EFAMA s Submission to ESMA on Issues related to Exchange Traded Funds (ETFs)

EFAMA s Submission to ESMA on Issues related to Exchange Traded Funds (ETFs) EFAMA is the representative association for the European investment management industry. It represents through its 26 member associations and 56 corporate members approximately EUR 13.5 trillion in assets under management, of which EUR 8 trillion was managed by approximately 53,000 funds at the end of 2010. Just under 36,000 of these funds were UCITS (Undertakings for Collective Investments in Transferable Securities) funds. EFAMA s membership includes a very large proportion of the European investment management industry, as well as nearly the entire European ETF industry, therefore EFAMA fully supports initiatives to increase the understanding of ETFs. We understand that ESMA is currently working on possible policy options to address concerns related to potential risks associated with ETFs. With this in view, EFAMA would like to provide more insight into the structure, organisation and functioning of the ETF market in order to support ESMA's ongoing work on ETFs. Other regulatory bodies such as the Financial Stability Board, the IMF and the Bank for International Settlement have recently dealt with issues related to ETFs. In particular, the Financial Stability Board consulted on a Note on Potential financial stability issues arising from recent trends in Exchange Traded Funds (see EFAMA s reply in Annex I). As a general observation, we would note that all these papers fail to distinguish between EU ETFs that are UCITS and those (in other parts of the globe) that are not subject to such detailed regulation. Indeed, commentators too often use the acronym ETF when they are actually talking about exchange traded products, not funds. This is confusing to investors and leads to an ill informed debate. EFAMA members strongly encourage ESMA not to limit its work to fund structures under the UCITS Directive, but to carry out a comprehensive analysis of all Exchange Traded Products (ETPs), including products covered by the Prospectus Directive such as notes and certificates (ETNs, ETCs). UCITS are already very strictly regulated, and it is very important that regulatory arbitrage be reduced among financial products. We also wish to highlight that ETFs not only are subject to the highest investor protection standard, but also provide investors with many useful features and advantages (see Section 4 and our reply to the FSB Note) at 18 Square de Meeûs B 1050 Bruxelles NEW ADDRESS AS OF 8 JULY 2011: rue Montoyer 47, B 1000 Bruxelles +32 2 513 39 69 Fax +32 2 513 26 43 e mail : info@efama.org www.efama.org VAT Nr BE 0446.651.445

2 a low investment cost. ETFs also did quite well during the past financial crisis and continue to show healthy growth rates, albeit from a low basis. This submission to ESMA gives technical details regarding different existing ETF structures, and addresses some concerns that have been raised by various regulators. The following topics will be covered: 1. Different ETF structures 2. Counterparty Risk and Collateral Management 3. Conflicts of interest management 4. Securities lending 5. Liquidity risk 6. Redemption possibilities for unitholders who purchased on the secondary market 7. Availability to retail clients 8. Special disclosures 9. Index construction 1) ETF structures ETF structures can be broadly divided into physical, or synthetic (swap based), depending on the replication technique used. The two techniques that predominate in ETF creation are: physical replication, either complete replication of the index ( full replication ) or optimized portfolios designed to track without full replication ( sampling replication ); swap based replication, either with unfunded structures (physical investment with a swap overlay), or with funded structures (investment using derivatives). Each of these techniques is compliant with UCITS rules, and is often employed in other (non ETF) UCITS funds. Each of these techniques exposes investors to a certain degree of risk and while we believe these risks to be well regulated and appropriately managed it is important and appropriate that these risks be evaluated and understood by providers, investors and regulators alike. Physical ETFs ETFs using physical replication hold the underlying index constituents either all the components of the index (in case of full replication ) or only part of them (in case of sampling replication and rebalance the portfolio periodically according to changes by the index provider, corporate actions and other events.

3 All these aspects can potentially lead to some tracking error, which is managed by the portfolio manager of the ETF. It has full responsibility of delivering high quality (i.e. low tracking error) products, and these skills become even clearer where optimized sampling is employed. Physical ETFs may use securities lending to partially or fully offset costs (such as transactions costs) and potential tracking error. In exchange for shares lent out, the ETF will receive a fee as well as collateral, to mitigate counterparty risk. Such risk is subject to UCITS counterparty risk management rules and may be offset through robust monitoring, daily mark to market and overcollateralization requirements. More detailed rules relating to securities lending are set at national level. PHYSICAL ETF

