Over the last 30 years or so, security settlement times have slowly been shortened to satisfy the needs of investors for immediacy, reduced risk, and standardisation across countries and regions. In the early 1990s US stocks settled on a T+5 basis, this cycle incrementally reduced to the point where T+1 settlement was implemented earlier in the US this year.
Most other countries in Europe and Asia operate on a T+2 basis, with India moving to T+1 ahead of the US and China effectively settling on a T+0 basis domestically. The market consensus is that over time those countries operating on a T+2 or T+3 will follow suit.
In the short term, these changes create mismatches in settlement cycles between different regimes, with the burden falling especially hard on APs working in the primary market to create ETFs that comprise securities from T+1 regimes, when the ETF itself settles on a T+2 basis. And this comes at a time when the ETF market is soaring, with assets growing $3tn in the last year.
The market is not just growing in size, it’s also growing in complexity, with more thematic, factor, multi-asset, active and derivatives-based ETFs popping up. This is exposing the deficiencies of systems originally designed for mutual funds, but adapted for ETFs. A further headache for APs that are facing increasing operational complexity and costs.
The shift to T+1 is likely to further highlight the start gap in automation and standardisation that exists between the primary market where ETFs are created, and the secondary market where they’re sold. The difference now is that it will be harder to hide system inefficiencies – and regulators are ready to come down on those that fall behind.
Europe, meet T+1
Even though T+1 is yet to formally arrive on EU shores, eyes are already on the impact, with 38% of ETF issuers already citing T+1 settlement as the biggest challenge they face.
It’s a valid concern – Europe’s current patchwork of market infrastructures, varying settlement timeframes and diverse policy positions complicates any attempt to impose this new regime, unlike the relatively straightforward single market in the US.
However, even without implementation at home, local EU laws are adding extra pressure to APs working with T+1-native securities. The EU’s Central Securities Depositories Regulation (CSDR) can now impose fines for settlement failures, which has already sparked backlash from a region having to manage 14 currencies, 17 central counterparty clearing houses (CCPs) and 31 central security depositories (CSDs).
Given that ETFs tend to have higher fail rates relative to the underlying assets that they track, issuers will be particularly exposed to these fines, potentially leading to a widening of spreads. ESMA has set a 2027 timeline to address these challenges comprehensively, but APs will have to confront the issue of managing settlement in the T+1 era well before then.
T+1 and the limitations of the primary market
The reality is that the demands of T+1 are likely to lay bare existing challenges in ETF servicing technology that already exist in the European market, where a significant disparity exists in satisfaction with existing servicing technology between asset servicers and their clients.
Our research reveals that 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 ETF issuers.
The growth and competitiveness of the ETF market shows no sign of abating. In fact, the adoption of the ETF wrapper by active managers in recent years supports the view that in the next 5-10 years most asset managers will have an ETF offering. This increase in the number of issuers, coupled with the complexity of the products being brought to market, means ETF servicers are facing unprecedented challenges in servicing their clients.
Issuers and APs are demanding more from their service providers and in an increasingly competitive market, service providers need to reassess the technology that supports their clients and the efficiency of their primary markets.
The efficiency, robustness, and transparency of an Issuer’s Primary market process results in reduced trading costs for APs, resulting in tighter spreads and optimal Premiums and Discounts to NAV for investors. The move to T+1 and the resulting mismatch in settlement cycles for the underlying securities and the ETF, creates additional challenges and potential costs for APs.
APs may need to settle trades for T+1 securities before receiving the corresponding cash from the T+2 ETF transactions, forcing them to either borrow (which incurs additional costs) or delay the creation of ETF units, causing cash flow issues. The need to borrow funds to manage the settlement timing mismatch can also increase costs, which are then passed on to issuers and ultimately investors, widening the bid-ask spreads. Furthermore, to align cash flows, APs might delay creating ETF units, exposing themselves to market price changes and requiring hedging, which further adds to operational complexity and cost.
Competing in the ETF market will require an approach that can not only deal with the current complexities of ETF creation and issuance, but also laying the groundwork for future changes.
Rethinking ETF technology foundations
North America’s T+1 transition highlights the importance of early preparation and system modernisation when it comes to primary market servicing technology. T+1 raises the bar for automation and standardisation, but it also creates an opportunity for APs to create a competitive advantage over competitors who are still working with patchwork systems of manual processes and spreadsheets.
Our research found 40% of asset servicers say product complexity is their main issue driving new technology needs. And as the market grows, automating order-taking processes, contract note processing, and settlement tasks, will become an essential part of scaling your service. With time frames tightening,visibility and access across the ETF ecosystem will be essential to help APs, issuers, and asset managers monitor and manage their transactions more effectively and align cash flows and settlement processes. Standardisation is essential too, especially as the need for collaboration grows, according to 93% of asset servicers, 100% of authorised participants (APs), and 93% of ETF issuers. This includes adopting technologies like direct API and FIX for streamlined connectivity and reducing the operational risks associated with diverse, manual processes.
With the ETF market showing no signs of slowing down, T+1 has the potential to be a testing ground for the agility and adaptability of primary market participants. With 2027 the European target date, forward thinking APs have an opportunity to build both short- and long-term advantage – those who don’t may find themselves playing catch up.
First published in ETF Express October 2024: https://etfexpress.com/2024/10/15/navigating-the-shift-to-t1-how-europes-etf-market-must-adapt-to-a-new-era-of-settlement-calastone/
