The price of diamonds has always seemed opaque and subject to price manipulation by producing countries or purchasing houses who controlled the flow of diamonds into cutters, polishers and jewelry manufacturers. Regulators have always seen the diamond market as not a suitable investment for the modest investor. The idea of any large transportable financial asset, where $100MM dollars fits within a very small package has always been a large concern to government officials.
Prior to Basel III and Dodd-Frank regulations diamond merchants could easily finance large inventories of diamonds at a high percentage of their market value. The same market value as set by the diamond merchants. However, this is not the case any longer. Today the financing percentage on diamonds are less than half of the haircut percentages prior to the adoption of these regulations. Today stocks and bonds are traded in regulated public markets on exchanges or electronic markets, where trading prices can be collected, published to market participants, and made available to all investors. In the late 1800s and early 1900s the stock market in the U.S. experienced much of the same negative fundamentals that the diamond market is viewed today.
Diamond producers and jewelry consumers will need to change investor perception of the global diamond market and adopt the path of equity markets and their regulators to produce: transparent trade prices, regulated pricing platforms with actionable bid/offer prices, and the distribution of market prices to third party media distributors. The Dow Jones Industrial Average, the first U.S. market index of note, was based upon closing prices of 30 stock prices and it provided a key benchmark for market and investor performance. The prices of the 30 constituent stocks were made public and the index calculation method, the sum of the closing prices divided by 30, disclosed to the marketplace, in order to permit third parties to replicate the index’s value.
The same market infrastructure needs to be achieved for diamonds if they are to become investable. Futures, equity prices, OTC and listed derivatives and all such investor tools need to be captured and derived from real time bid/offer diamond trading prices. The diamonds that makeup the market index value must be representative of the global diamond marketplace seeking to finance diamond stone inventories and migrate diamonds into the financial marketplace.
Diamond merchants will want to foster the creation of diamond depositories and listed financial securities, based on actual bid/offer diamond prices if diamonds are to transition from gemstones to the public markets. But unlike gold, silver or commercial metals that are refined to a specific purity standard, diamonds occur naturally, and therefore their impurities and imperfections become a matter of skilled analysis using defined market diamond rating standards. There is currently an individual gemstone market in Singapore, but its’ focus is based on single stones. Unfortunately, as no two stones are identical and therefore the unit of measure needs to go beyond one stone and must be a measure of some size so that the securitized quantity can be “normalized” into a uniform trading unit for investment. The unit must be large enough to be normalized, but not so large as to prevent market making, the holding of inventory positions, or the ability to secure insurance coverage on the trading unit. By establishing a fixed unit of many diamonds, investors will have a measure of price increase/performance. Without this fixed unit size the issue of performance, on one stone, could be too subjective and the foundation of measure subject to manipulation. The cost of manipulation of $100s of billion in diamond assets from the primary and secondary markets would be beyond the control of any diamond producer, group of diamond producers, or group of jewelry manufacturer. This will be a key fundamental for the diamond market in the years to come.
The creation of diamond depositories, that bring diamond inventory into approved depositories, using a single standard of diamond value assessment, will promote investor confidence currently exhibited by custody depositories where notations of stock positions can be verified and audited annually by public auditors. If diamonds are to become investable assets, regulators will need to help establish a set of custody guidelines that the diamond market must adopt to migrate diamonds from the obscure gemstone market to equity exchanges.
ETFs, backed by physical diamonds supported by in-kind creation and redemption of a diamond Unit can be adopted by the ETF marketplace. The public prices of the diamond constituents and their composite indexes will prove to be the source against which commercial lenders can finance diamond inventory during the cutting and polishing process, at market haircuts established by these new laws. Diamond backed ETFs would provide a regulated means to settle exchange trades, and provide incremental investor income to a non-income generating security. Physical backed natural diamond ETFs would transform this opaque market, provide suitable financing standards for commercial lending, jewelry inventory financing; and investors looking to transition diamond investments into the public investment sector.
The sector will require oversight by regulators. Diamond rating organizations, like the GIA, could provide a single set of diamond rating standards accepted globally. Excellent custodial controls, and participation from the service provider community will build investor confidence in this new asset class. This diamond asset class increases annually in excess of $25 billion dollars in new diamonds inventory mined, cut, polished and used for jewelry and investments. Like gold, the existing inventory of secondary diamonds available to the marketplace far exceeds the annual production that would be available for investment inventory.
