Problems arising from the settlement of European ETF trades is a technical topic that will not spark an immediate rush of excitement in the hearts of many investors, but they will sit up and pay attention once they realise that these issues are costing them real money.
Individual investors are paying additional costs as a result of improvements made this year in the speed of finally completing trades involving ETFs and stocks, compared with the slower processes that remain the standard in the EU.
In the dry language beloved by financial supervisors, there is a “negative impact” for the asset management industry and individual investors who use ETFs due to the misalignment of settlement cycles between the EU and US, according to the European Securities and Markets Authority (ESMA), the regional regulator.
The acknowledgement of a negative impact on end investors is made by members of ESMA’s securities and markets stakeholder group – ETF market participants, trade associations and academics – so it is not just the regulator making this point.
This negative impact arises because North American trading venues moved in May to a T+1 settlement cycle so transactions must be settled - completed – by the end of the following business day.
ESMA has proposed that trading venues in the EU also move to a T+1 settlement but this change will not come into force until the fourth quarter of 2027. In the meantime, the current two-day T+2 settlement process will remain as the required standard in the EU.
ESMA found that following the move to T+1 in North America, the average premiums paid over the net asset value (NAV) of EU domiciled ETFs that invest in US securities had risen by 22% in June and by 33% during the third quarter, compared with transactions completed in the first quarter of the year before the change to the settlement protocol was introduced.
EU domiciled ETFs that invest in European securities also saw increases in the average premiums to NAVs but not as much – by 16% in June and 18% in the third quarter.
ESMA also noted that the premium of EU ETFs investing in US securities, averaging 3.9% in the third quarter of this year was significantly higher than the 2.8% NAV premium for ETFs that invest in European securities.
The increase in costs matters because plenty of European investors have been increasing their exposure to the US equity market during its current bull run to an all-time high.
About $61.5bn or close to 30% of new investor business this year for European ETF managers has gone to EU ETFs that invest in US equities, according to the consultancy ETFGI. More cash will also have flowed into US equities via European domiciled global ETFs where the settlement frictions will also apply.
The settlement frictions have created a curious anomaly known as the “Thursday effect.”
Investment flows into EU ETFs that buy US securities drops significantly on a Thursday because market makers need to pay up by the end of the day on Friday but they might not for receive the cash needed until after the weekend, leaving them with a funding gap. This funding gap is one explanation for the increase in costs for ETFs that invest in US securities.
It is clearly undesirable if the ETF market is conspicuously less efficient towards the end of the week for everyone – investors, asset managers and policymakers.
A related issue is whether this is having an impact on settlement failures which then result in cash penalties imposed on market makers which are in turn passed on to investors through wider bid and ask spreads when creating or redeeming ETF units.
ESMA highlights settlement failures as a significant problem for ETFs as they are “very high” compared to other asset classes, such as sovereign bonds. Around one in five ETF settlement instructions in Europe fail, accounting for 15% of the value of settlement instructions.
Penalty payments for failed settlements are running at around €127m each month, according to ESMA’s latest data. This suggests ETF managers could be paying around €19m each month in cash penalties. This is not trivial and it reduces the net returns earned by investors.
It could also be an underestimate given the limitations of the data that ESMA was able to collect. It would also not be hugely surprising if failed settlements and penalties have increased as a result of the frictions that have arisen between EU and US processes this year.
For ETF investors, sadly, no obvious remedy is in sight. It would appear that they will have no choice but to continue paying these increased costs until the EU manages to harmonise its settlement processes in-line with the US and that looks unlikely to be enacted for at least three years.
