First Take – OSC Study and CSA Consultation on ETFs

Overview:

• The number of authorized participants (APs), a proxy for AP primary market activity or secondary market activity, may influence arbitrage effectiveness.
• There is evidence that passively managed ETFs have better liquidity than actively managed ETFs.
• There was no evidence suggesting that public disclosure of full portfolio holdings affects either liquidity or arbitrage effectiveness.
• Overall, most Canadian ETFs were liquid and well-functioning as measured by tight quoted spreads and narrow price deviation from NAV.

Recently, the Ontario Securities Commission (OSC) published a detailed study of Canadian ETF liquidity and the effectiveness of the arbitrage mechanism. The findings of this study informed and supported the Canadian Securities Administrators (CSA) consultation on Enhancing Exchange-Traded Fund (ETF) Regulation. The long-expected consultation is driven by the ETF review initiated by the CSA in 2023, which is likely to lead to regulatory changes that may alter the industry landscape. The consultation outlines potential gaps that may need to be addressed and proposes enhancements to the ETF regulatory framework. The proposals consider the IOSCO ETF Good Practices published in 2023.

Given the length of the OSC study and CSA consultation, we highlight some of the major findings of the OSC ETF study and discuss a few key consultation questions and comments related to ETF market making. The full report can be read in the link below. Please note the below commentary is not to be considered an official submission from TD Bank to the CSA consultation.

Key Consultation Questions and Comments

The 25-page consultation paper includes 35 questions covering key topics such as AP arrangements, disclosure of portfolio information, ETF series of mutual funds and availability of U.S. listed ETFs in Canada. The paper also covers topics such as disclosure metrics and monitoring of arbitrage and liquidity provision, which are more ETF issuer focused.

Authorized Participants (APs) Arrangements

An AP is an organization that has the right to create and redeem shares of an ETF and is a critical part of the ETF ecosystem. APs increase price transparency and improve ETF liquidity.

The AP's economic incentive stems from the arbitrage mechanism and transaction fees. Although it works well for ETFs with frequent trading activity, APs may not be compensated for supporting ETFs that barely trade. As a result, less-traded ETFs may have difficulties attracting APs. According to the OSC study, just shy of 10% of ETFs in Canada only have one AP, which raises concerns within the industry.

We've collected several relevant questions posed by the CSA. Our analysts share their insight below:

Does having only one AP pose undue risk for the primary market? Are there obstacles for ETFs to contract with at least two APs?

Having only one AP, which in this case would be the designated broker, poses risks for ETF issuers. For example, if that sole AP experiences outages, the arbitrage mechanism would cease to exist and the ETF's quote may not be as orderly and consistent as it would only rely only on natural buyers and sellers. Primary market activity would also stall as there would be only one participant with access to the fund. From an investor and issuer point of view, a single AP also risks the fund having wider spreads unchecked and contested, which in the case of an outage could lead to the ETF closing at a price significantly away from the last day's closing price. The above creates significant statement and liquidity risk for ETF investors.

It's important to clarify that not all APs are created equally. Being an AP is different from being a market maker. The OSC/CSA likely used AP as a general term for market maker. An AP can create/redeem a fund once an AP agreement is signed between the fund issuer and the participant. Simply having multiple APs does not necessarily translate to removing many of the risks highlighted above. There are many kinds of APs, with different lines of business. Some market participants become APs as part of their market making function while others do so mainly to be able to facilitate execution in that ETF. The latter need not be involved in arbitraging the ETF or actively and consistently quoting on the ETF. Some APs may only be involved in primary market activity and not involved in providing daily liquidity as a market maker. A well-supported ETF should have multiple market makers (not just APs) to provide competitive pricing and foster primary and secondary liquidity. We have previously highlighted that an ETF's spread narrows on average by 0.09% for every additional active market maker added. It is in the ETF issuers' interest to onboard more market makers to support their ETFs. What the ETFs need is more market makers actively quoting.

