Since first entering the market in 1993, exchange-traded fund providers have had to ask government regulators for special exemptions to list on U.S. stock and bond exchanges.

The process can take years to complete and cost ETF firms millions of dollars to fill out the proper forms. Fund sponsors say it's tedious and doesn't really get to the heart of the most important issues facing ETF investors. 

Consumer advocates counter that any relaxing of such regulations could open the floodgates for poorly constructed and risky funds.

The debate is about to move to center stage. At the Securities and Exchange Commission's open meeting on March 4, a proposal was made to change two key rules. 

A two-month public comment period is now underway. After that, the SEC could officially adopt the rules, which many say would represent the most significant regulatory changes since ETFs were introduced 15 years ago.

But industry observers are warning that a host of issues, including those that are more procedural in nature to broader concerns about the impact on market pricing, could delay implementation of any reforms for quite some time.

Now, even those most optimistic about prospects for change say they doubt the SEC's proposals will pass public inspection intact. That's even though supporters say critics are missing an important fundamental issue central to the reforms.

Transparency Is Key

"The SEC's goal is not to decide on whether a particular ETF is a good investment or a bad one. In the U.S., that role traditionally falls to the market," said Stacy Fuller, an attorney specializing in investment company regulatory issues at K & L Gates, a Washington, D.C.-based law firm.

"The SEC's role has always been to make sure that ETFs are put on the market in a transparent manner," she added.

The current filing process for ETFs is overly redundant and wasteful in terms of costs and use of SEC resources, agrees Kathleen Moriarty, a partner at Katten Muchin Rosenman.

The New York-based lawyer was involved in creation of the first ETF, the SPDR Trust (AMEX: SPY) and consults fund providers as well as government agencies around the world on ETF regulatory issues.

Moriarty says that after 15 years, it only makes sense to streamline the system. "The ETF sponsors don't want to take so much time putting together these 100-page applications that are pretty cut-and-dried," she said. "And on the SEC side, the staff doesn't want to take up their time reading these applications over and over that say the same basic things."

A similar situation took place years ago with money market funds. Those seemingly staid investment products initially weren't permitted under the Investment Company Act of 1940. "So money market funds were forced to go through a whole huge application process like ETFs do today," said Moriarty. "The SEC finally got to a point where they'd seen enough of these types of filings to codify the exemption process."

That's exactly what is happening with ETFs now, she adds. "They've seen enough similarities among applications over the past 15 years to update and streamline the process," said Moriarty.

Trickier Than It Seems

The real question she sees is whether a new process should be extended to active, nonindex-based ETFs. "A lot of people are going to be asking if the SEC has the experience with active ETFs to know if the portfolio transparency issue is going to be sufficiently resolved," said Moriarty.

And that might not be as easy as it first appears.

That debate could very well hold up implementation of any new rules, says Moriarty. "After the first round of comments, the SEC could just decide to cut out active ETFs," she said. "They could narrow the scope of the rules to just index ETFs."

Fuller also doesn't expect the rules to be adopted exactly as proposed. She worked for nearly six years on the SEC staff before leaving last spring. Much of that time was related to regulation of ETFs. "Each of the new rules has some meat of its own," Fuller said. "And the commissioners seem very open to changes."

One of those, the 6c-11 rule, seeks to liberalize the regulatory regime for fully transparent ETFs. That means portfolios made public on a daily basis are covered by the reforms.

The other rule, 12d1-4, is designed to make it easier for hedge funds and mutual funds to invest in ETFs, Fuller says. "It could create additional competition between ETFs and mutual funds," she said.

Fuller says the new rules proposals speed ETFs to market. "But they shouldn't have a substantive effect on the types of ETFs that would've been permitted under the old orders," Fuller said.

If those rules and related amendments are adopted, "ETFs will just have to file a registration statement to launch," she added.

But some analysts and advisors say they're concerned that a debate over timing and other procedural issues will blur what regulators really need to address.

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