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Tilburg Law and Economics Center

TILEC supports and stimulates academic research on the governance of economic activity. It fosters academically path breaking and practically relevant research and aims to be a leading center worldwide.

TILEC Seminar: Henry Hu (University of Texas Law School)

A Regulatory Framework for Exchange-Traded Funds
10:45-11:45, M 1003

Henry Hu is the Allan Shivers Chair in the Law of Banking and Finance at the University of Texas Law School. Hu’s writings and public service relate to the law and economics of capital markets and institutions (including derivatives and other financial innovations) and corporate governance. The writings are in law reviews (e.g., Columbia Law Review, University of Pennsylvania Law Review, and Yale Law Journal), finance and specialist journals (e.g., Annual Review of Financial Economics, European Financial Management, and Risk), and newspapers (e.g., Financial Times, New York Times, and Wall Street Journal).  A 1993 article was the first to show how compensation and other factors could cause sophisticated financial institutions to engage in excessive risk-taking as to derivatives.  Sole and lead-authored articles in 2006-2015 offered the first systematic analysis of debt and equity “decoupling” (through, e.g., equity swaps and credit default swaps) and coined terms now in worldwide use such as “empty creditor” and “empty voter.”  In 2018, he co-authored the first academic work to show the need for, or to offer, a regulatory framework for exchange-traded funds.

Hu was the founding Director of the Securities and Exchange Commission’s Division of Economic and Risk Analysis (initially called “Division of Risk, Strategy, and Financial Innovation”) (2009-11), the first new Division in 37 years. He was chair of the Business Associations Section of the Association of American Law Schools and a member of the Legal Advisory Board of the NASD (now FINRA), the NASD and NASDAQ Market Regulation Committees, and the Board of Trustees of the Center for American and International Law. In 2010, the National Association of Corporate Directors named him as one of the 100 most influential people in corporate governance (the “Directorship 100”). Hu is on the Editorial Board of Oxford University Press’s Capital Markets Law Journal. Hu has given many talks worldwide at major universities and at a wide range of non-academic venues. He has testified before Congress as an academic and on behalf of the SEC. He has consulted for leading US and non-US law firms and governmental authorities on seminal matters. Hu teaches corporate law, modern finance and governance, and securities regulation, and has also taught them at Harvard Law School. He holds a B.S. (Molecular Biophysics and Biochemistry), M.A. (Economics), and J.D., all from Yale.

Abstract

This is the first academic work to show the need for, or to offer, a regulatory framework for exchange-traded funds (“ETFs”). The economic significance of this financial innovation is enormous. U.S.-listed ETFs now hold more than $3.2 trillion in assets and comprise seven of the country’s ten most actively traded securities. ETFs also possess an array of unique characteristics raising distinctive concerns. They offer what we here conceptualize as a nearly frictionless portal to a bewildering, continually expanding universe of plain vanilla and arcane asset classes, passive and active investment strategies, and long, short, and leveraged exposures. And we argue that ETFs are defined by a novel, model-driven device that we refer to as the “arbitrage mechanism,” a device that has sometimes failed catastrophically. These new products and the underlying innovation process create special risks for investors and the financial system.

Despite their economic significance and distinctive risks, ETFs remain a regulatory backwater. The United States has neither a dedicated system of ETF regulation nor even a workable, comprehensive conception of what an ETF is. A motley group of statutes divide similar ETFs into a plethora of different regulatory cubbyholes that were originally intended for very different vehicles such as mutual funds, commodity pools, and operating companies. Other regulatory constraints center on a process of discretionary review that generally allows the Securities and Exchange Commission (“SEC”) to assess the merits of each proposed ETF on an ad hoc, individualized basis. This process of review is opaque and unfocused. It is also inconsistent over time, with the effect that older funds often operate under lighter regulation than newer ones. And because it has its roots in statutes originally designed for other kinds of vehicles, the regulation of ETFs fails to address the ETF’s distinctive characteristics. Rooted in a disclosure system largely designed for mutual funds, the SEC’s disclosure mandates for ETFs fail to comprehend the significance and complexities of the arbitrage mechanism and often require no public disclosure of major breakdowns in the mechanism’s workings.

Our proposal contemplates a single regulatory framework for all ETFs. The treatment of all ETFs would be unified. This systematic approach, rooted in the arbitrage mechanism common to all ETFs, would largely displace the hodge-podge of regulatory regimes that vary widely across both the different ETF regulatory cubbyholes in use today and different ETFs within each such cubbyhole. The functional elements of the framework would streamline and rationalize the creation, substantive operations, and disclosure of all ETFs. Such elements would include a shift away from ETF-by-ETF discretionary review and toward written rules of general applicability. In terms of the creation of ETFs, we would narrow the range of ETFs subject to close substantive scrutiny while retaining some discretion for the SEC to address concerns related to the arbitrage mechanism or related structural engineering issues, risky or complex ETFs not adequately addressed by suitability rules and investor education, and large negative externalities. In terms of disclosure, we contemplate quantitative and qualitative information addressing what we here call “trading price frictions,” such as those relating to the performance of the arbitrage mechanism and related engineering during the trading day, model-related complexities, and evolving understandings and conditions.

Click here for the paper


 




When: 06 February 2019 10:45

End date: 06 February 2019 11:45