DEEP LOOK | Exchange-traded funds, ETFs, have become increasingly popular with investors attracted by diversification, liquidity and cost-effectiveness. At an operational level, this has increased the pressure on fund sponsors to address issues relating to settlement in a challenging regulatory environment. Paul Golden speaks with the experts.
ETFs have appeal for investors as they can access a wide range of asset classes in one place and choose a fund that matches their risk appetite. Most ETFs are passive products (the sole task of the fund manager is to replicate index performance), so the ETF investors don’t pay a premium for active fund management as they would with funds that have the objective of outperforming an index or benchmark.
ETF shares, too, can be created or liquidated
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When end investors trade an ETF share over an exchange they are interacting with other investors – the secondary market. That share is essentially handled in the same way as a standard equity share, going through the same clearing and settlement process. The transaction does not directly impact the ETF, i.e. it does not trigger a buy or sell of the underlying assets. This is one of the main differences between ETFs and mutual funds, where investors buy and sell units directly in the fund, triggering a net creation or liquidation of underlying assets on a daily basis at a set valuation point.
However, this does not mean that the ETF’s holdings (and number of units) are set once and for all. As well as regular rebalancing of underlying holdings, ETFs also have a mechanism for creating and redeeming shares according to market supply and demand, then generating separate transactions in the underlying assets – the primary market.
This article reflects how this involves not only the ETF sponsor, who has issued it, but also ‘authorised participants’, who play a key role in managing the price of each ETF and its market liquidity.
There are thousands of funds to choose from and because they are traded on an exchange, they can be used to make tactical as well as long-term allocations.
Data on Q3 2024 global ETF flows published by Morningstar shows that year-to-date flows stood at $947 billion as of 30 September. The $392 billion allocated to ETFs in the third quarter of this year was the highest amount ever recorded in a single three-month period, pushing total ETF assets to a record $13.4 trillion.
From a post-trade perspective, settling transactions that involve creation or redemption of ETF shares is more laborious than settling single name securities because the trade fulfilment requires the sponsor to buy or sell each individual component of the ETF in order to settle the otherwise simple first step of the trade.
Failure costs
Settlement failures have increased over the last couple of years following the imposition of the settlement discipline regime or SDR, which came into force in February 2022 as part of the Central Securities Depositories Regulation (CSDR).
Despite the introduction of cash penalties with the intentions of discouraging settlement fails, Danielle Farley, passive investment analyst at Hargreaves Lansdown, explains that the cost of these penalties is simply passed on to the end investor through wider spreads.
The success of ETFs is dependent on the support of authorised participants in creating and redeeming these funds in the primary markets to provide liquidity in the secondary market. In Europe, these authorised participants buy and sell shares across numerous exchanges, working to manage their inventory such that they do not hold (and need to hedge) long positions.
“This activity has certainly become easier as European ETF issuers have moved to an international central securities depository model from a fragmented CSD model in recent years,” says David McGuinness, product director at Calastone. “However, authorised participants still need to balance the cost of creating against the cost of failing and in many instances it is more cost effective for them to fail and pass on the associated fines to the end investor.”
According to Brieuc Louchard, head of ETF capital markets at AXA Investment Management, many investors will take post-trade factors such as the ability to settle in due time or flexibility for shares transfer into consideration when selecting an ETF.
Unsettling move
Inevitably, ETFs have been impacted by the difference in settlement times between Europe and the US following the latter’s move to T+1.
When an authorised participant needs to create on an ETF that has holdings that settle on a T+1 basis it can either pay the funding cost to settle the T+1 securities or wait a day to create the ETFs on a short-settled T+1 basis, paying the additional hedging costs. Ultimately, both costs will be passed on to the end investor through the spread and/or a premium to fair value.
Louchard observes that many ETF issuers changed the settlement cycle for their fund on the primary market with the majority of European ETFs with 100% US underlying moving to a T+1 creation/redemption settlement cycle.
“Several funds with a large majority of US underlying also moved to T+1 for creation but remained T+2 for redemption,” he says. “This asymmetric settlement cycle is there to avoid pushing the ETF into an overdraft situation.”
Patterns have also emerged around trading activity on certain days. With the shorter settlement cycle in US trading, L&G Asset Management has observed that trading activity on Thursdays has been impacted due to the funding requirements brokers face.
