* Securities lending main regulatory gap
* Physical and synthetic ETFs need level playing field
* Need for greater disclosure and transparency
By Anjuli Davies
LONDON, March 1 (Reuters) - Regulation of exchange-traded funds (ETFS) needs to refocus on physical providers and their practice of lending securities, one of Europe's largest synthetic ETF players said on Thursday, reigniting debate about scrutiny of the $1.5 trillion industry.
Over the past year the synthetic ETF camp, which seeks to replicate the returns of an index tracked by the fund through the use of derivatives, has been chastised by critics concerned about collateral and counterparty risks.
New guidelines proposed in January by the European Securities Markets Authority (ESMA) made no distinction between the two types of ETFs.
But Alain Dubois, Chairman of Societe Generale-owned Lyxor Asset Management, said regulators should turn their attention to rules surrounding lending out securities.
"The main regulatory gap in Europe as regards ETFs is the lack of securities lending regulation," he told journalists at a briefing. "Securities lending has been very much ignored by EU regulation."
ETFs - funds tracking baskets of shares, bonds or commodities that are traded like stocks - have become increasingly popular amongst investors seeking cheap access to indices without having to buy the underlying securities.
So-called physical ETFs take in baskets of the underlying assets tracked by the index, and can enhance revenues by lending out securities for a fee, sometimes to hedge funds betting on a fall in the underlying index through short selling the shares.
In Europe about 40 percent of ETF assets are based on synthetic products, asset manager BlackRock estimates.
Synthetic providers worried that the new ESMA proposals might undermine their products by reclassifying them as "complex", following warnings last year from international watchdogs that the use of derivatives could expose investors to collateral and counterparty risk.
In October, Laurence Fink, CEO of BlackRock, the world's largest asset manager which owns ETF provider iShares, called on U.S. lawmakers to ban synthetic funds from calling themselves exchange-traded funds, arguing they are too "opaque."
"I have never seen any regulator, anywhere in the world that has ever proposed that an ETF index be considered as complex," said Dubois.
Synthetic ETFs subsequently saw outflows of almost $5 billion in 2011, estimates Blackrock.
In the event, ESMA backed away from any draconian rules specific to ETFs, recommending that they should be regulated like all products falling under the Ucits brand.
Ucits -- Undertakings for Collective Investment in Transferable Securities -- is a European regulatory framework that allows funds, like ETFS, to be sold in any European Union country after approval from a single member state.
But physical ETFs have also been criticised for potential counterparty risks from providers engaging in securities lending.
Under ESMA's proposals, ETF providers would be required to disclose if they make use of securities lending, along with specific criteria and disclosure requirements about the quality and diversification of collateral posted.
Dubois says that whilst derivatives have been regulated for a long time under the Ucits framework, securities lending has never been looked at in the same way.
He argues that there is currently less transparency with regard to securities lending because providers are not required to state what fees they earn from any activity and collateral rules are not as strict as for derivatives.
"What we propose is to extend regulation of collateral for derivatives to securities lending," he said.
At the moment synthetic ETFs have to restrict their counterparty exposure to 10 percent, compared with 20 percent for physical ETFs.
Some ETF providers are making strides to ensure the practice is more transparent.
Blackrock's iShares reports its securities lending operations on a daily basis on its website where investors can also see the underlying collateral holdings for each Dublin-domiciled fund. It also states that 40 percent of the revenue earned goes to Blackrock, whilst 60 percent is returned to investors.
In October, the FSB set up a task force which will examine the practice of securities lending including possible measures on margin requirements and haircuts.
Editing by David Cowell