Move to faster stock settlement creates unique hurdles for ETF market

The move to next-day settlement for trading in U.S. securities on Tuesday will require exchange-traded funds (ETFs) and the marketmakers to juggle multiple jurisdictional requirements and capital needs, market participants said.

U.S. trading moves to a shorter settlement on Tuesday, which regulators hope will reduce risk and improve efficiency in the world's largest markets, but is expected to temporarily increase transaction failure for investors.

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The biggest headache that many ETF issuers and their service providers face is what happens when there's a "mismatch" between when trades of the ETF wrapper -- the fund itself -- settle, and the settlement schedule for the ETF's holdings traded outside of the United States.

A U.S.-listed ETF will be subject to the new "T+1" settlement rules but not all of the constituents of that fund face the same parameters. Meanwhile, European ETF issuers will have to wait for two days for buyers of their products to pay but they will have only a single day to pay for new orders of any ETF components that trade in the United States.

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The primary impact will be felt by asset managers whose funds include European holdings, since China and India already have accelerated their settlement periods and Canada, Mexico and Argentina also made the switch this week, said John Hooson, managing director of ETF services at BBH.

"The majority of ETF issuers are dealing with this in some way shape or form."

Such dislocations, he added, "will have to be solved with an authorized provider posting additional collateral."

Authorized providers, the marketmakers who respond to ETF orders by purchasing or selling baskets of shares, will have to find ways to continue creating those ETF baskets in a timely and cost-efficient manner, or see their cost of capital and need for short-term liquidity increase.

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Time zone differences may stress the settlement process still further, said Todd Rosenbluth, head of ETF research at VettaFi.

"That may lead to wider bid/asked spreads and reduced liquidity as people try to address all these mismatches," Rosenbluth said. He added he expects this to be a short term challenge that "will work its way through the markets over a few weeks."

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Robert Humbert, global head of ETF product at BNY Mellon, one of the largest custodians and asset servicing firms, said that about 30% of the order volume his company oversees already settles on a T+1 basis, and expects that to bump up to 70% when the SEC-mandated rule change kicks in on Tuesday.

"Certainly, mismatching could be an issue for some but the flip side is that T+1 ultimately is a more capital-efficient process," Humbert said. Market participants "will only need to hold capital for one day, not two."

Both Hooson and Humbert point to another area where ETF market participants will need to adjust. Currently, marketmakers manage their own inventories on a T+1 basis, in order to create or redeem new ETF baskets on the old T+2 settlement cycle. The change means those liquidity providers will now have to shift to T+0.

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Humbert, however, argues that the industry is prepared.

"We've spent the last 12 months working with ETF issuers and their authorized participants to iron out problems," he said.

Rosenbluth agrees, noting that asset management firms "tend to be very good at getting ahead of known and anticipated events."

(Reporting by Suzanne McGee; editing by Megan Davies and Chizu Nomiyama)