U.S. regulators are advancing rules this week to tighten standards on the ballooning exchange-traded fund industry over the objections of asset managers including BlackRock Inc and Invesco Ltd .
The U.S. Securities and Exchange Commission last year pushed the three main ETF trading venues to draft rules that explicitly require the funds to continually pass a number of tests or face the possibility of being shut down, according to three people with knowledge of the matter and the regulator's filings.
The regulator approved the second of the three proposals in a notice posted on Wednesday and could rule on the third in coming days.
The latest regulatory actions highlight concerns over the potential for trading abuses affecting ETFs, especially those tracking indexes that include assets that are not traded often.
ETF managers including BlackRock and Invesco have sent letters to the SEC arguing that the rules are unnecessary and could force some ETFs to be declared out of compliance or shut down even if the fund itself is not at risk.
The funds have remained one of the fastest growing parts of the market despite concerns over their durability during periods of market stress, for instance after a "flash crash" that pummeled some ETFs on Aug. 24, 2015.
ETFs will be required to meet requirements detailed in 314 pages of exchange filings unless they are granted an exception. For instance, a stock index fund needs to track a benchmark with a minimum number of equities that meet a target market value and trading volume.
"There is a lot of concern about manipulation," said James Simpson, president of ETP Resources LLC, a consulting and data company, and a former American Stock Exchange official, who said the listing standards for ETFs are "problematic" and "outdated."
The SEC backs the rules on the belief they could prevent market rigging, for instance, if an ETF tracks a group of rarely traded stocks whose prices could easily be manipulated, according to a person familiar with the SEC's reasoning and the agency's disclosures on the topic.
A SEC spokeswoman declined to comment.
ETFs have grown at double-digit percentages every year this century, allowing investors to buy commodities such as gold, companies in an entire industry sector or vast swaths of the bond market as easily as trading single stock. Assets in the funds reached a record near-$3.7 trillion in January, according to industry researcher ETFGI.
Rules answering the SEC's concerns drafted by CBOE Holdings Inc's Bats exchange were approved in the notice posted on Wednesday, and a verdict could come soon on a proposal by the Intercontinental Exchange Inc's NYSE Arca exchange, the largest listing venue for ETFs. Nasdaq Inc's revised listing standards have already been approved.
ETFs already have to meet requirements to be listed. But the latest changes specify the funds must meet those standards not just when they launch but as long as they are trading.
The rules also bolster restrictions on trading firms or fund managers for setting the rules determining what stocks are in an index and calculating what the index is worth.
But even one of the exchanges has reservations about the new standards.
"The continuing listing standards in their current proposed form may cause undue costs for fund managers as well as a negative impact for investors, without offering additional protections for the shareholders of the ETF," said Doug Yones, NYSE's head of exchange-traded products, in a statement to Reuters.
Nasdaq and Bats declined to comment.
In its notice, the SEC dismissed industry concerns, writing that the absence of ongoing standards is a "gap" in regulation. The agency, which in 1992 first approved exceptions to U.S. law that allowed ETFs to trade, has been conducting a broad review of the industry.
The rules are aimed at achieving the same goals as the requirements applied before funds start trading, including ensuring the products "are not susceptible to manipulation and maintaining fair and orderly markets," the SEC wrote.
An ETF could violate the rules if it tracks an index holding stocks falling below a certain trading volume, even if the ETF does not hold that stock, ETF managers and an industry group argued. They said it is not clear how the proposals address concerns about market manipulation.
"This would introduce monitoring and oversight for something that we don't control," the funds' indexes, said Chuck Thomas, head of U.S. ETF capital markets at Vanguard Group. He said the impact on Vanguard funds would be minimal.
BlackRock and Invesco declined interview requests.
(Reporting by Trevor Hunnicutt; Editing by Jennifer Ablan and Meredith Mazzilli)