A recent discussion paper released by the Central Bank of Ireland on the growth of the ETF industry has concluded that Mifid II changes stand to make passive investing a more powerful proposition.
Released on May 15th, the bank states that the paper's primary intention is to make a contribution to the international regulatory debate and to the risk assessments regulators must constantly refresh in order to supervise the market effectively.
'Because of their recent growth and their likely continued growth in the period ahead, there is every reason to believe that ETFs will be an even more important element of the global funds market. Any such locus of innovation requires close regulatory attention to ensure that the benefits of innovation are delivered within a robust, but enabling, regulatory framework.'
One of the big questions it poses is whether the regulatory framework in which ETFs operate can bear the weight increased growth brings? Or could it, itself, lead to a significant market failure?
Mifid II will increase appetite
Although ETFs are constituted as investment funds (and thereby subject to the full spectrum of investment fund regulation) they are also exchange-traded financial instruments, like equities or bonds,
and as such are subject to stock exchange rules and regulations applicable to publicly traded assets.
This dual nature means that ETFs are subject to the overlapping framework of both the UCITS Directive 15 and Mifid II, both of which are designed to address specific issues and risks.
Currently ETFs do not have pre- and post-trade transparency requirements, but this will change significantly under Mifid II, which will be implemented from January 2018.
Therefore Mifid II is expected to actually help move the European ETFs landscape closer in line with the US ETF market which is more advanced especially in terms of trading and transparency.
The paper states: 'The vast majority of ETF trading takes place OTC (over-the-counter). ETF liquidity is the level of demand/supply on the exchanges on which it is listed, combined with OTC demand. As noted elsewhere, Mifid II changes should help with providing a more comprehensive trading volume/price data set.'
The London Stock Exchange (LSE) estimates that around 70% of ETP trading in Europe currently takes place over the counter.
While embracing the transparency Mifid II compliance brings, the Irish Central Bank paper however also questioned whether regulators fully understand the potential risks posed by the rapid growth in ETF flows.
Ireland has reason to be cautious; it is now one of the largest centres for ETFs in Europe, which in turn is the fastest growing type of investment fund globally - the industry surpassed US$4tn in assets at the end of April 2017.
Morningstar's director of passive research in Europe, Hortense Bioy explains: 'Ireland has become the domicile of choice for ETF providers in Europe because it has been one of the most, if not the most, welcoming hubs in the region, with a wide range of services and expertise from legal and tax to administration. Ireland as a fund domicile also benefits from one of the most favourable tax treaties in Europe.'
What is behind the increase in appetite for ETFs? Recently we have seen a flurry of M&A in asset management with Standard Life and Aberdeen Asset Management and Henderson and Janus announcing they will merge.
One of the driving factors the shift of money from active management to passive management which has created pressure on industry fees.
Hargreaves Lansdown, senior analyst Laith Khalaf says: 'ETFs have been on the up and up as providers have produced more new products in response to increased investor appetite.'
He adds: 'Passive investments as a whole have been increasing as a share of the overall pot of assets invested, which has helped ETFs. The liquidity characteristics and speciality of some ETFs also appeal to institutional investors who are a key driver of inflows.'