What proportion of ETF trades in Europe result in failed (delayed) settlement? Is it less than the 4 percent of ETFs in issue that are reported as failed on a daily basis in the US market? In fact it is dramatically more, according to some.
“Only 40 percent of exchange-based trades in certain ETFs settle on time,” one London-based market maker told IndexUniverse.eu recently.
Unfortunately, it is impossible to verify such claims or to establish which funds are causing problems. In the US market the central post-trade utility, the Depositary Trust and Clearing Corporation (DTCC), publishes statistics showing the proportion of trades in individual bonds and equities (including ETFs) that settle later than scheduled. But in Europe there’s no equivalent source of information.
IndexUniverse.eu requested data on ETF settlement efficiency from several European stock exchanges, central counterparty clearing firms (CCPs) and national and international regulators. Both the Bank for International Settlements and the European Central Bank said they didn’t collect such information. The UK’s Financial Services Authority said that it collected information on settlement efficiency from the entities it supervises, but that this information was confidential. Several ETF issuers we contacted said that while they monitor the efficiency of transactions with authorised participants in the primary market, they don’t do so for secondary market trades.
However, we did get limited feedback from one market specialist with access to post-trade data, who preferred to remain anonymous. Based on a random small sample of ETF trades (lacking statistical significance) from the London Stock Exchange and NYSE Euronext Paris, the effective settlement rate was between 96 percent and 100 percent in Paris (using exchange-based data only) and between 82 percent and 90 percent in London (based on both exchange-based and OTC trading activity). While up to 4 percent of trades in French exchange-based ETF trades fail in other words, up to 20 percent of all types of ETF transactions may result in settlement delays in London.
The high prevalence of delayed ETF settlements in Europe is hardly surprising. The fact that Europe’s equity trading infrastructure is complicated is not a secret. The region’s web of clearing and settlement facilities is well illustrated in a chart on page 4 of a 2010 presentation from a staff member of the European Central Bank (ECB). Since ETFs, unlike most equities, are typically listed on multiple exchanges across Europe, trades in a single fund have to clear and settle in different, often unconnected parts of the post-trade network.
In a presentation given to the Inside ETFs Europe conference in May, Eamonn Ryan, director of product management at Euroclear, described the problem. The transfer mechanisms between the European central securities depositaries (CSDs) in which ETFs are held can differ at almost every imaginable level, Ryan explained: per pair of markets, per issuer of ETFs and even per security. Under such circumstances, it’s clear that delays in moving ETF inventory around Europe are inevitable, as are failed settlements.
What can be done to alleviate the problem?
In the short term, said Ryan, arming market participants with a better knowledge of the issuance structures of different European ETFs, and of the processes necessary to move ETF shares from one CSD to another, could help. In the longer term, however, structural reforms of the type the ECB is pursuing under its Target 2 Securities (T2S) programme are necessary, Ryan argued. T2S aims to arrive at a single pan-European settlement platform by the middle of this decade.
According to market specialists, the more widespread use of ETF lending facilities could also help to ease supply problems in the market. In turn, this would improve settlement efficiency as well. However, institutional holders of ETFs, who might otherwise lend out their shares to help market makers cover short positions, are wary of doing so, possibly due to an awareness of the potential for settlement delays, argued one European expert on market infrastructure.
“Even if European ETF inventory appears to be in the right place at the right time, a lot of settlement instructions do still fail. The knock-on effect of this is elevated counterparty risk, additional need to hedge counterparty exposures and a general reluctance by the institutional owners of ETFs to lend them out. That’s because they’re not sure they’re going to get them back in a timely fashion,” said the expert.