However, contracting more than one AP can be challenging for new and/or small ETF issuers if they have no previous relationship with ETF market makers. Quoting on ETFs requires capital and resources to be an AP. Why would a market maker commit capital and resources to an ETF that is not expected to trade much and where there is no strong business reason to do so? As a result, new ETF issuers may be challenged to attract APs before they reach a certain scale. At the end of the day, APs need to be compensated by the street in some shape or form. In the U.S., many ETFs trade enough that their market makers have plenty of opportunities to profit. In markets like Canada and Europe, where ETFs trade considerably less, different models are needed. In Europe, ETF issuers pay market makers a fee to quote on their ETFs, thereby ensuring a minimum quality of market making on their ETFs. In Canada, no such arrangement exists, and regulators should consider providing guidelines around the pay for market making model as this would ensure there is a minimum level of support and quality of market making on each ETF.

Would the presence of a second AP (and therefore, the potential for competition) help mitigate concerns associated with a single AP?

The OSC study indicated that the number of APs, a proxy for AP primary market activity or secondary market activity, may influence arbitrage effectiveness. As a result, a second AP should benefit ETF issuers. In addition, ETF issuers need multiple APs as relying on one AP represents business risk. ETFs with only one AP may see their spreads balloon significantly during unexpected outages or market volatility. If an ETF does not disclose daily portfolio information to the public, it will be difficult for non-AP dealers to provide secondary market liquidity in size.

In our opinion, disclosure of holdings to the public has a negligeable impact over business risk or quality of the quote of an ETF. Apart from true ETF market makers, there are few participants mandated to uphold the integrity of the quote daily. Few investors need daily holdings for the purpose of providing daily liquidity on an ETF.

If an ETF has only one AP due to specific obstacles in contracting with more APs, should exclusive arrangements with the AP be prohibited, thereby making it possible for the ETF to contract with additional APs once the obstacles do not exist?

Exclusive agreements should be prohibited. From a market makers point of view exclusive arrangements are favorable, but from an issuer and investor's point of view they are never favorable. Exclusive agreements limit competition, resulting in lower service quality and less innovation. Overall, fostering a competitive environment should eventually benefit the long-term growth of the ETF industry. Today it is up to the ETF issuer to decide if the benefits outweigh the risks in entering exclusive agreements, but most of the time those arrangements are agreed to with the issuer in a position of need. IOSCO's ETF Good Practice suggests that ETF managers are encouraged to avoid exclusive arrangements with APs and market makers that may unduly affect the effectiveness of the arbitrage mechanism.

There are scenarios today where the ETF's designated broker has an exclusive agreement over the ETF while the ETF is in seed. Although this benefits market makers by allowing them to quote without competition with the hope of reducing seed costs and getting out of seed faster, this practice does not benefit investors. Without an exclusive arrangement, the ETF issuer could allow the seeding partner to get off seed as other APs create in the fund.

Disclosure of Portfolio Information

Canada is one of the jurisdictions that allows non-daily transparent ETFs. This is mainly to protect the ETF’s proprietary trading or investment strategy especially as it relates to actively managed ETFs. The CSA raised some questions around non-daily transparent ETFs and their disclosure to the public.

Should ETFs continue to be allowed to determine the type of valuation information they provide to facilitate the arbitrage mechanism?

ETF managers should be highly encouraged to disclose all holdings to the APs of the fund. If privacy is a concern, non-disclosure agreements (NDAs) should be standard practice for the fund in question. ETF issuers should, however, not be forced to disclose their holdings to the public daily as it has no impact over the arbitrage mechanism. Having the ETF issuer provide their own parameters is not an ideal state as it leads to vastly different valuations from market makers. Although protecting IP is a key risk, ETF issuers are better off picking their AP partners and providing them with all the tools to quote and service the ETF. If disclosure is mandated to APs, it should include all information.

Do you agree that permitting ETFs to provide full portfolio holdings (or other valuation information) daily only to APs for market making purposes strikes an appropriate balance between offering investors more product choice and the potential risks of information asymmetry?