4 Synthetic ETFs Synthetic ETFs track their index by using OTC derivatives. The main benefit of this choice for investors is that minimal tracking error can be achieved, and ETF performance is not driven by the ability of the fund manager to manage the portfolio according to index composition: the swap counterparty will pay the performance of the relevant index, increased by enhanced portfolio returns (achieved at the swap counterparty level) and possibly adjusted to reflect certain index replication costs (if any). Like physical replication, swap based ETFs may provide investors with exposure beyond equity, bond, and money market indices, facilitating access to market segments not penetrable through full replication. In this context, the swap construction often has risk mitigating effects, as it allows for the transfer to the swap counterparty of particular risks deriving for example from less liquid markets or not freely convertible currencies. The exposure is gained through financial indices, in compliance with the UCITS Directive requirements on portfolio composition, counterparty exposure, and collateral. However, such exposures are not unique to ETFs or to UCITS. Direct investment with Swap Overlay: Unfunded Swap based Structures ETFs employing this investment technique invest all their assets in UCITS eligible securities which may be purchased from the swap counterparty (but may also be purchased directly from the market) and then use OTC derivative contracts to receive the index return and thus manage portfolio tracking error. In the industry, the portfolio of securities owned by the fund is typically referred to as the Substitute Basket and the OTC derivative is called an Unfunded Swap or an Outperformance Swap. The assets held by the fund in the Substitute Basket are not collateral and do not therefore need to comply with UCITS collateral requirements, but they rather need to comply with the UCITS eligible assets requirements and risk spreading rules. Collateraralization is required only to the extent of the profit and loss on the swap contract (discussed in more details below).

5 UNFUNDED SWAP ETF Note: Swap collateral only on the marked to market profit and loss on the swap. As an example, an ETF tracking the MSCI World Index might invest in a Substitute Basket of European equities and then enter into a swap transaction (or multiple swap transactions), pursuant to which the fund agrees to pay to the counterparty under the contract the performance of the Substitute Basket, and receive that of the index. Assuming the swap is on the full notional of the fund, and that the counterparty fulfils its obligations under this contract, this ensures that the fund will track the MSCI World (plus enhanced performance if any, and possibly less management fees and the cost of the swap, if any). Synthetic investment with collateral: Fully Funded Swap based Structures In order to provide investors with a return linked to the performance of the index, the subscriptions are invested in one or (typically) more swap contracts, whereby the full proceeds are exchanged against the index performance. The swap is on the full notional of the fund. The counterparty risk against the swap counterparty is reduced to a maximum of 10% of net assets in accordance with UCITS rules, through the exchange of collateral (and is frequently overcollateralised). The collateral needs to comply with the UCITS requirements and with the rules of the ETF domicile (for example, UCITS implementing regulations in Ireland require that any collateral taken in connection with such arrangements must be of a prescribed kind, marked to market daily, held by an independent trustee or its agent and be immediately available to the UCITS, without recourse to the counterparty, in the event of a default by that entity).

6 FUNDED SWAP ETF Note: Swap collateral on the total fund assets 2) Counterparty Risk and Collateral Management Concerns have been raised by regulators regarding the type of collateral received by the ETF and its liquidity. 2.1. Derivatives Regarding OTC derivatives, the UCITS rules on collateral included in the CESR Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS (CESR /10 788) cover liquidity, valuation, issuer credit quality, diversification, enforceability, and how the collateral is held. Furthermore, it is important to remember that the purpose of collateral is not to track the index, but rather to preserve capital and provide liquidity; the Substitute Basket (see charts) should serve the same purpose. Most ETF track equity benchmarks and, where this is the case, the Substitute Basket will typically perform in a highly correlated manner, and the swap transaction may only deliver a very small percentage of the fund s overall performance. The Eligible Assets Directive also lays down rules for the valuation of OTC derivatives, and the depositary must ensure that the value of units is calculated in accordance with the applicable national law and the fund rules, adding an oversight role to the activities of the Management Company. Detailed collateral regulation can be found in national regulation implementing the UCITS Directive.

