When a member exchanges TRACE-eligible securities for a Creation Unit of an exchange-traded fund ("ETF"), the transfer of TRACE-eligible securities is not required to be reported to TRACE. Similarly, when a member redeems a Creation Unit of an ETF and receives TRACE-eligible securities, their acquisition is not required to be reported to TRACE.


March 18, 2003

 

Alice Yau
Vice President, Compliance
J.P. Morgan Securities, Inc.
270 Park Avenue
41st Floor
NY, NY 10017-2070

 

Dear Ms. Yau:

 

I am responding to your e-mail inquiry dated September 5, 2002, your submission of additional information on September 30, 2002, and our subsequent conversations on January 8, and January 13, 2003. You inquire whether J.P. Morgan Securities, Inc. (“JP Morgan Securities”), a registered broker-dealer and an NASD member, is required to report the disposition or the receipt of certain debt securities to the Trade Reporting and Compliance Engine (“TRACE”) system when the disposition or receipt of such debt securities by JP Morgan Securities occurs in connection with the acquisition or redemption of a Creation Unit, as defined below, that represents an interest in an exchange-traded fund (“ETF”).

 

Background

 

Shares of an ETF are issued by an investment company. Shares represent an ownership interest in a specified fund and are assigned a unique CUSIP number and an exchange trading symbol. In the example you provided, the ETF shares are listed and traded on the American Stock Exchange, Inc. (“AMEX”). JP Morgan Securities purchases and sells shares of various ETFs in the secondary market. Some of the ETFs invest solely in debt securities, including some that invest in corporate debt securities that are “TRACE-eligible securities” as defined in Rule 6210(a) of the TRACE Rules.

 

In the example you provided, the ETF invests in corporate debt securities and may issue fund shares in a large quantity, such as a block of such shares (a “Creation Unit”) to certain market participants that execute a participation agreement (e.g., market makers, large investors, and institutions).1 In addition, through secondary market purchases, you state that a purchaser of such fund shares may acquire a sufficient number of the shares to equal a Creation Unit. You indicate that the holder of a Creation Unit may dispose of the Creation Unit by requesting that the investment company redeem it. In the example you provided, when the holder redeems the Creation Unit, the holder receives a portfolio of bonds held by the fund (and, in some cases, a specified amount of cash). You ask if the transfer of debt securities from a broker-dealer, such as JP Morgan Securities, to the fund, upon the creation of a Creation Unit, is required to be reported by the broker-dealer to TRACE. Similarly, you ask if the transfer of debt securities out of the fund’s portfolio to a broker-dealer that holds a Creation Unit, such as JP Morgan Securities, upon the redemption of a Creation Unit, is required to be reported to TRACE.

 

Discussion

 

Rule 6230(b) requires a member that is a party to a transaction involving a TRACE-eligible security to report the transaction to NASD. It is the view of the staff that the disposition or acquisition of TRACE-eligible debt securities by a registered broker-dealer and NASD member in order to acquire or redeem a Creation Unit of an ETF is not a transaction that is required to be reported under TRACE for the reasons below.

 

In 1992, the Securities and Exchange Commission (“SEC”) addressed the issue of whether acquisitions or redemptions of Creation Units should be reported to the tape when it reviewed and approved the first application of a national securities exchange to list and trade shares of an ETF.2 Specifically, when the SEC approved the trading of “SPDRs,“ which are shares of a unit investment trust (“Trust”) that hold a portfolio of securities linked to the S&P 500 Composite Stock Index, the SEC concluded that the transfer of stock to acquire a Creation Unit or the acquisition of stock when redeeming a Creation Unit was not subject to reporting to the tape by any party.3 In this regard, NASD staff does not require members to report equity securities to NASD’s Automated Confirmation Transaction Service (“ACT”) when such securities are acquired or disposed of by the member to redeem or acquire a Creation Unit representing an interest in an ETF holding a portfolio of equity securities, such as the SPDRs.

 

It is the staff’s view that the ETF described in your letter is similar in structure to the ETF that is the subject of the SEC’s December 1992 order, except that the Trust would hold a portfolio of corporate debt securities rather than equity securities. Accordingly, it is the staff’s position that the transfer of debt securities to acquire or redeem a Creation Unit as described in your letter is not required to be reported to TRACE.

 

.I hope this letter is responsive to your inquiry. Please note that the opinions expressed in this letter are staff opinions only and have not been reviewed or endorsed by the Board of NASD. This letter responds only to the issues you have raised based on the facts as you have described them in your communications, and does not necessarily address any other rule or interpretation of NASD or all the possible regulatory and legal issues involved.

 

Very truly yours,

 

 

 

Sharon K. Zackula

 

cc: Cathleen Shine, Senior Vice President and District Director, District 10

1 When a broker-dealer such as JP Morgan Securities seeks to be issued Creation Units, the broker-dealer deposits into the applicable ETF a portfolio of bonds that closely approximate the holdings of the fund (and, in some cases, a specified amount of cash) in exchange for a specified number of Creation Units.

 

2 See Exchange Act Release No. 31591 (Dec. 11, 1992), 57 FR 60253 (Dec. 18, 1992).

 

3 Id. at footnote 19.