At Calastone, we’ve spent over 15 years working to transform the mutual fund industry, helping firms reduce cost and risk through automated processing. When we started, the industry was burdened with inefficiency and manual processes. Today, while there’s still work to be done, the mutual fund industry is increasingly automated, globally connected and frictionless.
The ETF market, by contrast, has long been automated and efficient, at least in the secondary market. However, in the primary market, on which ETFs are created, we see many of the problems that we’re working to solve in mutual funds. Most asset servicers rely on outdated technology designed for mutual funds, but adapted for ETFs. These individual systems desperately need standardisation, too often still involving manual processes and spreadsheets, resulting in inefficiencies and higher operational risks.
Recognising the problem, we sought to understand its scope. Considering the scale of growth in the ETF market, figuring it out felt like an essential task to help the industry realise its full potential. Anyone with even a passing interest in the fund industry will have seen how the number of ETFs has skyrocketed in the last decade or so, first in the US and more recently across Europe. The numbers, however, bear repeating: ETF assets under management (AUM) have increased 9.2% year-to-date (YTD) from $11.63 trillion at the end of 2023 to $12.71 trillion in April 2024, according to ETFGI.
It was this that led us to approach ETF Stream about surveying the three main players in the ETF primary market ecosystem – the Asset Servicers, Authorised Participants (APs) and Fund Issuers. While already working with a number of primary market players, we wanted a bigger picture. ETFs are, by their very nature, collaborative. To truly transform the market that creates them, we first needed to know how all the collaborators felt.
A transforming asset class in need of automation
The ETF industry is at a pivotal moment. While the US market has led the way, European and UK ETFs are now catching up, meaning a growing volume and complexity of ETF products are entering the market. ETFs have expanded significantly and are no longer limited to simple index-tracking funds. The introduction of leveraged and inverse ETFs, cryptocurrency-backed ETFs, and options-based strategies adds layers of complexity to the market.
All of this has accelerated the need for efficiency, automation and, most importantly, standardisation – something that hasn’t gone unnoticed by the key players, nearly all of whom, the survey found, felt that the need for standardisation in ETFs has become equally or more important over the past decade.
Active management within ETFs is also becoming more prevalent, challenging the traditional view of ETFs as solely passive investment vehicles. This, too, adds to the number and complexity of the products and the workload for asset servicers, nearly half of whom cited this as a reason for needing improvements in primary market servicing technology. As the ETF market grows, the volume of transactions increases, putting pressure on existing systems.
New regulatory pressures further complicate the landscape. The EU’s Central Securities Depositories Regulation (CSDR) means market participants can now receive fines for settlement failures, a provision that is having a disproportionate impact on ETFs, which tend to have higher fail rates relative to the underlying assets that they track. The US’s move to T+1 settlement times and the likelihood that other markets will follow suit adds to that pressure, for APs in particular. These changes create mismatches in settlement cycles and increase the complexity of managing ETFs across different markets; APs must now navigate different settlement cycles across various markets, increasing operational complexity and costs. The survey results reflect this, with APs considering CSDR and T+1 settlements as the industry developments that most require servicing technology improvements.
Interestingly, there’s a significant disparity in how different parties feel about the servicing technology. Over 60% of asset servicers consider the current servicing technology to be ‘very good’, compared to just over 10% of APs and less than 5% of fund issuers. While most asset servicers feel the status quo is working just fine, their clients feel there’s vast room for improvement.
This aligns with previous Calastone research, which found that clients of asset servicers are particularly concerned about the lack of automation in the subscription and redemption process – a major issue for the industry. Primary market liquidity hinges on the efficient creation and redemption of ETFs, the importance of which was also highlighted in our research. Efficient and cost-effective ETF creation and redemption are critical for market makers, upon whom ETF issuers and investors heavily depend.
Bringing the primary market together
As increasing numbers of managers develop ETF solutions, they will need to refine not just their distribution strategies and product mix, but also ensure that their total costs of ownership (TCO) are kept in check. Although many providers are investing heavily in their businesses, most of this spend is either being earmarked for maintaining legacy technology or for supporting highly bespoke builds for specific clients. This is making it harder for asset servicers to both innovate and standardise their technology, which in turn is preventing them from achieving scalability.
Leveraging our experience in automating mutual funds, we’ve developed specialised technology to address the inefficiencies in the ETF primary market, helping asset servicers manage the complexity of ETF transactions, reduce costs, and mitigate risks.
Earlier this year, we announced our partnership with HSBC to develop an ETF asset servicing platform with real-time processing, monitoring, and cash calculation capabilities for APs and ETF issuers throughout the creation and redemption cycle. By automating processes and providing better tools for managing ETF orders, this technology enhances the efficiency and scalability of asset servicers so they can better support the growing ETF market and its increasingly complex products.
Key to this is increased standardisation. Calastone’s technology facilitates this, enabling seamless interaction among market participants. While bespoke technology services may go down well with individual clients, the competing demands from customers can overwhelm providers, and may even impede scalability at a time when the wider ETF industry is expanding fast. Instead of continuously developing tailored solutions on a client-by-client basis, asset servicers instead should focus on standardising their underlying technology.
The same goes for the creation and redemption process, something asset servicers need to upgrade to retain and win business moving forward. Standardisation here should be prioritised over continually re-investing in legacy technology.
Asset servicers recognise the need for change, understanding that automation and standardisation will be integral to keeping costs low for ETF issuers and investors. Along with APs, 60% of servicers think FIX/APIs (through which standardisation is implemented) will be the dominant means of connectivity in the primary market process within one to two years.
An automated, standardised future
Our ambition at Calastone is to meet this demand for an automated, standardised primary market and replicate the cross-market connectivity we provide to mutual funds within the ETF ecosystem.
Forward-thinking asset servicers are already turning to third parties to help them automate and standardise the ETF lifecycle in the primary market, which until recently has been a major gap in the market. The ETF market is expected to continue its rapid growth, driven by increasing investor adoption, especially among retail investors – a trend that the ease of trading ETFs and their cost advantages over mutual funds will sustain. As the market grows, the adoption of advanced technologies, including potential future developments like tokenisation, will be crucial for managing complexity and enhancing operational efficiency. Although tokenisation is yet to be widely implemented, we have seen how impactful it can be for the fund industry in simplifying settlement processes and improving liquidity through our current work on tokenised assets.
For now, however, providers in the ETF primary market should focus on preparing for the near future. The results of this survey show that many are already taking steps – or understand the need to start. Those that don’t risk being left even further behind.