7 Furthermore, counterparty risk rules limit to 10% of AUM the exposure to any individual counterparty in case the counterparty is a credit institution with its registered office in a Member State of the European Union or is subject to equivalent prudential rules (5% in other cases), Last but not least, UCITS assets are strictly segregated, and held in accordance with the custody rules prescribed by UCITS. Differences exist between title transfer and pledge agreements, but any collateral received to reduce OTC counterparty exposure must also be immediately available to the fund, without recourse to the counterparty, in the event of the counterparty s default. In terms of disclosure, there are extensive requirements in the UCITS Directive, and most UCITS ETF providers already provide on a voluntary basis a higher level of transparency on fund assets and swap exposure via their websites. EFAMA agrees with the need for transparency to investors on the type of replication methodology used, policies on counterparty risk management, and collateral practices. 2.2 Securities Lending Securities lending is a well established portfolio management technique and the revenue from securities lending is a source of offset of cost and tracking error for fund investors. Concerns have been raised regarding the fact that securities lending may create similar counterparty and collateral risks to synthetic ETFs, as it also involves bilateral collateralization. In this regard, EFAMA wishes to point out that securities lending must also comply with UCITS regulation and counterparty risk management. Furthermore, securities lending can also be diversified across a number of borrowers, and UCITS conflict of interest rules also apply. Overcollateralisation, daily mark to market and careful collateral acceptance rules can also provide an important protection against counterparty default risk. In case of market fail costs or buy in costs associated with the late return of securities, the borrower will be liable for them. Detailed rules regarding collateral for securities lending are currently found in national implementing regulation, not in the UCITS Directive. EFAMA members are open to a dialogue with ESMA on the harmonization of rules on collateral provided for derivatives and for securities lending exposure, if deemed appropriate for market clarity and to reduce the risk of jurisdictional arbitrage. 3) Conflicts of interest management Concerns have been expressed regarding derivatives transactions between entities belonging to the same financial group. Such transactions can arise between the UCITS Management Company and a derivatives counterparty, or between the Management Company and the Lending Agent in case of securities lending.

8 However, the UCITS Directive provides a strong risk mitigation and risk management framework for conflicts of interest, particularly with the modifications included in UCITS IV. First of all, a separation of legal entities is required between the UCITS Management Company and the swap counterparty (a credit institution also subject to supervision and to MiFID rules). Conflicts of interest rules apply to the choice of counterparties for the fund, and the risk management process must be submitted to regulators for approval. Above all, UCITS Management Companies have the fiduciary duty to act in the best interest of the UCITS and its unit holders, and the Board/senior management must ensure compliance in this respect. Best execution requirements in UCITS IV (Art. 25 (1) of the Level 2 Directive) also provide that the manager must act in the best interest of the UCITS they manage when executing decisions to deal on behalf of the managed UCITS in the context of their managed portfolios. 4) Liquidity risk ETFs have enjoyed great success as investors are attracted by their many advantages: intra day liquidity through exchange trading, multiple listings, availability of intra day NAV, tight spreads, commitment by multiple market makers, low investment costs and an established settlement system. Exchanges have similar rules on liquidity and maximum spreads for market makers, so as to guarantee minimum liquidity. However, ETFs also include in their prospectus very clear warnings to investors about liquidity risk on the secondary market, and liquidity rules will not cover catastrophic circumstances or special circumstances related to the liquidity of the underlying markets. Investors should always consider that: a) The ETF liquidity is not related to the type of replication or size of the fund. It is strictly linked to and depends on the liquidity of the underlying. Therefore an extraordinary event on the underlying would have an effect on the liquidity of the ETF. The ETF is a tracker, not a liquidity enhancement instrument b) ETFs are traded on exchanges, which are regulated bodies. Each exchange sets out specific sets of rules covering extraordinary events. For example, for LSE/Borsa Italiana, reference can be made to Article 4.5.10, # 3 of the Rules, publicly available at the following link: http://www.borsaitaliana.it/borsaitaliana/regolamenti/regolamenti/rules08112010ccpno_pdf. htm We would recommend ESMA to engage in a discussion with European stock exchanges to involve them on this point.

9 It must also be considered that liquidity on the secondary market offered by ETFs is above and beyond that of other UCITS, and investors could still redeem their shares on the primary market if they wish to do so (see Section 5 below). 5) Redemption possibilities for unitholders who purchased on the secondary market The possibility to redeem fund units directly with the fund 1 is subject to the legal provisions in the fund s jurisdiction, and to rules in the fund s prospectus. A survey of EFAMA members showed that all major jurisdictions (particularly France, Ireland, Luxemburg and Germany) allow direct redemptions. However, at prospectus level fees are usually foreseen by the Management Company (only Authorized Participants do not bear entry/exit fees), and such a procedure may be more complicated and time consuming from an operational point of view. 6) Availability to retail clients ETFs in Europe are still primarily purchased by institutional clients, or by discretionary asset managers for private clients. Almost all European ETFs are UCITS, and therefore intended to be a retail product. Furthermore, they are subject to a second layer of regulation in the form of exchange listing rules. The overwhelming majority of ETFs are linear, passive products that offer exposure to the market at low cost, very appropriate for retail investors. A large majority of retail investors are not self directed and will receive advice, therefore in these cases investment in ETFs is subject to a suitability test under MiFID. EFAMA members once again encourage ESMA to maintain in this regard a level playing field with other (non fund) Exchange Traded Products, which provide much less investor protection and transparency than UCITS. 7) Special disclosures UCITS already provide very extensive disclosures in their prospectus on a variety of ETF specific issues, for example on secondary market activity. Examples can be provided upon request. EFAMA members would agree to extend such disclosures if it is deemed appropriate. 1 Via an intermediary

