Issuers of European-domiciled ETFs have been overhauling their operations over the past 12 months as they brace for one of the biggest changes to trading for years.
The recent move from a T+2 to a T+1 settlement cycle in the US, announced by the Securities and Exchange Commission (SEC) in February 2023, has created a litany of potential issues for European ETFs, all of which could create additional costs for the industry and investors.
Despite intentions to boost trading efficiency, a move to T+1 means European issuers risk falling foul of UCITS cash and overdraft rules while authorised participants (APs) are to be hit with additional funding burdens.
This comes amid simmering frustrations with the way the European Securities and Markets Authority (ESMA) has supported the market ahead of the changes.
Europe and Asia will continue to settle trades two days after the trade agreement (T+2), however, primary market trades involving US equities will need to settle a day earlier, creating a misalignment between primary and secondary markets that must be carefully managed.
Concerns have been raised over industry preparations and the lack of help from regulators. Tara O’Reilly, co-head of asset management and investment funds group at Arthur Cox, said she was “less optimistic” about the task at hand and questioned the lack of regulatory forbearance in helping the market transition.
“The industry has indicated there will be issues and, in our engagement with the Central Bank of Ireland (CBI), there is no indication there will be anything other than breaches,” she said.
The European Commission has earmarked a move to a T+1 cycle in the future, expected to resolve the issues of the shortened cycle in the US. However, the fragmented nature of Europe’s capital markets poses its own challenges, all at a time when settlement fail rates face increasing scrutiny under the Central Securities Depositories Regulation (CSDR).
An industry underprepared?
Europe’s ETF market has been keen to stress its readiness for the shortening of the settlement cycle in the US, but others have warned of an industry unprepared for the changes.
Asset managers with exposures to US equities were required to update their prospectus before the switch on 28 May – with little regulatory leeway – leaving many waiting to be finalised just days before the deadline, according to O’Reilly.
“We went through this process with no fast track or appreciation by the regulators of the steps needed,” she said. “We went through the normal processes and some prospectuses were still waiting to be finalised before the deadline.”
There were also concerns about a lack of engagement from smaller asset managers about moving to T+1. One person familiar with the topic told ETF Stream smaller players “have not been very present in the conversation” which could contribute to higher settlement fails across the industry.
“It could be they are less impacted with less US exposure, but this has also been an issue in the US,” the person said. “A large part of the market is good to go, but there is a whole cross-section of asset managers that could be caught off guard.”
Many asset managers have prepared their ETF settlement cycles ahead of the move, shifting their primary market models to T+1 for creations and redemptions for US equity ETFs and T+1 create and T+2 redeem for global exposures.
Ciaran Fitzpatrick, head of ETF solutions for Europe at State Street, who has been heading up an industry working group on T+1, played down the issues, noting larger issuers have been helping to educate the smaller issuers on the topic over the past year.
“We have spent months working with issuers, service providers and custodians to make sure everybody is doing the same thing,” he said. “We have been settling nearly 60% of creations on T+1 for several years. The changes will amplify this, but the planning has been significant.”
UCITS breaches ‘unavoidable’
One of the major concerns for asset managers is breaching the rules around cash and overdraft limits for UCITS funds. Under the rules, UCITS funds must limit cash held with a single bank to 20% of its net assets while its overdraft is limited to 10%.
Jim Goldie, head of ETF capital markets and indexed solutions, EMEA, at Invesco, told ETF Stream breaching the cash or overdraft limit will be “unavoidable” depending on the size of the trade, noting Invesco’s funds would have breached the limits on 6% of its create-redeem trades if it had not prepared its funds to be long cash ahead of the switch.
“From an ETF perspective, you can position the funds to ensure you minimise the number of breaches,” Goldie said. “In certain instances, depending on the size of the trade, the size of the fund and the proportion of T+1 securities in the basket, it is going to be unavoidable that you might breach the 20% long cash or 10% borrow limit.”
As a result, issuers have been moving to position their ETFs to go “long cash” by implementing a T+1 settlement cycle for creation and T+2 for redemption on global exposures.
Other tools to manage these limits have also been implemented by asset managers. For example, sweeping cash into money market funds, split settlement or, in certain situations, amendment of the underlying securities settlement cycle have all been touted to help manage funding implications.
Jamie Hartley, European head of capital markets at DWS, said: “Market participants can manage inventory to support demand, hedge with various strategies including derivatives, as well as offsetting cash positions at book level to help manage any potential funding implications.”
Regulatory frustrations
While some believe they have the tools to manage potential breaches, many remain deeply concerned with ESMA’s ‘wait-and-see’ approach. The regulator has also been accused of doing little to address divergence at a national level which has added to uncertainty for issuers.
