However, according to Fred Sommers, one of the Kauffman report’s authors, there is still cause for systemic concern when delayed settlements occur on a regular basis, and ETFs are a symptom of a disquieting trend.
“Since the 1960s there has been an effort to put rules, systems and processes in place to reduce settlement periods to minimise settlement risk exposure in the capital markets,” said Sommers in an email exchange with IndexUniverse.eu.
“We’ve moved from T+5 to T+3 in the equity market and to same-day settlement in the US Treasuries market. For ETFs, it seems we have reversed direction and actually increased settlement risk exposure for a security that is supported and managed by some of the most systemically important and influential [firms] in the capital markets,” Sommers argues.
“Further, individual investors must settle T+3; who gets the benefit of the 3 days between T+3 and T+6?” asks Sommers. “The data indicate that ETF systemic operational risk has a very different look from equity systemic operational risk. And this risk is concentrated in a small number of ETFs, imposing a disproportionate weight on market costs, processes, liquidity and possibly best execution.”
Sommers’ reference to the “benefits” available to some market participants from delaying settlement ties in with other studies on the subject.
Although operational difficulties can result in settlement fails, according to Federal Reserve Bank economists Michael Fleming and Kenneth Garbade in a 2005 publication, economic incentives may offer a better explanation for the phenomenon. “Surges in fails sometimes result from operational disruptions, but often reflect market participants' insufficient incentive to avoid failing,” said Fleming and Garbade.
Put another way, there may be profits (or reduced costs) available to those market makers who delay settlement beyond the pre-agreed date.
One obvious reason for market makers to delay settlement is that it may be preferable to cover a short ETF position or sell a long position in the secondary market rather than going (via an authorised participant) to the ETF issuer to create or redeem fund units. Going to the primary market carries costs, while waiting for an opportunity to trade in the secondary market, or to borrow the ETF, may be cheaper. If there’s no real penalty for delaying settlement, why not wait, in other words?
There may also be arbitrage opportunities available to traders. According to Morningstar’s Johnson, “there is a financing rate that is implicit to the settlement process. If this financing rate is lower than the cost of borrowing securities or cash to settle a transaction, there may be some small incentive for a party to temporarily delay delivery.”
Or, viewed from a trader’s perspective, a delay in closing out a short position in an ETF can potentially generate a profit, since the short position “earns” the fund fee.
It’s important to point out, argues Morningstar’s Johnson, that the average investor shouldn’t notice any of this.
“Investors gain (or cede) economic exposure to securities at the time a transaction is completed, at what we can describe as ‘T=0’,” says Johnson. “Whether a trade ultimately settles at T+3 or T+4 will have no impact on an investor's returns or access to cash proceeds. And, in fact, investors virtually never even see in their accounts that any trade ever "failed" to settle.”
But while that argument may be true, it’s missing the real point about delayed settlements, argues Basis Point’s Sommers. Beyond systemic risk concerns of the type regulators should be concerned about, says Sommers, institutional investors (and their clients) are paying the cost for operational inefficiencies, of which ETF fails are a symptom.
According to the Kauffman report's authors, “delays caused by settlement failures...result in hidden costs to beneficial owners of assets of as much as twenty-seven basis points every day, or about $300 billion in assets that cannot be reinvested. At a conservative annual interest rate of 3%, this estimate implies that institutional investors are losing US$9 billion annually to settlement failures. Investors are underwriting this transfer to trading profits on Wall Street as one part of this endemic fail-to-deliver problem being overlooked by regulators.”