10 8) Index construction EFAMA members consider that regulation should allow for innovation in indices used by ETFs, but no aggressive index innovation is currently seen in the ETF industry. EFAMA is open to a constructive dialogue regarding ETFs and stands ready to support ESMA s work with further input or clarifications. Peter De Proft Director General 30 June 2011 [11 4049]

Annexe 1 EFAMA Reply to the Financial Stability Board s Note on Potential financial stability issues arising from recent trends in Exchange Traded Funds (ETFs) EFAMA is the representative association for the European investment management industry. It represents through its 26 member associations and 51 corporate members approximately EUR 13.5 trillion in assets under management, of which EUR 8 trillion was managed by approximately 53,000 funds at the end of 2010. Just under 36,000 of these funds were UCITS (Undertakings for Collective Investments in Transferable Securities) funds. EFAMA s membership includes a very large proportion of the European investment management industry, as well as nearly the entire European ETF industry. ETFs are a growing segment of the industry, and EFAMA fully supports initiatives to increase the understanding of ETFs, among them this Note by the Financial Stability Board. First, we wish to highlight the key issues which we will address in detail in this reply: 1) ETFs in the European Union are already subject to one of the most respected and widely recognized frameworks for public investment funds the UCITS (Undertakings for Collective Investment in Transferable Securities) Directive; 2) The areas of concern in the Note are not unique to ETFs; 3) A significant number of exchange traded investment products are not ETFs appropriate distinctions must be drawn and understanding among investors and the public must be improved; 4) The distinguishing features of ETFs are highly valued by investors; 5) The ETF segment is a very small percentage of the overall investment fund market. We wish to highlight that EFAMA s comments apply only to European ETFs/UCITS ETFs, not to ETFs from other jurisdictions. ETFs as UCITS The vast majority of retail funds in the European Union are structured as UCITS, and a large majority of European ETFs are UCITS as well. The UCITS Directive provides a robust regulatory framework for investment funds which has evolved over time and provides the necessary flexibility together with strong risk mitigation provisions. Further enhancements to risk management and transparency to investors have been introduced by UCITS IV 1 in 2010, which will enter into force on 1 July 2011. The 1 http://eur lex.europa.eu/lexuriserv/lexuriserv.do?uri=oj:l:2009:302:0032:0096:en:pdf 18 Square de Meeûs B-1050 Bruxelles +32 2 513 39 69 Fax +32 2 513 26 43 e-mail : info@efama.org www.efama.org

Annexe 1 2 EFAMA s reply to FSB s note on ETFs high quality and strength of the UCITS framework are recognized and appreciated not just in Europe, but also in Asia and Latin America. Summary of relevant UCITS regulation All UCITS (including UCITS ETFs) are regulated and are subject to the same requirements and constraints. This robust product regulation is at the heart of the high level of investor protection UCITS provide. Key elements of the framework include: a fiduciary duty for the management company to act in the best interest of the fund and of investors; that the assets of the fund are held separately from the management company s balance sheet; that there is an independent depositary that oversees the activity of the manager and safeguards the assets; and that the manager is subject to detailed requirements relating to the management of conflicts of interest. The universe and strategies of UCITS are evolving due to investor demand for risk reduction and return enhancement. This is true for all UCITS (including UCITS ETFs) and is a global trend. In relation to UCITS, however, all strategies must fit within the detailed UCITS requirements and constraints. The key UCITS investment limits and requirements relevant to the FSB s stated concerns are: There are strict limits in relation to the global exposure of a UCITS; cover for investment in derivatives, and counterparty risk. There is a limit on absolute Value at Risk (VaR): a 99% confidence limit of 20%. Relative VaR: with the same confidence levels VaR has to be less than 2 times that of the benchmark. Benchmark Indices: where a UCITS aims to track a particular index, that index must be sufficiently diversified, an adequate benchmark for the market to which it refers and published in an appropriate manner. Liquidity: investor right to redeem and NAV publication at least twice a month. In practice, most UCITS are priced daily and UCITS ETFs provide investors with the ability to buy or sell shares at intra day prices in the market. Collateral: there are strict requirements regarding liquidity and issuer credit quality in respect of collateral received for transactions in OTC derivatives. In addition, the collateral must be capable of being valued on at least a daily basis. Disclosure requirements: annual and semi annual report, simplified prospectus (to be replaced by the key investor information document, the KIID, under UCITS IV) and a prospectus for the fund need to be published. In particular, the specificities and characteristics of the investment strategy of the UCITS and the relevant risks involved must be adequately explained. In practice, UCITS ETFs provide much more frequent disclosures relating to portfolio holdings, collateral compositions and counterparty exposures. All these limits and restrictions are minimum requirements. In practice, UCITS managers (including UCITS ETF managers) operate against self imposed tighter limits. Also, the UCITS requirements impose detailed responsibilities on management companies in relation to risk management and risk measurement, in terms of both their organisation and procedures and in the way that funds are monitored. Management Companies are required to employ an