Despite industry-wide calls for forbearance and a relaxation of the UCITS rules in anticipation of increased breaches and settlement fails under CSDR, Europe’s financial watchdog ruled out any changes, adding it would “keep monitoring market developments” but did not find “sufficient evidence” for legislative changes.
Arthur Cox’s O’Reilly said the industry has been clear with the regulator there will be issues.
“They [ESMA] are looking at this post-fact, despite the fact the industry has indicated there will be issues,” she said. “I am usually quite optimistic, but I am less optimistic about where we will end up because we will have more breaches and there has been little regulatory forbearance.”
Furthermore, O’Reilly believes many of the breaches will be considered ‘active’, meaning issuers will be required to report them to the regulator. Once reported, asset managers will have to embark on a list of remedial measures that could involve compensating investors for their time out of the market.
The situation is also made less clear by National Competent Authorities (NCAs) taking differing views on what is considered an active and a passive breach.
For example, regulators in Luxembourg and Ireland – where most ETFs are domiciled in Europe – take a strict approach to the 20% cash limit. Meanwhile, France and Italy have a more relaxed approach, with the latter not setting any limit on holding cash.
“ESMA has not wanted to step up and bring convergence between national regulators which would have been nice to have,” an industry source told ETF Stream. “They think they have gone as far as they needed to go, but it does not really address the issue that once you cross 20% cash limits you are in active breach.
“The regulation is lacking, the UCITS rules were not drafted with a view to having misaligned settlement cycles across the world.”
Inés de Trémiolles, global head of trading at BNP Paribas Asset Management (BNPP AM), said asset managers “have not had a lot of help” from European regulators on breaching issues.
“If you have too much cash in your fund, it is a regulatory breach, and believe me, you do not want a regulatory breach,” she said.
An ESMA spokesperson said: “ESMA is closely monitoring the situation and may provide further guidance, where needed.”
Widening spreads
The end impact could result in increased trading costs for investors. Growing complexity around inventory management for APs and an uptick in settlement fails could potentially result in wider spreads.
Frank Mohr, global head of ETF sales trading at Société Générale, said he is confident the industry will overcome the challenges of a shortened settlement cycle in the US, but added investors could see spreads widen as a result.
“There will be increased complexity. More work on our side can add up with wider spreads on the other side,” he said. “It is the only way we can get repaid for the additional costs.
“Inventory will rise, which is not something you want with the higher cost of interest rate funding. Higher complexity means higher costs.”
The industry is said to be working on several solutions to ensure overnight interest rates accrued by ETFs under a T+1 creation model can be “allocated more effectively” to APs.
In addition, an increase in settlement fails will lead to more penalties under CSDR, potentially widening spreads further. Fitzpatrick said he would “not be surprised" if ETFs see an uptick in settlement fails.
“I suspect we may see an increase but I would like to think it will not be overly significant because the industry has had time to prepare for this,” he said.
DWS’s Hartley added the process enhancements put in place means he does not expect an increase in settlement fails.
“An increase in fails is not expected. Further, the expectation is that the ability to create some ETFs with a T+1 settlement cycle will potentially reduce secondary market fails, supporting APs with inventory management.”
Europe’s T+1 ‘nightmare’
Of course, many of these issues will be ironed out should Europe follow the US in moving to a T+1 settlement cycle. The industry is clear that this is the direction of travel and could be implemented anytime between 2026 and 2029.
However, unifying Europe’s fragmented market is a big challenge while many see harmonisation with the UK – which said it will push ahead with T+1 before 2027 – as imperative.
“We are all in favour of alignment with the UK. That is a huge objective we would like to meet,” one source close to the European T+1 Industry Taskforce said.
“The timing could not be worse from a European perspective, ESMA is taking the long approach and buying themselves time to see what happens in the US. They are also waiting for the new European Commission to be put in place to have a political steer, that will come in September.”
BNPP AM’s Trémiolles said the UK’s self-imposed deadline will be a tough ask for Europe.
“The end of 2026 will be a stretch. Anything shorter than that will be a nightmare as we would need to get unification across Europe.
“What worries me most is the UK. Will they be pragmatic and realise the UK in itself is not a big market? They will ostracise themselves by doing this. They want to move quickly and be close to the US, but they are not the US.”
The reasoning behind the UK’s deadline is in part to ensure it has achieved T+1 before the US inevitably moves to T+0.
“If we take too long to move to T+1 from a European perspective while the US is already considering T+0, obviously that creates a lot more work,” Goldie said. “We would love harmonisation because the more fragmented the migrations are to T+1 the more misalignment you have between securities.”