As no two stones are identical, the unit of measure needs to go beyond an individual stone and therefore must be a measure of some size so that the securitized quantity can be equalized into a uniform trading unit for investment that represent the diamond market. The unit must be large enough to be equalized, but not so large as to prevent market making, the holding of inventory, or the securing of insurance coverage on the trading unit. By establishing a fixed ETF Unit, investors will have a measure of price increase/performance. Without the fixed unit size the issue of performance could be too subjective and the foundation of measure subject to manipulation. The cost of manipulation of $100s of billion in diamond assets would be beyond the control of any diamond producer, group of diamond producers, or single jewelry manufacturer.
Prior to Dodd-Frank, Basel III and many other government regulations, diamond producers could withhold rough diamonds from the market, but today each diamond producer can’t afford to do so by policy and their inability to finance this inventory under the banking regulations. However, government policy and the diverse source of diamond production has broken the historical consortium control of diamonds into the global diamond market. Additionally, the growth of industrial diamond usage has increased the overall participants in the diamond marketplace. Conflict diamonds are a major concern to the diamond industry and diamond rating companies, like the GIA, can identify conflict diamonds based upon their composition. The greater challenge for the diamond rating companies is the growth of synthetic, man-made, diamonds. The manufactures of these synthetic diamonds can produce diamonds with no impurities, but also diamonds with the same impurities as known diamond ore bodies. Thus there is difficultly in separating synthetic diamonds from the naturally occurring diamonds in the marketplace. The GIA, and other rating services, have developed improved technology to discern these diamonds from natural diamonds and will exclude them from the ETF Unit.
The value of synthetic diamonds is less than natural diamonds and for investor confidence each ETF Diamond Unit created must be certified by an approved rating company, sealed, numbered and held by an authorized diamond custodian. No sealed or numbered ETF Units should be destroyed as it would bring into question all of the diamonds held within the ETF Unit. Any Unit where the seal is broken must be resubmitted to the GIA and recertified prior to being included in any ETF Unit under a new Unit seal. Investor confidence in the chain of custody and rating standards, uniformity of standards, and third party audit of the ETF diamond inventory will be a cornerstone to the success of the diamond ETF.
The most challenging role in the ETF marketplace is the Board of Trustees overseeing the ETF platform. The landscape of exchanges and services providers for ETFs shifts and evolves, often at a pace which leaves Trustees looking for answers.
In over two decades of advising and working with fiduciaries on ETF products, Bob can evaluate and report on the structure and performance of an ETF platform at all levels of the operation – from the granular technical activities to the highest tiers of governance.
Robert Tull & Co. will work with your Board and/or service providers:
Provide fiduciaries with the necessary assurance in overseeing and validating the performance of service providers
Provide a holistic view of the platform’s service providers and identify strengths, opportunities, weaknesses, and threats
Enhance that ETF platform’s strategy for brand distinction, cost compression, and value accretion, including alleviating growing pains and forecasting growth issues
Advise on launch marketing and fundraising plans
Provide expert insight into specific and general matters of interest to the Trustees
A 360 view of the 19b-4 Process
When an issuer of an active equity, fixed income, commodity or new asset type ETF wants to list their ETF on public stock exchange the exchange must first have trading rules established to permit the ETF to trade on the exchange. The exchange must submit a 19b-4 filing with the Trading and Markets Division of the SEC for approval of its trading rules. In the 19b-4 filing, the exchange must justify the new rules to the 34 Act Division staff to support “fair trading markets”, investor protections and adequate surveillance procedures.
Each 19b-4 approval is dependent upon previous Trading and Markets 19b-4 approvals and these ruling are often cited as part of the current 19b-4 request. Each 19b-4 request is accompanied by a public comment period whereby other exchanges and the public can submit letters of support or reasons for rejection of the new rule filing. The issuer will include reference to the listing exchange within their prospectus filing. The prospectus must be approved either by the 33 Act staff, Capital Markets, or 40 Act staff, Investment Management staff. Each exchange’s listing rules reference a specific group of securities that trade on their exchange.