Yes. The OSC study indicated that there was no evidence to suggest that public disclosure of full portfolio holdings affects either liquidity or arbitrage effectiveness. In addition, allowing non-daily transparent ETFs encourages more active fund managers to bring their strategies to the ETF wrap thus benefiting ETF investors and the ETF industry. Forcing ETF issuers to disclose holdings every day to the public would discourage active ETFs, while providing information to APs simply for market making purposes ensures product availability and an orderly and efficient ETF quote.

ETF Series of Mutual Funds

The Canadian ETF market has been one of the pioneers in adding ETF units to mutual funds given the overall progressive regulatory environment in Canada. Many fund providers in Canada have adopted the dual share class structure (ETF and mutual fund units) with a significant number of ETFs also offered in a mutual fund class structure. Our previous ETF weekly report discussed the ETF series landscape in Canada in detail. However, many ETF investors may not be fully aware of the differences between an ETF series and a standalone ETF.

Are there differences between investing in an exchange-traded series and a standalone ETF in addition to those discussed above?

This is a lengthy topic, but in essence some of the benefits of the ETF structure are negated the moment an ETF is launched as part of a pool of assets with a larger mutual fund. Although the ETF does a good job of externalizing costs, the mutual fund does not, and the new ETF will now share in the weaknesses of the mutual fund. Larger rebalancing costs from the mutual fund will now be also shared with the ETF. On the flip side, in preparing for the evolution of the industry, it is to the benefit of the issuer and investor to have access to the ETF series.

Is additional disclosure necessary to inform investors of the differences between investing in an exchange-traded series and a standalone ETF?

The prospectus is likely the right place for this information. Many ETF investors are not fully aware of the differences between investing in an ETF series and a standalone ETF. As a result, ETF issuers should make it clear whether the product is an ETF series or a standalone ETF and the potential differences between the two. For easy access, it may also be a good practice to disclose in the ETF facts document and on the ETF website. However, the risks and concerns of the ETF series should be outlined in the prospectus.

Availability of Foreign ETFs

Currently, Canadian investors can access U.S.-listed ETFs through brokerage accounts with Canadian investment dealers, including full-service brokerages and discount brokers. This includes U.S.-listed ETFs that may engage in strategies not permitted under NI 81-102. Also, Canadian ETFs have been granted relief to invest 100% of their net assets in related underlying active U.S. ETFs. Now the regulator is examining whether this needs to change.

Please provide your views on the availability of foreign ETFs for investors through brokerage accounts and through holdings by investment funds subject to NI 81-102.

Canadian ETF investors overall benefit from the convenience of buying U.S.-listed ETFs via full-service brokerages and discount brokers. The U.S. ETF market is larger with more product offerings and provides more investment opportunities for Canadian investors.

However, allowing access to U.S.-listed ETFs that may engage in strategies not permitted under NI 81-102 can be problematic. Canadian ETF investors may not be aware of the risks involved in these products as the strategies involved in these products are technically not allowed in Canada. Also, it gives U.S. ETFs a competitive advantage in Canada as they are not subject to the same regulations as their Canadian counterparts.

Also noteworthy is that other jurisdictions do not allow products that are not filed in that jurisdiction to be sold in the jurisdiction. The investor protections and costs to ETF issuers to file and comply with Canadian regulations are fully avoided by U.S. issuers when a Canadian investor buys a U.S. ETF. Perhaps under consideration should be warning labels for investors when buying a foreign ETF not filed in Canada and under the same protections as Canadian ETFs.

Are there any additional measures that would be beneficial for investors in their consideration of investments in foreign ETFs in comparison to investments in Canadian ETFs?

Withholding tax should be a major consideration for Canadian ETF investors when selecting international investment. Canadian investors who invest in international securities directly through a U.S. ETF, or indirectly through a Canadian ETF that buys a US ETF holding international securities may be subject to both U.S. withholding tax (currently at 30% on U.S. dividends) and foreign withholding tax. However, Canadian investors who buy a Canadian ETF holding international securities directly may only be subject to foreign withholding tax and avoid any U.S. withholding tax.

Overall, the OSC consultation paper covers key topics for all industry participants, including ETF issuers, market markets/APs, and investors. Based on the consultation, the CSA will address potential gaps in ETF regulations, making them more appropriate for ETFs to support continued growth for the benefit of investors.