Last Updated: 22 May 2023
Traders in exchange-traded funds say new settlement rules across European stock exchanges are likely to reduce liquidity and increase costs for investors.
The rules, which were proposed by the European Commission in March this year, aim to reduce systemic risk and increase competition between securities depositaries by moving to a region-wide procedure of settling securities transactions two days after the trade date.
The so-called “T+2” regime will, however, take some years to arrive, according to market participants.
But the EC has also moved to impose a hard limit on the period during which market parties can complete trades, allowing firms only four more days after the planned settlement date before being hit by financial penalties. The new regime comes into force from November 1. Previously, in certain European post-trade systems firms had up to 30 days from the planned settlement date to complete transactions before being obliged to notify the market of a failed trade.
However, some ETF market makers say the new settlement rules will widen bid-offer spreads and decrease liquidity on stock exchanges.
According to Laurent Kssis, partner at Bluefin Trading, an ETF market maker, “This is a big issue for us and the ETF market. Liquidity is going to be hit and spreads will widen. It all means that costs are going to increase. We will consider where we make markets now and will not always be able to make markets for certain products.”
Kssis added: “It’s possible that several ETF market makers will simply stop quoting on-screen altogether by Christmas if they have to settle within the four-day window. The risk is just too high now and the fines too big.”
Bart Lijnse, managing director at market making firm, Virtu Financial, also told IndexUniverse.eu: “Market makers will have to hold more inventory on their books to be able to always settle on time, and this also increases their costs. They have to reduce the risk of not settling and therefore will not make tight markets on every order now, they simply won’t always be able to, and this of course will reduce liquidity for those products involved.”
A shortened settlement cycle may also pose problems for those market makers (so-called “authorised participants”) involved in creating and redeeming ETFs. The creation of an ETF unit involves supplying the index’s underlying shares or bonds in precise proportions and if a hitch occurs in the delivery process the whole creation process can fail, threatening fines for those involved.
Common causes of settlement delays when ETFs are created are that market holidays are different around the world and the securities underlying the ETF may trade in many different time zones, according to Virtu’s Lijnse.
However, other ETF market participants argue that the new rules are a long time in coming.
Matt Holden, managing director and head of ETF trading in Europe at Knight Capital, said: “We support these rules. They are going to make trading ETFs in Europe much more efficient.”
Holden said: “It will increase costs, but only slightly. The buy-in costs are also not big enough in London for it to have a massive impact on market makers.”
LCH Clearnet, the clearing house for the London Stock Exchange, charges £12.50 a day for each net failed settlement, plus 0.004% of the failing net settlement amount, also per day.
While the increased settlement costs will be passed on, said Virtu’s Lijnse, investors will also benefit from a more efficient system.
Ljinse said: “The new regulations will mean more risk and more cost. It’s going to be a short term adjustment period that is going to sting here and there. However, you will hope that we end up with more efficient settlement and it will make the markets better, albeit with slightly wider spreads on certain listings.