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Shortened Settlement Threatens ETF Liquidity
By Paul Amery and Joanne Christie | 08 March, 2012


Like it or not, market makers on Europe’s stock markets may soon be forced to settle all of their trades within a two-day period or pay a fine, putting the existing business models of the region’s ETF providers under significant pressure and potentially raising dealing costs, according to some traders.

Yesterday the European Commission released a proposal aimed at harmonising Europe’s fragmented network of central securities depositories (CSDs). Key aspects of the plan include a mandatory settlement period of two days for all 30 of the CSDs across Europe, and the imposition of penalties for trades that fail to meet this goal.

Currently, securities settlement in Europe takes place on a trade date plus two days (T+2) or three days (T+3) cycle, depending on the exchange, clearing and settlement systems involved. If settlement takes place later than planned, fines can be imposed on the party responsible for the late delivery of securities.

However, under existing rules the point in time at which fines become payable and the scale of the potential sanctions vary widely from one European market to another.

In Euroclear’s CREST system, the central securities depository for the UK and Ireland, notification of a failed trade is only obligatory after 30 days have passed from the intended settlement date, while in Germany notification of a delay occurs four days after intended settlement. Penalties in Germany can be severe—on day five a party failing to deliver shares is liable to be “bought in”, suffering a financial penalty that can exceed the value of the initial trade.

Although public data on the scale of delayed settlements in European ETF transactions is not available, one study conducted last year pointed to a higher level of “fails” in London, where settlement rules are currently the laxest, than in other European securities markets. According to an anonymous trader, quoted in an article last year, at times over half of ETF transactions in London may fail to settle on schedule.

Inconsistent practices in European ETF-related settlement have also been blamed as a contributory factor in the UBS fraud of 2011. The alleged UBS rogue trader, Kweku Adoboli, is said to have created “forward-settling” ETF trades in his bank’s systems as the main means of disguising fictitious transactions.

The Commission’s proposal would seem somewhat overdue. In January 2011, it put out a consultation on the issue, indicating that a legislative proposal would follow in the summer of that year. However, it was not until yesterday that the proposal was forthcoming, although rumours of its intention to impose a two-day cycle have been circulating since November.

Along with a desire to improve the stability of the European securities market, the EC has also argued that the regulations will create more competition between CSDs and, ultimately, lead to lower prices for cross-border transactions and lower costs for investors along the whole post-trading chain.

However, some in the ETF industry said the proposed new measure would have the opposite effect. Bart Lijnse, managing director at Dutch market maker Nyenburgh, said a shortening of settlement cycles would raise investors’ costs. “Implementing this measure would force market makers to increase their inventories, leading to higher costs, wider spreads, and fewer market makers,” said Lijnse.

Bastian Ohta, former director of market making at Unicredit in London, explained why ETF market makers might face challenges under a T+2 settlement cycle in an interview with last year.

“ETF issuers set a daily cut-off point for primary market orders—that is, orders to create or redeem their funds,” said Ohta. “The cut-off point is often 2.30pm or 3pm. So if a client places a trade with us later in the afternoon than that, the earliest we can go to the primary market is the next day. That’s already T+1 with respect to the original client trade. If the ETF tracks global equities, the valuation point for that primary market order may be the end of the following day, meaning we get the ETF shares only the day after that, i.e. T+3. If we have an obligation to settle with the original client on a T+2 basis in the secondary market, as is the case with trades on the German stock exchange, we face a potential mismatch.”


Laurent Kssis, partner at Bluefin Europe, an ETF market-making and proprietary trading firm, also pointed to the significance for Europe’s ETF business of a potential change in the continent’s securities settlement procedures, and the possible negative impact on liquidity that might result.

“Market makers will have to rethink, if not change their creation/redemption models completely if ETFs are to be included in these new rules,” said Kssis.

“The change could have dramatic implications for ETFs’ liquidity providers, since a fine could potentially outstrip the profits from ETF trading,” Kssis added.

Kssis added that funds whose creation and redemption mechanisms are in specie, that is, whose ETF units are exchanged for the bonds and shares in the underlying index, rather than for cash, may face more frequent operational difficulties if settlement cycles are reduced.

He gave the example of an ETF creation that he had witnessed in iShares' JP Morgan US dollar Emerging Markets Bond fund (LSE: IEMB). Trades in the underlying bonds take place on a T+3 settlement cycle and his firm had bought the 74 emerging market bonds in the creation basket from a range of banks and agreed to exchange them for ETF units with iShares, also on a T+3 basis.  When one of the banks failed to deliver a bond that was needed to form part of the ETF creation basket, the whole exchange failed and it took over a week for the trade to settle.  In such circumstances, said Kssis, the market maker undertaking the exchange of securities for ETFs could be hit with a fine under a tightened post-trade timetable, even though the failed settlement was the result of a chain and beyond its individual control.

Eamonn Ryan, director of product management at Euroclear, also pointed out that any reduction of the settlement cycle for ETFs and equities could be more of an issue for physically backed ETFs, many of which use the in specie creation mechanism, and which will have to purchase the shares underlying the index within a shorter time frame, while synthetic ETFs, which tend to use cash creations and are therefore not so directly dependent on the settlement cycle of the underlying securities, may be less affected. In general, though, said Ryan, the EC’s proposed changes should be welcomed.

“Reducing the settlement cycle is a very good thing because it reduces risk,” said Ryan. “There is less time for the ETF to change in value vis-a-vis the price that was agreed to be paid. That should save money for the market makers and brokers involved, since they should end up paying less in margin to central counterparties (CCPs) to collateralise counterparty risk. Reducing the settlement cycle to T+2 brings it into line with the cycle for FX spot transactions, which I believe must be a good thing,” added Ryan.

Robert Rushe, head of ETF servicing at State Street Global Servicing in Ireland, said that business practices in Europe’s ETF market may need to change if settlement cycles are shortened across the region.

“I would suspect that the window between the dealing cut-off point in the ETF and the closing time in the underlying market that currently causes the issue would be closed if there was a suggestion that the ETFs’ authorised participants (APs) could be getting penalties,” said Rushe.

The introduction of stricter settlement rules for ETF trading in Europe could also kick-start the securities lending market for such funds, suggested Rushe.

The proposal will now go before the European Parliament for negotiation and approval.


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