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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.”


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