“The misalignment between the US and other markets forces brokers to fund their position over the weekend, which can lead to wider spreads on Thursdays,” says the firm’s ETF capital markets specialist, Erik Bartolucci.
“For ETFs with global exposure affected by the underlying settlement misalignment, brokers have begun pricing their services differently depending on whether the order requires T+1 or T+2 settlement,” he adds.
Pressure rises
Northern Trust was concerned about ETF trading and unexpected stresses and strains in the market after T+1 implementation and expected that some of those pressure points would only manifest after weeks or months says Gerard Walsh, global head of client solutions, banking and markets at the Chicago-based investment manager.
“Based on data and reports from market participants, the strains are starting to show,” he adds. “Issues arise when the ETF is listed on a T+1 market and the component parts are listed on non-T+1 or ‘off-cycle’ exchanges as sponsors need to carry enough liquidity to fund T+1 settlement while waiting for the off-cycle proceeds to be delivered to them.”
Walsh recommends investors concerned about the impact of unexpected costs on performance to keep a close eye on total fund costs.
While acknowledging that settlement quality could be expected to improve once Europe moves to T+1, ESMA’s securities and markets stakeholder group recently observed that the ETF market largely relies on the intervention of market makers, some of whom can ask for the creation or redemption of ETF shares to the issuer when they are short or long on such shares.
This creation/redemption process may depend on the ability to transact on securities located in different time zones and as many ETFs are issued with different CSDs, authorised participants have to manage their positions across multiple CSDs using transfers between the depositories.
Without additional measures to improve settlement efficiency, the group suggests that moving to T+1 could make the process more difficult to operate.
Work needed
“Once the ETF market aligns its primary and secondary settlement cycles across Europe, we should see a marked improvement in settlement quality, reduced spreads and enhanced market efficiency,” says James Pike, interim CEO of Taskize. “But getting there will require significant coordination among market players to avoid disruption during the transition and secure improvements in inventory management on cross-border settlement.”
Another issue impacting the ETF market is the fragmentation of post-trade service provision. According to Hargreaves Lansdown’s Danielle Farley, this fragmentation can lead to operational inefficiencies due to lack of standardisation.
“Different systems and processes among providers can complicate and slow down the settlement process, particularly for cross-border trades,” he explains. “They can also drive up operational and regulatory costs, leading to wider spreads.”
Most European fund servicers have an ETF servicing capability. However, service levels vary considerably from provider to provider as each servicer has developed its own in-house technology, resulting in a lack of standardisation of process, file formats, and timing.
“Authorised participants support multiple issuers and as such, interact with their chosen service providers in different ways – adding further complexity to their role,” says David McGuinness of Calastone. “As new ETF issuers come to market with complex products, this lack of standardisation across fragmented, legacy technology will only make it more challenging for service providers and authorised participants to support the growth of the ETF market.”
Fragmentation is creating more complexity, potential realignment and risk of late/fail trades, adds AXA’s Brieuc Louchard. “We often compare the European ETF market to the US – which is much bigger – and one of the key success factors there is the efficiency of the single central securities depository and central counterparty clearing house in the shape of DTCC,” he says.
Erik Bartolucci takes a more positive view though, suggesting that with the European ETF market being predominantly serviced by a small number of major players who between them service around three-quarters of total assets under management, fragmentation of post-trade service providers might foster healthy competition, leading to improved service and greater innovation.
Taking stock
From an investor perspective, post-trade evaluations can help improve understanding of the market impact of each trade and determine whether the chosen execution strategy delivered on its objective.
“Our global trading desks find them very useful and, in our view, it is how trading desks all over the world demonstrate value to the portfolio managers/dealers who send orders to them,” says Northern Trust’s Gerard Walsh. “Best execution and trade cost analysis is becoming increasingly sophisticated as data science (and AI-based tools) are applied to measuring execution performance versus benchmarks.”
Given that investors have a duty – often regulatory – to demonstrate best execution, data science techniques are useful when interrogating the huge volume of trade-related data generated by a large global desk.
“In our experience, such analysis leads to mutually beneficial conversations between investors and trading experts as each party looks for more efficient ways to trade,” adds Walsh.
Bartolucci agrees that post-trade evaluations have evolved significantly on the back of the emergence of new and independent data analytics providers and that investors are increasingly recognising the importance of these metrics.
