(Bloomberg) -- A big push by US regulators to speed up settlement times for securities trades is supposed to boost market efficiency and protect investors from potential losses. Yet for at least $1 trillion of ETFs, the oncoming overhaul to Wall Street plumbing threatens to drive up costs and create new operational headaches.
The industry pros who keep America’s $7.3 trillion exchange-traded fund market humming are warning that the settlement shift next May spells trouble for more than 500 US-listed funds that hold overseas assets. That’s because while transactions in shares of the ETFs themselves will settle in one day — down from two currently — the underlying assets will still take two to five days to complete, depending on where they’re listed.
The mismatch will lead to a double problem for the liquidity providers who are essential to the mechanics of an ETF — a type of market maker known as an authorized participant. They will be obliged to post collateral for an extra day when money is flowing into the fund, and will potentially have to borrow cash when it’s flowing out.
On both sides of the equation it means extra costs that will likely be shouldered by investors.
“I do predict that the cost to borrow and the number of settlement failures are going to go up,” said Reggie Browne, co-global head of ETF trading and sales at trading firm GTS and a veteran of the industry. “That’s going to force spreads to be wider in ETFs to pay for financing costs.”
Around 900 members of a financial services industry working group — which includes both buy- and sell-sides as well as the Securities Industry and Financial Markets Association, the Investment Company Institute and the Depository Trust & Clearing Corporation — are busy preparing for the switch. In the sub-unit dedicated to ETFs, around 90 professionals gather on a regular basis to discuss potential headwinds this shift may bring.
The issue stems from an AP’s role as an intermediary between a fund and its investors. They make money by arbitraging away small price differences between the ETF and its assets.
When demand for a fund is high, they can create new shares to sell to investors by buying more of the underlying assets and swapping them with the fund manager. When demand is low, they buy the ETF shares from investors and redeem then in exchange for the assets, which they can then sell.
That will work smoothly for funds that are both US-listed and holding American assets, but it gets complicated if the underlying securities are overseas.
For instance, a large afternoon inflow into an ETF holding Asian securities leaves the AP needing to give shares of the fund to the investor within one day, but the basket of stocks it is delivering to the fund manager to create those shares will take two days at least to acquire. It means the AP posting an extra day of collateral so the ETF manager will advance it the shares.
“The settlement mismatch could result in higher creation and redemption costs for Authorized Participants,” said Kimberly Russell, market structure specialist at State Street Global Advisors. “Ultimately, increased costs in the primary market could be passed on to investors in the form of secondary market transaction costs.”
The headache in the event of an outflow is potentially even larger. The exiting US-based investor will expect cash for their ETF shares within one day, but the proceeds from the AP’s sale of the underlying international stocks will take at least two days to settle. To meet the settlement obligation therefore, the AP faces having to tap short-term borrowing facilities — an increasingly expensive prospect in this era of rising interest rates.
“There’s potential for a little bit of a mismatch in financing,” said Andrew Lekas, partner at market maker Old Mission. “I’m going to have to pay that cash out on Tuesday, but I’m not going to receive it until Wednesday.”
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It’s hard to put a number on the exact costs the end-investor will face as spreads widen, or to know exactly how market participants will adjust to the shift. It’s also too early to tell which regions will feel the friction more.
To be sure, there are market participants who say concerns may be overdone. This isn’t the first time a change of such magnitude has occurred, and the industry has had years to prepare — SIFMA started discussing the move to T+1 in 2020, and announced in April 2021 that it was pushing for the switch. The Securities and Exchange Commission issued its proposal to accelerate the settlement cycle in February 2022, part of a bid to cut risks in the wake of the meme-stock frenzy experienced about a year earlier.
“We are certain it will be a non-event,” said Tom Price, managing director and head of technology, operations and business continuity at SIFMA. He is also among the authors of the 185-page T+1 playbook. “None of these issues are insurmountable. None of these issues are show-stoppers.”
In 2017, the SEC moved to a two-day settlement cycle from three for most securities transactions. That ultimately prompted many other global markets to follow suit, which some suggest will be the ultimate outcome of next year’s change. Already, Europe’s regulator has begun a consultation about speeding up transactions in the region.
A global acceleration of settlement may help ease the burden for many ETFs.
“We’ve been through this before, where one major market center moves their standard settlement and then everyone else follows,” said Rafael Zayas, senior vice president and head of portfolio management and trading at Vident Asset Management. “My guess is that we would do that again and global markets will all move towards T+1 settlement.”