Annexe 1 3 EFAMA s reply to FSB s note on ETFs appropriate liquidity risk management process in order to ensure that each UCITS they manage is able to meet redemptions. Senior management is responsible for approving and reviewing the risk management policy and arrangements, and the processes and techniques for implementing the risk management policy. UCITS management companies must establish a permanent risk management function, which must be functionally and hierarchically independent from other departments within the management company, and which is responsible for implementing the risk management policy and procedures. Managers are required to measure and manage at any time the risks to which the fund is or might be exposed, and must ensure compliance with the UCITS limits concerning global exposure and counterparty risk. It should therefore be emphasised that risk management in UCITS is already state of the art, and will be enhanced even further by the entry into force of the UCITS IV Directive on 1 July 2011. These new rules include many, even more detailed provisions on internal control mechanisms for the UCITS management company, including conflicts of interest management. The rules cover the risk management, compliance and internal audit functions, risk management policies, risk measurement, counterparty risk and issuer concentration risk calculation, as well as procedures to value OTC derivatives. In addition, UCITS ETFs are subject to listing rules, to European wide requirements relating to their prospectuses, and to national rules on securities lending. Furthermore, market makers in shares of UCITS ETFs are subject to European wide rules on transaction reporting. Concerns not unique to ETFs and effectively mitigated by the UCITS framework We note the concerns raised by the FSB regarding potential conflicts of interest, synthetic exposure, securities lending and the use of collateral. We wish to stress that, whilst these types of issues and risks are common across the financial services industry, they are managed and mitigated to a large degree within the highly regulated framework of UCITS. UCITS ETFs must comply with the same stringent requirements applicable to all UCITS. Some of the structures mentioned in the Note would not be possible under the UCITS Directive, and in other examples raised the UCITS rules deal with the concerns expressed. For example, the same legal entity cannot be the ETF provider and the derivative counterparty. Conflicts of interest rules (to be strengthened under UCITS IV) apply to the choice of counterparties, and the risk management process must be submitted to regulators for approval. Counterparty risk rules limit to 10% of AUM the exposure to any individual counterparty for OTC derivative transactions in case the counterparty is a credit institution with its registered office in a Member State of the European Union or is subject to equivalent prudential rules (5% in other cases) 2, and collateral for transactions in OTC derivatives is subject to strict liquidity and issuer credit quality criteria 3, thus mitigating collateral risk to a 2 Art. 52 of the UCITS Directive. 3 CESR Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS (http://www.esma.europa.eu/popup2.php?id=7000)

