With the impending transition to a T+1 settlement cycle in the United States, scheduled for May 2024, market participants are bracing for transformative changes. Some markets will be taking the leap together with US, notably Canada and Mexico. Other jurisdictions, particularly the UK and EU, are carefully considering when and how to follow suit in a synchronised manner. Decisions will depend on factors such as market dynamics, regulatory considerations, and the desire to enhance efficiency and risk management in the financial ecosystem.
The challenges of T+1 for ETFs
Timing is everything
Timing is everything and in the dynamic landscape of financial markets, the concept of settlement acceleration has emerged as a pivotal theme. Three things seem certain, even if timings are not. Firstly, North America will move to a T+1 settlement regime in May 2024. Secondly, market consensus is that Europe will, at some point, follow suit. Finally, until the markets converge once more, there will be challenges for timing mismatches for participants who operate in divergent markets. As we accelerate towards this transition how do we ensure the aims of boosting efficiency, and diminishing counterparty risk, don’t simply transition into operational risk as back-offices struggle to overcome the challenges it brings?
Not every market may choose to align with the move to shorter settlement cycles. According to EFAMA, T+2 might be an optimal settlement cycle for UCITS held by non-EU investors in time zones where a shorter settlement cycle would increase errors, impede the fund administration process and make the daily Net Asset Value (NAV) calculation difficult. Indeed, for some countries in regions like APAC, LATAM and the Middle East, the current 48-hour cycle compensates for the fact that when Asia trades, Europe is closed, with only a short overlap in the morning in Europe.
One inherent feature of an ETF is that the ETF shares will often be listed on multiple stock exchanges in different countries, time zones, and now different settlement cycles. Essentially, the same ETF is available for trading on various global exchanges. Multi-listing provides global exposure for ETFs but introduces complexities and challenges. Market Markers (MM) play a crucial role in maintaining price alignment across exchanges. ETF issuers can choose to settle their ETF shares in the local market of each stock exchange where listing occurs, or they can choose to centralise the settlement of their multi-listed ETFs through Euroclear’s ICSD model. The choice will typically depend on the desire to ease the operational flows of cross-border realignment while maximising international investor reach via the ICSD, or using local markets when focused on domestic investors only. The increased complexity, potential additional funding requirements and the costs of settlement cycle mismatches on exchanges and between markets, risk ultimately being passed on to investors via their impact on spreads.
A major challenge of T+1 will be its impact on timings on ETF creation and redemptions workflows. The creation and redemption process for ETF shares involves APs delivering or receiving underlying securities to/from the ETF issuer as required. T+1 settlement impacts this process, requiring APs to act swiftly to create or redeem ETF units. The settlement cycle of the ETF shares will remain at T+2 within the EU while the cycle of the underlying US securities will move to T+1 potentially leading to increased funding requirements as a result of the one-day mismatch. Today the FX settlement cycle is predominantly on T+2 whilst the time window to do FX in the US on T+1 and settle via CLS will become very limited.
For fully US-exposed ETFs, the consensus amongst ETF issuers seems to be that both creations and redemptions in the EU will be moved to T+1 cycle where appropriate. Hence, misalignment will relate to secondary market activity within the EU with a T+2 settlement cycle, for which there is a dependency with timely creation/redemption in US on T+1 settlement cycle.
Unlike mutual funds, ETFs trade on stock exchanges and have an active secondary market. APs engage in arbitrage with MM to keep ETF market prices in line with the NAV of the fund’s underlying value. When an ETF’s market price diverges significantly from its NAV, APs create or redeem ETF shares. This process ensures that ETF prices remain close to the underlying asset value. The secondary market for ETFs is highly liquid, allowing investors to enter or exit positions swiftly.
Misaligned primary/secondary settlement cycles will generate both a financing requirement and, depending on the case, an increase in settlement fail rates for UCITS ETFs. These two factors have a cost that is expected to be passed on to the end investor and therefore create a less competitive price on the secondary market vis-à-vis the current status quo, as well as vis-à-vis US providers of ETFs where basket and ETF settlement cycles are aligned.
