Exchange Traded Funds : EU and US Analysis and Recommendations for Market Development Based on Information Symmetry and Arbitrage

When in May 2012 the market experienced the ‘flash crash', many equity products, including ‘exchange traded funds' — or ETFs — experienced an extraordinary rapid decline and recovery prompting significant public scrutiny for allegedly causing market distortions and being a source of systemic risk. Concerns are raised especially with respect to those European ETFs employing a high degree of leverage, which could be particularly harmful for investors. The purported solutions to investor protection and systemic stability concerns are focused on fine-tuning product rules and developing a more interventionist approach to ETFs relative to the existing processes.This article asks whether the premises of ETF regulation are consistent with the ETF's market origin and its continued viability and, more specifically, whether the existing ETF regulation promotes an effectively functioning mechanism, generally referred to as arbitrage by market participants, supporting the active market in ETF shares. The article introduces a path for achieving an effective arbitrage mechanism. We argue that the blueprint of European ETF regulation ‘ought to' focus on the full disclosure of the funds' portfolio holdings as the primary measure for investor protection. Public disclosure of the ETF portfolio holdings also addresses systemic stability concerns by empowering regulators to properly monitor the transmission channels of liquidity risk. In ‘effect', given the rather positive experience of the US ETF market, this article advocates a harmonized international approach to the ‘transparency' of ETF investment activities