Last Updated: 3 June 2023
According to some participants in Europe’s trading community, enforcing stricter rules for the settlement of ETF transactions will harm liquidity.
Costs will rise and market makers may withdraw from quoting prices in certain ETFs, say these firms.
Traders argue that having the leeway to settle ETF trades late gives them more flexibility to create fund units with the ETF issuer, if needed, or to cover a short position over time via the secondary market. Traders quote tighter bid-offer spreads in ETFs than they would if settlement procedures were tighter, goes this train of thought.
There are also incentives to delay settlement deliberately. If you’re a market maker, the ability to run a short position in an ETF for a few weeks (hedged with a long index position elsewhere) can earn you the management fee on the fund for no risk.
Europe’s complex network of stock exchanges is the prime cause of poor settlement discipline. Europe’s exchanges dispatch trade processing into different clearing and settlement systems, some of which are interlinked, most of which aren’t, and all of which have traditionally played by separate rules.
At one extreme, LCH Clearnet, the clearer of trades contracted on the London Stock Exchange, would only issue a compulsory “buy-in” notice if a seller hadn’t delivered the shares he’d contracted to sell 30 days after the intended settlement date. Other European clearing systems would initiate buy-ins only a few days after such a settlement “fail”.
And the penalties for failed settlement could range from the monetary equivalent of a mild slap on the wrist in London to a sizeable and very painful fine in Frankfurt.
The “dark arts” of European clearing and settlement—as one industry veteran described this specialist area—are a largely untold story of national rivalries and protectionism, with the sums at stake growing in importance.
According to a recent article in the FT, the clearing and settlement arms of the German stock exchange—Eurex and Clearstream—now contribute three-quarters of the exchange’s operating income, compared with 30 percent a decade ago.
Where they have them, exchanges are fighting tooth and nail to retain the mini-monopolies that result from controlling the post-trade business. The European Commission cited the unwillingness to open up clearing facilities to competitors as a key justification for its veto earlier this year of the proposed merger between Deutsche Boerse and NYSE Euronext.
But while harmonising European clearing and settlement systems remains a formidable challenge, and is an area the Commission has been working on for over a decade, in the meantime the EC is making an effort to standardise some of the post-trade rules. This year’s regulation on implementing a new, region-wide timeframe for failed settlements is an example.
The issues at stake go far beyond technical inefficiencies.
The EC wrote a decade ago that ironing out post-trade barriers in securities markets could raise European GDP by 1.1% in a decade, or by €130 billion.
And murky practices in securities settlement may well have allowed fraud. I wrote over a year ago that the confusing European procedures for ETF clearing and settlement seem to have laid the ground for the US$2.3 billion trading loss at UBS.
Kweku Adoboli, who is currently on trial for fraud and false accounting, told a London court this week that even his own boss didn’t understand the ETF trades Adoboli’s desk was involved in.
Adoboli is reported to have booked, cancelled and rebooked thousands of trades in ETFs, moving settlement dates weeks into the future, even as colleagues queried the reasons for delaying payment.
“How come the value (settlement) date is pushed a month forward?” Adoboli’s colleague from UBS’s trade support department, Rory Boulton asked Adoboli during a chat dated February 16 2011, it was revealed in court a couple of weeks ago.
“So that I have a bit of time to do the creations. Gives me a bit of leeway on the entry for it,” Adoboli responded in the internal chat.
Given what we already know about what went wrong at UBS, it’s amazing that some European ETF market participants can still argue against harmonised treatment for settlement fails. It’s time for ETF traders to pay up on time.
And if market makers can’t quote reliably in an ETF because they are not sure of being able to create a fund unit within the necessary timeframe, then that index tracker shouldn’t have been launched as an ETF at all.