Settlement failure on ETFs could be driven by different factors.
- Structural problems of inventory management by the MM / AP due to several listing venues (i.e. multiple exchanges) places
- Illiquid products where settlement cycles are not aligned
- Operational issues
A shorter settlement cycle will leave less time to resolve the above issues, hence we can expect it to become more relevant for market participants to know where their ETFs are (i.e. at domestic or international CSD) and maintain a buffer inventory and/or to have access to an additional stock of lendable ETFs for lending and borrowing purposes.
ETFs have witnessed remarkable growth globally, and this trend is expected to continue. EU-listed ETFs need to embrace market changes to remain competitive and to continue to offer attractive investment opportunities globally. The EU competes with other financial centers (such as the US) for ETF listings and consequently a harmonised approach to settlement cycles ensures a level playing field and maintains competitiveness.
The UCITS is a hugely successful EU framework for investment funds, being widely distributed globally due to their regulatory passporting. The intermediary structure – where fund managers work with custodians, transfer agents and other service providers – has been instrumental in UCITS’ success as it facilitated ETF distribution and broad access to investors across borders.
Overall managing the transition to T+1 settlement while safeguarding existing competitive advantages is crucial for EU-listed ETFs. Intermediaries must manage the loss of this extra day for processing, reconciliation and risk management. Tools and support are crucial to ensure smooth operations and minimize disruptions.
The ICSD model for ETFs reduces the fragmentation at settlement level. The market makers and the authorized participants can manage their ETF inventory from one centralised place: Euroclear Bank. This results in a higher settlement efficiency rate, compared to ETFs in the fragmented, domestic structure. The multi-currency settlement ability of Euroclear Bank is a real asset to provide access to different ETF products. Euroclear Bank facilitates the global distribution of ETFs via efficient cross listing flows from Europe to Israel, to Asia (Hong Kong and Singapore) and Latin America (Mexico). We are committed to investing to support market stability, by ensuring the efficiency of markets and actively enabling the reduction of risk. Our financial strength and decades of experience mean we have the skills and experience to ensure the transition to T+1 is expertly managed within our ecosystem, in turn minimising the risk of disruption to your business flows.
ETFs held in Euroclear Bank can be used as collateral in Euroclear’s Triparty Collateral management service. Triparty can be used to cover the exposure from a range of transactions, going from repo to securities lending, to covering non-cleared OTCD margining obligations. Euroclear, as a triparty agent, handles the selection, valuation and settlement of collateral securities, delivering operational and risk management benefits to both collateral givers and collateral takers. The transition to T+1 and the timing mismatches between international markets will bring challenges, but our efficient and robust triparty service will continue to deliver collateral on time.
Settling ETFs on the Euroclear Bank platform also allows you to benefit from the automated Securities Lending and Borrowing program. This tried-and-tested service is an integral part of the infrastructure and has supported settlement on the platform for many decades. As a borrower you can increase your settlement efficiency and generate liquidity by automatically borrowing the missing balance for a failing delivery. The challenges of T+1 may lead to a greater risk of fails in the short term, this service ensures you have a solution should you need it. As a lender you can boost the return on your portfolio with minimal operational impact and with the comfort of Euroclear Bank’s AA rated guarantee that securities will be returned to you. Euroclear provides both safety and anonymity as the agent standing between the parties to the transaction. More than 3,000 international ETFs and more than 2,000 domestic ETFs are currently eligible in the program. T+1 may lead to more opportunities to lend your collateral and Euroclear stands ready to facilitate you realising those opportunities.
In summary, the move to T+1 isn’t just about ticking boxes on a calendar. It’s a strategic move toward a more resilient, efficient and interconnected financial ecosystem. Euroclear, with its expertise and commitment, will ensure that market participants can embrace this transformation with confidence.
If you are an existing client, contact your Relationship Manager to discuss the initiative.
If you are new to Euroclear, contact us to learn about the full range of services we can offer to help you manage your business.
