What you need to know
- ASIC has updated its Information Sheet 230 (INFO 230) to provide additional guidance to exchange market operators and participating funds, following from its recommendations in 19-348MR last year.
- Some of the recommendations are designed to mitigate information asymmetry risks identified in certain internal market making arrangements. The changes are discussed in this article.
What you need to do
- Exchange market operators and exchange traded funds (ETFs) with internal market making arrangements need to be aware of ASIC's updated guidance to ensure that market participants are using compliant models.
- The measures that ETFs with internal market making arrangements need to put in place include adequate technology systems with internal controls, policies and procedures to preserve pricing integrity. This may include the use of information barriers.
- ETFs with internal market making arrangements should consider the mechanisms they have in place to confirm that they comply with the new requirements.
- Exchanges must be aware of ASIC's expectations going forward. Exchange market operators should integrate screening measures into their approvals process for new product applications in a timely manner and monitor participants' continued adherence to ASIC's best practice guidelines to maintain fair, orderly and transparent markets for investors.
- ETFs should continue to monitor changes to operating rules which occur as the market continues to develop. ASIC has flagged that Australian exchanges may need to adjust their rules in the future.
Background
On 11 December 2019, ASIC announced the lifting of its suspension on new listings of actively managed ETFs with an internal market making function on Australian financial markets (refer 19-348MR). ASIC had previously requested in July 2019 that exchange market operators do not admit any managed funds with internal market makers that do not disclose their portfolio holdings daily while it conducted a review. The review focused on, and confirmed the presence of, market integrity risks in market making models which incorporate certain non-public information into pricing formulas used to determine the market maker's quotes.
In its announcement lifting the suspension, ASIC identified a number of controls for responsible entities and market making agents to incorporate into their pre-existing arrangements to maintain "compliant models". Specifically, these entities were asked to ensure that:
- the input for market-making quotes is a reference price or other information that is publicly available;
- internal compliance and supervision arrangements are adequate;
- information barriers are established to ensure decisions to buy or sell units are not made by persons or systems with knowledge of the current portfolio holdings; and
- there are adequate arrangements for identifying and responding to instances of substantial information asymmetry in the market, which may include cessation of market making activities or requesting a trading halt.
In Ashurst's last publication on this topic, we highlighted the inherent difficulties for exchange market operators, responsible entities and market making agents to take practical action in this space given the lack of guidance and clarity around ASIC's suggested controls.
ASIC has since released on 15 April 2020 its updated INFO 230 Exchange traded products Admission guidelines. Here, ASIC maintains and expands upon the measures to manage market integrity risks outlined in its prior media release and provides additional guidance on improving internal market making practices. The key changes are described below.
INFO 230 guidance on managing market integrity risk
Approving issuers with new product applications
New measures will be imposed on licensed exchanges to screen and monitor exchange traded products (ETP) issuers making new product applications. Along with standard requirements such as licensing, exchange market operators must now also consider the financial position and ETP experience of the parent company of the applicant, whether there are information barriers in place with a fund's registry, portfolio calculation, market making and custodian arrangements with internal or third party providers, whether there are systems and controls to adequately manage conflicts, whether appropriate technology systems are in place and whether internal policies, procedures, systems and controls are established where required, particularly relating to information barriers. ASIC's objective in these measures is to ensure that where buy or sell decisions are made within a network where a person or system may have access to non-public information, adequate information barriers are in place to maintain price quotes based on public information only. ASIC also expects that an exchange should discuss any application for a new ETP with unique or new attributes with ASIC before making a decision.
Derivatives
ASIC has clarified that if an issuer intends to use derivatives with a total notional value of 5% of the ETP's NAV, then the exchange must have rules requiring the issuer to notify the market if that limit is exceeded.
Daily and delayed disclosure requirements
ASIC stresses that it is only in limited circumstances that an issuer may disclose full portfolio holdings on a delayed basis, rather than on a daily basis.