Section 19(b) of the Exchange Act requires each exchange to file with the Commission proposed rules or rule change. Rule 19b-4 requires specific information as stipulated in Form 19b-4. Rule 19b-4 and Form 19b-4 were adopted in 1975 and were significantly amended in 1980 to simplify the ruling process. 19b-4 filings will be rejected by the Commission if all of the required information is not presented in the 19b-4. Each 19b-4 filing is made electronically and viewable to other exchanges and the public on the EDGAR system in order to permit exchanges and the public to make meaningful comments on the proposed rule.
Each 19b-4 approval from the SEC which may be prepared by internal counsel, outside counsel and should be reviewed by the issuer’s counsel prior to submission to the SEC. The document will contain a summary of the prospectus and specific text regarding listing rules and surveillance procedures that the exchange expects to enforce. Recently, the cost of preparing the 19b-4 filing is being shared by the exchange and issuer; unless the rule filing adjustments are minor, such as the issuer’s name. The exchange often receives comments from the Commission, unless the 19b-4 is copied by another exchange who has received identical approval. The exchanges will revise new rule filing to reflect the Commission’s comments as they go through the Trading and Markets approval process. The exchange may also withdrawal its’ 19b-4 filing prior to the SEC rejection in order to preserve its’ right to file an amended version of the rule in the future. These 19b-4 exchange rules may include the annual number of beneficial owners necessary to maintain exchange listing, website data requirements, reporting requirements and any number of conditions the SEC deems necessary for a healthy public market. The 34 Act staff may require the issuer or the exchange to support the continued listing of the ETF on the exchange.
The SEC 19b-4 can take the SEC examiner anywhere from 23 hours to 129 hours to complete the internal review process through the various SEC divisions. Sign-offs of 19b-4 may involve Risk Analytics, Investment Management, Corporate Finance, Capital Market Trends, and Enforcement. The SEC 19b-4 process can take as little as 90 or a maximum of 270 days from the first filing with the SEC 34 Act staff. The current temperament of the sitting Commissioners has an important role in the approval or rejection of the 19b-4 filings. Exchange trading surveillance may be performed by either Finra or the listing exchange, but on-going listing standards are the responsibility of the listing exchange.
The 19b-4 process can be costly and each revision of the 19b-4 can be measured in counsel costs, lead time to the SEC Trading and Markets approval and loss of AUM to the issuer. The 19b-4 will include references to the creation and redemption unit size and unique settlement procedures that are included within the prospectus.
Generic ETF Listing Standards for Index ETFs
The American Stock Exchange was the first exchange to seek generic 19b-4 listing standards for index based ETFs. This would permit the exchange to list index ETF without obtaining 19b-4s on an ETF by ETF basis. This facilitated the growth of ETFs products on the exchange as long as the underlying investment objective was defined as an equity index. Internally, this was referred to as Rule 1100 and this rule was adopted by all the equity exchange in order to permit them to trade Amex ETFs under the UTP process.
As ETFs expanded their benchmark performance beyond tradition equity indexes the exchanges needed to seek additional 19b-4 approvals from the SEC and each exchange needed to expand their rules to incorporate the listing standards for each of the new ETF asset categories. If Trading and Markets see no objection or comments to an exchange’s 19b-4 request, the rules can go into effect automatically.
On July 22nd the NYSE-Arca and BATS received 19b-4 generic standards for disclosed active ETFs, SEC Release No. 34-74433, which should reduce the SEC 19b-4 process for issuers of specific disclosed active ETFs.
Beyond Index ETFs
Since 2004 the variety and scope of ETF approvals sought from the SEC have expanded greatly. This growth expanded beyond passive asset strategies and equities into assets classes that are considered harder to own or manage. This demanded has place significant pressure on the 34 Act staff to approve new 19b-4s.
The exchange employs the most experienced counsel for preparing or reviewing 19b-4 filings as this is one of the main tasks of each exchange functions. Exchange’s in-house counsel will, with their counterpart at the 34 Act staff, when seeking a 19b-4 approval. The General Counsel in the 34 Act Division and her appointees will seek to review, amend, and approve the exchange’s 19b-4 filing until it reaches final approval. During the final round of comments, the 34 Act staff will add the “Discussion and Commission Findings” and “Solicitation of Public Comments.” The public comment period will range between 15 to 21 days after publication in the Federal Register. But recently the 21day public comment period has become the standard for new 19b-4 approvals.
