Preparing for a new wave of ETFs: Asset servicers take stock______

David McGuinness, Product Director

Exchange traded funds (ETFs) are enjoying exponential growth, and this is forcing asset servicers to adapt.

During our recent webinar – “Innovating the Primary Market: Unlocking Tech Potential in ETF Servicing”, Paul Elflain, our Head of DMI Sales had a lively and in-depth conversation with Marc Knowles, our Senior ETF Advisor and Robert Rushe, Global Product Head for ETF Servicing at HSBC, about how asset servicers can better support the burgeoning ETF market.

ETFs continue to sweep up assets

Inflows into ETFs show no sign of losing any momentum.

According to data from consultancy ETFGI, 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. [1] “There is nothing certain in life except death and taxes, but you could probably add ETF growth to that list,” said Robert.

This AUM expansion is expected to continue over the next few years. 

A survey of ETF market participants by PwC found that seven in ten respondents expect ETFs will be managing at least $15 trillion globally by 2027, while a further 29% reckon the industry’s AUM could potentially jump to $18 trillion. [2]

This comes as more active managers either launch ETFs or convert their existing mutual fund products into ETFs.  Marc cited a study by Blackwater, which revealed that 92% of European active managers are either planning to enter the ETF space or are at least conducting due diligence into the possibility of doing so over the next two years. This is a staggering increase from 2021, when that figure stood at just 9%.  [3]

This activity is being driven by growing demand for ETFs from retail investors in Europe and Asia.   “I believe one of the main catalysts driving growth will be the increasing retail investor participation in the ETF market in Europe and Asia, both of which currently lag behind that of the US. In contrast to purchasing traditional mutual funds, buying ETFs is a very simple process, and normally just requires an investor to open up an account with an online trading firm,” said Robert.

Managing the TCO

As increasing numbers of active 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.

The TCO at an ETF comprises of three different variables, including the total expense ratio (TER), liquidity costs and tracking error.   Liquidity costs are perhaps the most critical, as they relate to the bid/offer spread, namely the premium and discount of the ETF’s tradable price in comparison to the value of its underlying assets.[4]

“Liquidity costs can be minimised by having an efficient primary market process, something that is underpinned by asset servicers,” explained Marc. This is because primary market liquidity is determined by the ETF creation and redemption process, in which asset servicers play a critical role.

Getting the selection right….

Choosing the right asset servicer is absolutely essential.

While an asset servicer may be well positioned to support the requirements of mutual funds, we heard they may sometimes struggle with the nuances of ETFs. 

 “A lot of active managers ask me, ‘do I really need to move asset servicers if I am launching an ETF business when I have one already for my mutual fund business?’ The answer is you do sometimes, depending on who you are with. The breadth of service capabilities, offerings and technology at asset servicers is quite diverse, so asset managers do really need to look around,” commented Marc.  

However, dedicated ETF asset servicers are also facing challenges of their own.

For instance, some of the older asset servicers are having to invest vast sums into maintaining their legacy systems as opposed to developing new solutions or innovative technologies, a point we made in our recent white paper – “A New ETF Asset Servicing Paradigm Emerges.”  Conversely, “new ETF asset servicing entrants may have better technology than some of their more established peers, but they are challenged to further invest in it, given the slower growth of their assets under administration base,” highlighted our paper.

Another issue facing the ETF market is that there is a lack of standardisation across asset servicers’ in terms of their technology infrastructure and platforms, which ultimately impacts the Authorised Participants (APs) and market makers, who are the ones supporting the issuers.  This is primarily being caused by issuers asking their asset servicers for customised or highly bespoke solutions.

Compounding matters further is the deepening chasm now emerging between issuers and their asset servicers, a point made by Paul. He cited a recent study we did whereby we discovered that 41.4% of issuers believed the creation and redemption process was one of the two areas of ETF servicing most in need of improvement, yet just 22.8% of asset servicers said this was one of their two main business priorities.

I feel this divergence between issuers and asset servicers over creations and redemptions is especially frustrating, given the heightened focus on settlement discipline following the introduction of the EU’s Central Securities Depositories Regulation (CSDR) and the global move towards shorter settlement cycles.

While Robert said there is often a disconnect between what buyers in any industry want versus what their sellers can actually provide, he conceded asset servicers had been a bit slow to keep pace with the changes sweeping through the world of ETFs.

Looking to the future of ETFs

If asset servicers are to flourish in what is becoming a highly competitive ETF market, then they will need to automate and standardise their operations.  

In addition to facilitating efficiencies in the primary market process, supporting APs in their remit as liquidity providers and driving TCO costs down for investors, Robert said technology solutions, such as those offered by Calastone, would enable providers to concentrate more on delivering additional value to customers, including in areas such as execution services, local custody, FX , securities finance and global coverage.

[1] Markets Media – April 12, 2024 – ETFGI reports that assets invested in the global ETF industry reached a new record of $12.71 trillion  at the end of Q1 2024

[2] PwC – ETFs 2027: A world of new possibilities

[3] ETF Stream – March 1, 2024 – Nine tenths of European mutual fund managers  to launch ETFs in next two years, survey finds

[4] Funds Europe – Counting the full cost of ETF Servicing

Learn more about ETF Servicing
Watch the webinar: Innovating the Primary Market
Download white paper: A new ETF asset servicing paradigm emerges

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