ASIC gives two examples of such circumstances:
- where the issuer relies on an internal market making model to protect the issuer's intellectual property, but only to the extent necessary. In any event, full portfolio holdings disclosure must be provided at least quarterly with a delay of no more than two months and an iNAV, which is the issuer's best estimate of the value of the ETP throughout the trading day, must be disseminated as frequently as practicably possible, given the nature of the fund; and
- where the issuer relies on material portfolio information (MPI) disclosure where the issuer has agreed with the market maker the characteristics of the portfolio which will be disclosed to the market daily. In that case, the issuer must disclose the MPI at the start of each trading day, the iNAV at least every 15 seconds throughout the trading day, the tracking performance between the disclosed MPI and the full portfolio on a quarterly basis and full portfolio holdings at least quarterly with a delay of no longer than two months.
Liquidity provisions and market making
ASIC has focused on the need for a licensed exchange to have rules requiring the maintenance of adequate product liquidity in an ETP of the issuer, and to actively monitor the participation in the market of a market maker and its compliance with agreed liquidity parameters for an ETP.
ASIC also requires licensed exchanges to make available average bid-offer spreads for all ETPs on a regular basis.
Internal market making
ASIC has now included in INFO 230 a better explanation of how an internal market making model operates in practice, recognising that an internal market making arrangement may be requested by an ETP issuer where there is a genuine need to protect the ETP's intellectual property, which may consist of, as an example, an unique investment strategy.
When assessing whether an issuer should be allowed to act as a market maker, the exchange market operator should consider whether:
- the issuer and trading participant appointed as execution agent have the appropriate resources, policies, systems and controls necessary to carry out their roles in relation to the internal market making;
- the internal market making arrangement complies with the Corporations Act, including the prohibitions on market manipulation and insider trading, and the duties to act in the best interest of members, manage conflicts of interest and maintain compliant withdrawal provisions – issuers are encouraged to seek legal advice;
- the input for market making quotes is limited to publicly available information, for example, the iNAV, publicly available portfolio holdings disclosures, general market conditions and trading activity. Licensed exchanges are required to verify that effective information barriers have been established at the issuer and the execution agent so that bids and offers are not submitted to the market by persons or systems with knowledge of the current portfolio holdings. If an execution agent has other functions such as transaction hedging, the issuer should not provide information about the fund's portfolio holdings unless appropriate information barriers are in place;
- the iNAV is as accurate and is disseminated as frequently as practicably possible, given the nature of the fund, for example, adjustments and proxies may be used to reflect market movements in assets that are not traded during Australian market hours. The licensed exchange is also required to be satisfied that the issuer has robust processes to maintain the integrity and distribution of the iNAV, which could include its own monitoring and integrity checks or a second iNAV as backup;
- the extent of delayed disclosure is appropriate, given the nature of the fund and only to the extent necessary to protect the intellectual property of the ETP, for example, an ETP with a higher turnover of its portfolio might be expected to disclose more frequently than one with a lower turnover;
- the trading arrangements including the bid-offer spread, minimum order size and time in market each trading day support exiting investors and incoming investors being able to transact at fair and orderly prices;
- risk management processes are robust;
- contracts underpinning the internal market making arrangement are appropriate and facilitate compliance with insider trading requirements; and
- there is adequate disclosure in the Product Disclosure Statement (PDS) about the additional risks of the market making arrangement, including that the ETP will bear the risk of market making activities, and may not always be able to make a market where its duty to act in the best interests of members prevails.
Best practice considerations for exchange market operators and ETP issuers
If an exchange market operator approves an internal market making arrangement, ASIC specifies that as a matter of best practice, the offering of market making incentive schemes is not appropriate, and nor is the holding of treasury stock (defined as units in the ETP that are part of scheme property and held for market making purposes) which internal market makers should be required to cancel before the next trading session. Moreover, where there are substantial information asymmetries in the market, such as where the iNAV no longer accurately reflects the fund's current value, ASIC recommends that issuers inform the market by announcement and cease market making until the information asymmetry is resolved, and notes that requesting a trading halt could be an alternative further step.
Authors: Lisa Simmons, Partner and Edwina Wang, Graduate.
