Hu served as the founding Director of the U.S. Securities and Exchange Commission’s Division of Economic and Risk Analysis (formerly called the Division of Risk, Strategy, and Financial Innovation) (2009-2011), and he and his staff were involved in certain matters discussed in this Article. This Article speaks as of July 1, 2019.