Each 19b-4 filing for an issuer is unique to a specific issuer group of listed ETFs and the exchange. Unlisted Trading Privileges (UTPs) for each non-listing exchange that wants to trade a new ETF can’t do so until the exchange has approved 19b-4 rules on its books. On several occasion we have seen exchanges begin to trade new ETFs without 19b-4 trading rules which may result in regulatory violations. This exchange process is often an effort to capture market order flow from investors on actively traded ETFs. However, on several occasions the 19b-4 rules were adopted after the ETFs were trading on the exchange. This accelerated process is accomplished by taking the listing exchange’s approved 19b-4, copying them and submitting this 19b-4 filing to the SEC for accelerated approval.
The SEC 19b-4 approval process has specific time lines for approval. An exchange may choose to file the initial 19b-4 in “draft”. When filed in draft the SEC clock is deemed not to have started, but it permits the exchange to receive comments on the 19b-4 prior to the formal filing. However, Trading and Markets may also fail to fully review draft filing internally or with other Divisions of the SEC resulting in extended approval process when compared to a formal filing process. The entire process can take as maximum of approximately 270 days to approve a 19b-4, public comment period and receipt of the formal approval letter from the Commission. The ETF issuer has input to the 19b-4 filing process, but ultimately the SEC process is controlled by the exchange.
When an exchange files a 19b-4 on behalf of an issuer, the issuer should confirm that the 19b-4 text reflects the most recent prospectus filings by the issuer as changes are required by either the 40 Act or 33 Act staff. Several of the exchanges consider the 19b-4 to be a proprietary filing between the exchange and the SEC and hence often fail to ask the issuer to view the formal filing. Often the issuer submits the original prospectus draft to the 19b-4 exchange counsel to permit drafting the 19b-4 on behalf of the exchange. However, as the issuer is required to changes the prospectus by either the 40 Act staff or 33 Act staff, they issuer’s counsel may fail to advise the 19b-4 counsel of the changes. This mistake can significantly complicate and extend the overall 19b-4 process due to the resulting inaccuracies. Ultimately both the exchange and the issuer have responsibility for the 19b-4 and its accuracy.
Which a complex prospectus the 19b-4 exchange counsel may not capture key points from the prospectus that must be incorporated in the 19b-4 filing. The issuer review of the 19b-4 filing is key to having an effective 19b-4 approval process. When the issuer choses to hire outside counsel for drafting the 19b-4 it is important for the issuer to hire experienced counsel familiar with the 19b-4 process and the current views of the 34 Act staff. Looking for experienced former SEC 19b-4 staff is often the preferred solution to assisting exchange 19b-4 staff with less experience.
The ETF issuer must meet the initial listing standards of the exchange and annually needs to confirm they are meeting the on-going listing standard as contained within in the rules adopted by the exchange and incorporated by the approved 19b-4 by the Commission. The exchange rules require each listed ETF to maintain a minimum number of beneficial owners and shares outstanding. For instance, an exchange may require a minimum of two creation units or 100,000 shares outstanding in order to list the ETF on the exchange. At the end of the first full trading year the exchange requires a minimum of one outstanding creation unit and 50 beneficial owners. Key to all of the exchange rules is the prohibition of that an ETF can’t be redeem out existence by an Authorized Participant. Any ETF must, like all funds, be closed by the issuer and net proceeds paid to shareholders.
If the issuer is unable to meet the on-going listing standards, the issuer is required to delist the ETF, liquidate the assets, and return the capital back to the shareholders. The liquidation process can take up to 30 days. Recent SEC enforcement has set the continued listing surveillance at the exchanges as a priority and the SEC is passing the responsibility on to the issuer to certify they are meeting the exchange’s listing standards annually.
The exchange’s 19b-4 requires additional responsibilities from issuers regarding website data, the production of the daily Portfolio Composition File to market participants, shares outstanding, premium discount information that compares the daily NAV to the closing price of the ETF. Each exchange requires the issuer to publish the Indicative Intraday Value (“IIV”) or Indicative Optimized Per-share Value (“IOPV”) every 15 seconds during exchange trading hours to the Consolidated Tape for investors. If the ETF issuer is unable to publish the IIV/IOPV prior to the open of trading, the issuer should notify the exchange not to open the ETF from trading until the indicative values can be calculated and published to the Consolidated Tape for distribution to the market and data community.
