Dear Chair Letter: Central Bank of Ireland’s ETF trading review

Key insights and actions for fund management companies

On 28 November 2024, the Central Bank of Ireland (CBI) issued a ‘Dear Chair’ letter addressing the primary and secondary market trading arrangements of exchange traded funds (ETFs). The letter focuses on the activities and oversight of authorised participants (APs) and market makers (MMs), outlining several findings and required follow-ups for fund management companies.

Background

The Irish ETF market represents approximately 32% of Irish assets under management (AUM) and 70% of the total EU ETF market. APs and MMs play a crucial role in maintaining market liquidity and the ETF ecosystem. Therefore, firms must conduct thorough due diligence and oversight to protect investors and ensure market integrity.

The Central Bank of Ireland’s (CBI) review aimed to understand the AP and MMs market better, focusing on market players and governance structures. The review consisted of two phases:

• Quantitative assessment: a questionnaire issued to all Irish authorised ETFs to collect data on APs and MMs, their activity levels over 12 months, and ETF listing locations.

• Qualitative assessment: a questionnaire issued to a sample of firms to assess their oversight of APs and contracted market makers (CMMs).

Key findings

Due diligence

The review revealed that only a small number of firms were conducting initial and ongoing due diligence on APs and CMMs. Most firms did not demonstrate appropriate levels of due diligence, with minimal reporting to boards on APs/CMMs activities and performance. Also, many firms lacked formal policies and procedures to assess these entities, and some considered APs and CMMs as outsourced service providers under their outsourcing frameworks.

Limited ongoing monitoring

Significant gaps were identified in the ongoing monitoring of APs and CMMs by most firms. Policies and offering documents should clearly define the roles and management of the oversight process. While some good practices were observed, such as regular reporting on defined metrics like primary market activity, pricing information, trading data, and average spread, depth and presence volumes, there was little evidence of risk monitoring and stress testing for APs/CMMs. This lack of ongoing monitoring limits firms’ understanding of the roles and importance of APs and CMMs.

Lack of board oversight

The review found that boards received minimal reporting on AP and CMM activities, which limited their oversight of the performance and associated risks of these entities. In the event that primary market activity does not function as expected, boards should have appropriate contingency arrangements in place to ensure ETFs continue to operate effectively.

AP and MM concentration

The review highlighted a high concentration of creation and redemption activity among the top five APs, which accounted for 81% of total notional activity. A similar level of concentration was observed in the CMM market, with the top five CMMs being used by 88% of ETFs. While the ETF ecosystem is currently functioning effectively, this concentration poses risks in terms of liquidity, effective arbitrage and market access during disruptions.

Key actions firms can take today

1. Consider IOSCO good practices for ETFs: firms should adopt Measure 4 of the IOSCO good practices for ETFs, which focuses on the due diligence of APs and MMs at onboarding and on an ongoing basis. Firms should also consider the findings of the CBI Dear Chair Letter and apply elements of their outsourcing framework, as per CBI outsourcing guidance, to APs/CMMs.
2. Reporting on activities of APs and CMMs: firms should assess the reporting received on the activities of APs and CMMs to ensure they are aware of the extent to which APs interact with an ETF and the extent to which CMMs’ trading is within the defined parameters of their contracts.
3. Review AP and CMM relationship risks: firms should evaluate the number of APs engaged and review CMM relationships considering the ETF in question. Substitutability risk should be considered, and relevant mitigants implemented. Firms should ensure that arrangements with CMMs are formalised and that CMM contracts have been noted by their boards.

We are here to help you

Our team is ready to assist you in implementing these recommendations and enhancing your oversight and due diligence processes. Contact us to learn more about how we can support your firm in maintaining market integrity and investor protection.