Annexe 1 4 EFAMA s reply to FSB s note on ETFs substantial degree. Further detailed collateral regulation can be found in national regulation implementing the UCITS Directive. Synthetic ETFs The counterparty risk limits and collateral rules in the UCITS framework ensure that at all times the exposure of the Fund to a single counterparty is managed to a very low level. The rules ensure that UCITS are at all times fully supported by own assets or collateral (unlike, for example, bank issued structured products). Securities lending is a technique commonly used in the fund industry and is not specific to ETFs. Efficient portfolio management techniques like securities lending or repurchase transactions are taken into consideration in the determination of the global exposure and counterparty risk for UCITS. Detailed rules regarding collateral for securities lending are found in national implementing regulation. EFAMA would welcome a dialogue on collateral rules with respect to collateral provided both for synthetic ETFs and for securities lending exposure, if deemed appropriate for market clarity and to reduce the risk of jurisdictional arbitrage. We entirely agree with the need for transparency to investors regarding investment strategies, synthetic or physical replication, and collateral/fund assets composition. As mentioned above, there are extensive disclosure requirements in the UCITS Directive, and UCITS ETF providers already provide on a voluntary basis a higher level of transparency on fund assets and swap exposure via their websites. Enhanced transparency has been driven in particular by institutional client requirements. ETFs and other Exchange Traded Products In order to address the concerns raised in the Note, we encourage the FSB not to limit the discussion exclusively to ETFs, as most issues are not unique to them. Furthermore, the concerns have already been addressed in some jurisdictions. We encourage the FSB as well as other regulators to carry out a comprehensive analysis of all Exchange Traded Products (ETPs) and to make appropriate distinctions among them and their regulatory frameworks (both by product and by jurisdiction). It is very important that a level playing field be maintained (or established, as the case may be) among financial products, and that regulatory arbitrage among ETFs, ETNs, ETCs and other product structures be avoided. Regrettably, ETFs are often confused in the public domain and in the press with other ETPs, and more investor education is required to correct some of the misperceptions. EFAMA members strongly believe that investors should understand that only ETFs have certain features, and that in Europe they are operating within the UCITS framework, which provides the highest level of investor protection.

Annexe 1 5 EFAMA s reply to FSB s note on ETFs ETFs: valuable features for investors An ETF is first and foremost a conventional investment fund. To be regarded as an exchange traded fund it must (i) permit and respect secondary market transactions in fund units (i.e., allow investors to buy and sell from each other and not just with the fund) and (ii) provide a high degree of transparency regarding its assets and performance in order to allow for accurate intra day pricing. As a consequence of these additional attributes, an ETF can be cleared, settled and held in custody like any other equity security. ETF investors are attracted by the many advantages arising from these additional features, among them intra day liquidity through exchange trading, multiple listings, availability of intra day NAV, tight spreads, commitment by multiple market makers, low investment costs. ETFs: fast growing, but a very small part of the overall investment fund market. EFAMA largely agrees with the FSB analysis of ETF trends and growth factors. ETFs in Europe have indeed enjoyed fast growth, and statistics show that they regularly attract approximately 6% of European equity traded volumes (in spite of incomplete trade reporting due to the exclusion of offexchange volumes). Rapid growth has also been underpinned by strong innovation, but the ETF phenomenon is still very small in comparison to the overall fund market and its impact on secondary markets and their stability should be put into perspective: only 2.6% of all European funds are ETFs (3.5% of UCITS funds), and high growth rates are due to a low starting base. In particular, new ETF types such as leveraged, inverse and leveraged inverse ETFs are a tiny proportion of the ETF universe, as highlighted by the FSB Note. Liquidity issues Lastly, EFAMA wishes to offer some comments on a number of concerns articulated by the FSB relating to the liquidity of the product and the liquidity of banks and asset managers involved in exchange traded products. As noted above, all UCITS managers are required to employ an appropriate liquidity risk management process in order to ensure that the UCITS is able to meet redemptions. This overarching requirement is supported by a number of prescriptive rules as regards eligible assets and markets, diversification of fund investments, a tight counterparty exposure limit as described above, and quality of collateral. The NAV pricing mechanism for UCITS reflects market prices of the underlying assets in a transparent way. Furthermore, for UCITS ETFs, intra day NAVs are regularly provided to the market, enabling all investors to track the value of their investment. Investors in UCITS ETFs may, depending on the jurisdiction and on fund rules, receive redemption proceeds in the form of the fund s underlying assets rather than cash. For UCITS ETFs, there are already national requirements as regards the handling of potential fund suspensions, and IOSCO has recently issued draft principles for CIS suspensions.

Annexe 1 6 EFAMA s reply to FSB s note on ETFs As regards potential liquidity issues for the parties involved in the ETF market, we would first note that the assets of a UCITS ETF are held segregated from the balance sheets of the UCITS manager, portfolio manager or counterparty. Instead, they are held by the depositary under custody arrangements. We therefore do not understand the reference in the Note to the liquidity of the large asset managers. Contrary to banks, asset managers do not issue balance sheet products. EFAMA looks forward to a constructive dialogue regarding ETFs with the FSB and other regulatory bodies, and we remain at your disposal for any clarification you may require. 13 May 2011