A decision by the US Securities and Exchange Commission to shorten the period for settling bond and share trades — from two days to just one — has prompted a burst of activity in the exchange traded fund industry.
Much of it has been trying to assess the difficulties this will pose in Europe — as US securities now represent more than 40 per cent of EU funds’ assets under management, according to the European Fund and Asset Management Association.
Biweekly trials of the new one-day settlement regime were begun in mid-August by the US Depository Trust and Clearing Corporation, which handles clearing and settlement for nearly all US equities and bonds. It is urging all market participants to take part.
“Due to the number and magnitude of changes that will be required to achieve a T+1 [one day] settlement cycle, it is critical that firms conduct a comprehensive and well-co-ordinated industry test to ensure readiness and a successful implementation,” explains Val Wotton, DTCC managing director and general manager for institutional trade processing.
Meanwhile, across the Atlantic, fund managers have been trying to assess the impact. On October 5, the European Securities and Markets Authority issued a call for evidence on the likely effects of shortening the settlement cycle. In the paper, Esma said preliminary fact-finding had identified that the US move would create “very high costs in a high interest-rate environment and, in particular, for ETFs”.
Among the problems created by the US decision, first announced in February, are settlement mismatches — for example, when an overseas-listed fund that settles in T+2 includes US share or bondholdings that will settle in T+1.
These problems are magnified for ETFs because they rely on a share creation-redemption process, which is carried out by authorised participants and market makers in the so-called primary market, while the trading of the ETF shares by investors takes place in the secondary market.
As a result, the move to T+1 will increase funding costs for authorised participants and market makers, since they will need to buy the underlying securities after one day, even though the corresponding settlement and payment of the ETF shares is allowed to take up to two days.
A shorter settlement cycle also increases the risk that trades fail to settle in time, which incurs fines under the EU’s Central Securities Depositories Regulation, warns Ciarán Fitzpatrick, head of ETF servicing at State Street.
In addition, Fitzpatrick points out that the EU’s Ucits regulations limit a fund to holding no more than 20 per cent of its assets in cash, or being 10 per cent overdrawn. Breaking these thresholds would be a breach of the regulations, but the additional funding required to bridge the mismatch of the two settlement times could cause such breaches.
The root cause of the difficulties, according to James Pike, head of business development at fintech Taskize and former Emea client operations chief at Morgan Stanley, is that current processes were developed to manage a two-day settlement window. “The settlement processes supporting securities trading are siloed and inefficient,” he observes.
Vikas Srivastava, chief revenue officer at currency technology provider Integral and former global head of ecommerce at Citigroup’s fixed income division, says: “T+1 should be a wake-up call for market participants to install highly automated trading technology.”
That transition could take some time, though.
Pike urges asset managers to get ready for the changes quickly, by setting up “pass-the-book” models, where trade details are passed to an office in the next timezone.
If they fail to do this, Esma has estimated that EU market participants would likely have to process “market-on-close” orders at night between 10pm and 3am central European time.
But a pass-the-book solution will only be easily implemented by asset managers with well-staffed, global operations — including settlement staff in the US — or those that can expand on existing arrangements to outsource settlement to custodian banks.
Esma found that the problems for European participants will hit smaller players harder than larger institutions.
Like Srivastava, Pike believes that managers should push for more automation of the processes underlying trades. He also says they should make plans for what to do in worst-case scenarios, as well as look for fintech solutions. And they must start to change their operational timings to fit with the coming regime.
But that last recommendation might be easier said than done. The Association for Financial Markets in Europe has pointed out that while, intuitively, one might think reducing T+2 settlement to T+1 would cut settlement times by 50 per cent, in reality it leaves even less time.
“AFME estimates this [reduction] to be approximately 83 per cent, with settlements teams only having two core business hours between the end of the trading window and the start of the settlement window, compared to 12 core business hours in a T+2 environment,” the body said in a report published last year.
One market participant with knowledge of the discussions going on behind closed doors in Europe claims regulators are actively considering making an exemption for ETFs, under current CSDR rules. An EU official says the bloc is “not in a position to confirm” whether the exemption was under consideration, but the “topic was raised, among many others” at a meeting last week.
Esma is still asking respondents to its call for evidence to say what they think about Europe itself moving to T+1. However, for now, asset managers, market participants and end investors — who will eventually bear any increased costs — will have to wait and see.
