The US government’s shutdown, the longest in its history, is beginning to impact the workings of the ETF industry with the much-lauded launch of ETFs as a share class in the US on hold until the situation resolves.
US law firm Morgan Lewis Bockius has been working in the ETF industry since it began. Morgan Lewis partner and co-head in the registered fund practice, Jack O’Brien, says: “I don’t know that there is a firm that has been doing ETFs longer, given that John McGuire [his fellow co-head] was one of the first lawyers in the industry to work on the concept of an exchange traded mutual fund back in the 1990s, and we have worked with asset managers to build ETFs ever since.”
Beside the delay in launching ETFs as a share class, O’Brien notes that the government shutdown has also had its impact on ETF launches with the SEC not using its full powers of review on new products.
Most ETFs are registered investment companies under the 1940 Act but can launch new ETFs as series of an existing registration. However, some firms offering ETPs, including those based on cryptocurrencies, have taken the opportunity to launch their products during this shutdown period, which can become automatically effective in 20 days, without gaining formal SEC approval.
“Because the government is shutdown and the SEC staff is not performing its day-to-day functions, a handful of registrants have been able to launch spot crypto ETPs which have never had formal approval from the SEC,” O’Brien says.
“The view is that the government is shutdown and investors want these products so why should market innovation be stymied? The idea is that if the SEC were open, the firms know what the staff likely would say so they will go ahead anyway.”
On return to work, there is a possibility that the SEC staff will review the registration statements and have comments on their disclosure after the fact, O’Brien says.
But he’s not overly concerned that these new products coming to market without SEC approval represents substantial risk. “It’s not like everyone is going to be tricked into buying them. You buy through brokers and advisers and the broker-dealers’ self-regulatory organisation, FINRA, is not shut down and is still regulating broker dealers’ sales practices and investor disclosures,” O’Brien says.
“FINRA brought lots of sales practice actions with leveraged and inverse ETFs when those first launched, so the brokerage industry learned its lessons; advisers have fiduciary duties so they will be liable for investment decisions made on behalf of clients that don’t live up to those duties. The new products that are coming to market may be atypical but downstream safeguards are in place.”
There are now some 80 applications to launch ETFs as a share class, and O’Brien says that his firm is watching developments closely, having filed applications for several of their clients, with Dimensional Fund Advisors leading the charge and announced as the applicant that the SEC staff is focusing on.
“The staff instructed the market to watch what they are doing with Dimensional before the shutdown as they only had so many resources, but now it’s on hold again with the government shutdown,” O’Brien says.
“Right before the shutdown on September 29th, the SEC published notice that it intends to grant the order. It will probably be granted when the government comes back but we have no idea whether the other applications in the queue will be approved in one big batch, chronologically based on their place in line, or otherwise.”
Mutual fund managers that are very interested in launching ETFs as a share class, include mutual fund managers who are cautiously on the side lines but want to have the option in case the market moves in that direction for competitive purposes, O’Brien says.
“There are a minority of mutual fund managers who have their set distribution channels that are not interested in ETFs as a share class. These firms have mutual fund-dedicated vehicles for ERISA plans or platforms, set up for single day valuation, without a lot of trading activity. But for many mutual fund managers, ETF shares will have the potential to add to asset raising.”
Other trends that O’Brien is seeing in the ETF industry are the increasing numbers of traditional asset managers looking at the industry and wanting to launch their own ETF products.
“I think recently what you are seeing is a fair number of traditional asset managers who are looking to get into ETFs as a product wrapper and the question is always: ‘Should I build my own platform or go to a turnkey platform?’ which have really proliferated and been an accelerant for ETFs coming to market. They are very efficient and that has become the preferred route to bring a strategy to market in an ETF wrapper in most instances.”
He also notes that lots of alternative asset managers are thinking about ETFs as a wrapper for products such as private credit – Morgan Lewis was the firm behind the recent State Street private credit ETF launches.
He says: “Firms offering private equity or secondaries strategies are exploring ETFs, but they are not always convinced they are the best vehicle given the high level of liquidity in the product. However, people want exposure to alternatives so there is lots of interest in that space.”
“Single stock ETFs are hot right now with several asset managers bringing products with leveraged exposure to single securities. Those are claiming a lot of attention and assets primarily through ETF strategists and traders.”
This past year has also been the year of digital assets, with O’Brien noting that there are a lot of differing views on cryptocurrencies as an asset class. “Regardless of the differing views there are lots of assets flowing into those with about 10 registrants creating products, ranging from household names to smaller start-up firms who focus on that product type exclusively.”
Despite the government shutdown, O’Brien reports that the firm is busy advising on new products, different strategies and different structures.
January this year saw Gary Gensler step down from his role as chairman of the SEC, eventually replaced by Paul Atkins after Mark Uyeda served on an interim basis.
O’Brien says: “My personal view is that the ETF industry under Gensler was critical of the paternalistic environment to rule-making that the SEC was taking. Now the industry has what it asked for with Chairman Atkins who is more pro-market and more commercial in leading the SEC.
“What are we going to do with that opportunity to be responsible market participants? If the industry disregards the norms and goes into rabid sales mode, there could be little risk bubbles that start to percolate – and it could swing back to a more regulated environment. We got what we were asking for and now what are we going to do with it?”
O’Brien’s practice uniquely spans the broker/dealer side of the market, representing lots of authorised participants and market makers, but also funds and fund sponsors.
“For the last 17 years I have been on both sides of the ETF world,” he says. “APs and market makers are thinking about the volume of new contracts they will have to enter into to be able to cover this whole new world of mutual funds with ETF share classes. The speed with which this will happen worries the authorised participants in terms of documentation and operational capacity.”
In conclusion, O’Brien says: “ETFs have proven for the last 25 years to be a very efficient vehicle for providing solutions for a wide range of investors and this is the next generation of that: more managers and more asset classes and more ways to use them creatively. It’s a pretty exciting time.”
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