Why is the issue of delayed settlement of ETF transactions generating such heated debate?
[This article previously appeared on our sister site, IndexUniverse.eu.]
The words “ETF” and “settlement fail” have been mentioned in the same sentence with increasing regularity in recent months. Is there anything to worry about? And—since the debate has so far focused primarily on the ETF market in the US—to what extent should European investors be concerned?
We’ll address questions of European ETF trading, clearing and settlement in a separate article next week. But why are ETFs being singled out as an example of market inefficiencies?
In a report released in March this year, Harold Bradley and Robert Fawls of the Kauffman foundation and Robert Litan and Fred Sommers of Basis Point Group, a consultancy, pointed out a broad-based trend towards rising settlement “fails” in US capital markets (a “fail” is defined as a trade that is not settled on the date agreed upon by the buyer and seller). According to the four authors of the report, ETFs (and mortgage-backed securities) are two types of financial instrument in which such fails are currently concentrated.
In 2010, according to the Kauffman foundation, settlement fails in US ETFs accounted for over half by value of all reported US securities market fails, even though ETF trades represent a much smaller proportion—less than 10%—of overall US equity trading volumes.
The trend towards rising fails, argued the Kauffman report’s authors, could be a “canary in the coal mine” for regulators, telegraphing that counterparties might be having trouble completing their trades on time and that systemic risk is on the rise.
ETF market participants have responded by saying that such assertions are exaggerated. For example, Noel Archard, North American head of product for the ETF market’s largest issuer, iShares, issued a blog-based rebuttal to the Kauffman report’s claims.
As far as the primary market is concerned (the market in which authorised participants or “APs” interact with ETF issuers to create and redeem fund units), said Archard, if an AP fails to deliver securities to the ETF issuer on the pre-agreed date (typically trade date plus three days, or “T+3”), the firm has to post collateral instead, protecting investors in the fund until delivery occurs.
In the secondary market, said Archard, the ability of market makers to settle with counterparties up to six days after a trade date means that an ETF trade can be reported as “failed” according to the standard equity settlement calendar (also T+3), even though the firm concerned intends to make good its obligations.
According to rule 204 of the US Securities and Exchange Commission’s regulation SHO, issued in July 2009, “subject to certain conditions, fails to deliver resulting from long sales or certain bona fide market making activity must be closed out by no later than the beginning of regular trading hours on the third settlement day after settlement date (i.e., T+6).”
Ben Johnson, European ETF analyst at Morningstar, made a similar point to iShares’ Archard in a report also published in March (“ETF Settlement Delays: No Cause For Alarm”). “While an equity trade that settles on a T+4 basis might be labelled a ‘failed’ trade,” argued Johnson, “it still is ultimately completed, just not within the stipulated time frame.”
Furthermore, continued Johnson, one reason for the fact that ETFs command a disproportionate share of reported trade “fails” is that they are simply traded more than many regular equities.
“The degree to which ETFs are affected by settlement failures is positively correlated with the velocity of their share bases,” said Johnson.