The SEC process starts when the exchange files the 19b-4 in draft or formally with the 34 Act staff. The filing is with the 34 Act Division of the SEC. In addition to the 34 Act staff, the filing is sent to Capital Market Trends and Risk Analysis.
The staff in these 3 area will determine if the proposed security present new exchange needs or risk; and what the impact might be on current margin regulations. The staff may also consider the appropriateness of the security for stock loan and the collateral percentage changes that the market will need to remain orderly.
As stated before the 19b-4 process can take as little as 90 days or as long as 270 days once the 19b-4 has been officially filed. Current ETFs have never received approval from the SEC as the issuer was told during the draft filing stage that the ETF, because of its attributes, would not be approved for trading.
This rejection notice result in two set of SEC correspondence one to the issue from either the Capital Markets staff of the 33 Act Division or the 40 Act staff in investment management. The second notice would come from the 34 Act staff in trading and markets and would be sent to the filing exchange of the 19b-4 request. One such example of this are 3 levered ETFs requests that were made after the multiple lawsuits against ProShares and other levered ETFs in 2005 and 2006 when investors held levered ETFs in their portfolio for longer than one day. Even though the issuers successfully defended their court cases on levered ETFs the SEC determined they could not be used properly by the public. Other examples of Trading and Market rejections have occurred but would be seen in the marketplace as the ETF issuer withdrawing the filing from Investment Management or Capital Markets.
One point to keep in mind with all 34 Act reviews is that the SEC will not permit a listed ETF to do indirectly any investment technique that can’t be done directly under the current regulations. This simple rule for ETF issuers to remember is that they can’t circumvent current SEC restrictions, and the issuers should remember this before they commit capital to build the product. Many potential ETF issuers have spent millions in legal fees looking to get around regulations that the SEC has said will not be exempted.
A new ETF, index, or market. A new ETF infrastructure or a new approach for an existing ETF platform. A new asset raise goal. Capitalizing on every new opportunity requires the right plan.
In over 20 years of bringing new ETF products to market, we successfully managed the design and development of over 300 exchange-traded products, both in the U.S. and internationally. Our unique expertise enables us to minimize time launch and to implement the right plan to elevate existing fund platforms to new heights.
Project management for New ETF Opportunities focuses the efforts of the key partners to ensure a coordinated and timely success. The project management plan will forecast the issues which could disrupt the timeline and take measures to ensure the project remains on schedule.
Robert Tull & Co. will partner with you to:
Collaborate on the formation of the fund business or restructuring plan
Develop and manage launch timelines and budget
Coordinate the key vendors and service providers: legal, tax, accounting, fund administration, underwriters, the exchange, and the regulators
Advise on launch marketing and fundraising plans
Post-launch or post-restructure evaluation
Examples of successful New ETF Opportunity project management engagements
Coordinated efforts of issuer and legal counsel to obtain regulatory approval and launch of first multi-asset long/short set of products traded on the NYSE Arca exchange.
Directed product and operational design, regulatory approval, and launch for patented unique long/short trust structured ETFs.
Collaborated with global investment managers to design, support, and launch first-to-market ETFs.
Developed and implemented the business plan for non-U.S. investment manager to establish and launch U.S. domiciled ETF platform, which included restructuring non-U.S. middle office support for the platform.
Advised European investment manager throughout implementation of the business plan to structure and launch U.S. domiciled ETF platform.
Developed and coordinated project plans for multiple global custodians and fund administrators to expand existing fund service infrastructure and processes to service ETFs.
Provided integrated collaboration with European capital markets board to draft and adopt domestic ETF regulations, including advising exchange and issuer on structuring, supporting, and processing domestic ETFs.
Formulated detailed work-flow plan for Asian stock exchange to develop domestic ETF market.
Advised Asian stock exchange and central depository to establishing processing logic and procedures to support in-kind creation and redemption process for first domestic ETF.
Worked with global investment manager to design and launch first REIT based ETF in the U.S. market.
Collaborated with global commodity organizaiton in the design of the first gold ETF in the U.S. market.
RTCO is experienced in NextShares and their operational needs.