ETNs are currently issued in Israel as bonds under the Israeli Securities Law and are a financial instrument with unique characteristics. For example, they are traded on the stock exchange and have a firm commitment. Accordingly, the issuer of the ETN has an obligation towards its holder regarding the return on the tracked asset (in general an index), according to a conversion formula. The existence of this obligation means that implicit in the ETN are a number of risks – credit risk, operational risk, liquidity risk, market risk, stability risk of the issuer and even systemic risk to the capital market, which is the result of the potential consequences in the event of default by an ETN issuer.
In recent years, the Israel Securities Authority has promoted a reform in the ETNs domain that will transform the ETN from a bond with a firm commitment into a mutual fund, a financial product regulated by the Joint Investment Trust Law and which does not include any promised return. Underlying the need to regulate this domain are two main factors: the existing regulatory gap between ETNs and mutual funds, where both these instruments essentially constitute an arrangement for joint investment in the capital market; and the stability and systemic risk implicit in ETNs. The current reform is the outcome of an intensive discourse that has taken place over more than a year between the Israel Securities Authority and the ETN Association, as well as other relevant players in the market, with the goal of arriving at an agreed-upon arrangement that will create the correct balance between protecting the interests of investors and the interest of issuers to continue their business activity in ETNs.
As part of the reform, ETNs will become mutual funds of a new type which will be called ETFs and which will be subject to the Joint Investment Trust Law 5754–1994.
Following are the main characteristics of an ETF:
1. Investment policy – the ETF will be a tracking fund;
2. Trade in units – The ETF is a closed-end fund whose units are traded on the stock exchange and accordingly when a unit is purchased or sold during trade its price will be determined by the result of trading on the stock exchange. In these circumstances, there may develop a gap, whether positive or negative, between the unit price on the stock exchange and its value, which is derived from the net value of its assets;
3. Redemption and creation – alongside to the units trading on the stock exchange, the fund manager will create and redeem units of the fund according to the unit/redemption price. Prices will be calculated each trading day according to orders for creation or redemption that will be submitted by a member of the stock exchange until a designated time, and most of the regulations that apply to an open-ended fund in this respect will apply to this activity as well. In creation, the fund manager will add a creation fee to the price of a unit of the ETF and on redemption will deduct a redemption fee from the redemption price. These fees will be transferred to the fund and will compensate the fund for it having to cover itself or sell assets due to the creations and redemptions at the end of the day, sometimes not at optimal prices;
4. Publication of prices – The manager of the fund will publish for each ETF under his management the unit price plus creation fee, the redemption price less the redemption fee and the net asset value;
5. Appointment of a market maker – The difference between the price of a unit on the stock exchange and its value, as mentioned in Paragraph 2 above, is dependent on, among other things, the supply and demand for a unit, i.e. its level of tradability. In order to increase a unit’s tradability, the fund manager will appoint a market maker in the fund’s units. Such a market maker will be a company whose only activity is market making and it will not be controlled by the fund manager or the company that controls the fund (though it can be a sister company). According to the proposed market-making system, the market maker will be like any other customer and therefore will not have any additional information than that which is available to any other customer. In order to close the exposures that were created for him during the day due to his activity in the units in trading, the market maker will have the right to submit orders for creation and for redemption to the fund manager immediately on the close of trading on the Tel Aviv Stock Exchange (herein: the “settlement process”). Unlike the execution of these trades with regular customers, the market maker will have the right to pay for the units with a mix of assets (assets, including cash, that create the exposure to the tracked asset). In order for the buy and sell prices that are submitted by the market maker to be optimal, and since payment by means of a mix of assets reduces the cost of coverage with assets or their sale, which is borne by the fund, the market maker will not be charged a creation/redemption fee as part of the settlement process that he will carry out with the fund manager at the end of the trading day.
6. A “magazine” of treasury units – The ETF, like the existing mechanism for ETNs, will have an inventory of treasury units (a “magazine”) from which the fund manager can respond to creation requests from the public and orders of units from the market maker. The units redeemed by the fund manager will not be cancelled but rather will become treasury units and will be added to the magazine. In order to ensure tradability in the units and since the ETF is a closed-end fund whose quota of units is as a rule known and restricted, the fund manager have the right to allocate additional units to the fund from time to time that will be listed for trade on the stock exchange, for the purpose of their sale in trading by the market maker and the meeting of creation requests from the public.
7. Variable management fees – Like any fund and unlike ETNs, the ETF is not a product that promises a return or a price. The income produced by the fund’s assets, such as interest and dividends, are a part of the fund’s assets and the unit price in creation and redemption is derived from the value of those assets. At the same time, the fund manager who chooses to do so will have the right, according to the instructions and conditions specified in the regulations, to create a variable management fee mechanism, which in certain circumstances will allow the fund manager to cancel or reduce the gap between the fund’s return and the change in the price of the tracked asset during the period of calculation, by collecting a “success fee” when the gap is positive (herein: a success fee or a positive management fee) and by the refund of management fees as a specific proportion of the fund’s assets when the gap is negative (herein: a security band or negative management fee). This situation also provides a solution to the issue of hidden costs that arises in investment in ETNs, which are characterized by low management fees. As a result of the shift of ETNs from the legal structure of a bond to the legal structure of mutual funds, the ETN holders will benefit from all the fruits of the investment in the ETN assets (including dividends, interest, etc.), less the management fee collected by the ETN manager.
8. Refund of management fees to the holder of tracking fund units – The manager of a tracking fund will have the right to refund part of the management fee, and on the condition that the size of the refund does not exceed the fixed management fee, to an institutional manager of others’ money who meets the conditions set down by the fund manager, without differentiating between one institutional manager of others’ money and another.
The reform will go into effect gradually starting in October 2018 and until the end of the year. During this period, about 700 products—ETNs and tracking funds—will be converted into ETFs. It will be carried out in ten stages, where each stage includes products that belong to similar classification groups.
The dramatic reduction in barriers of entry into this field, which was made possible by the removal of stability risk, will facilitate the entry of new fund managers into the market and thus will make it possible to increase competition in the market, which today includes only four issuers.