Introduction

Settlement is a crucial aspect of the ETF trading process, ensuring transactions between buyers and sellers are executed efficiently.

The ETF settlement process is the transfer of securities and cash between trading parties and takes place after an investor buys or sells the shares of an ETF. The process aims to ensure the buyer and the seller fulfil their obligations in a timely and orderly manner.

ETF trades typically follow the standard settlement cycle for equities that varies depending on the market. Currently, ETF trades in the US, Europe and Asia typically settle on a process known as T+2 (trade plus two days), although this is likely to vary in the future as settlement cycles shorten.

The settlement process

The first step of the ETF settlement process is the execution of the trade on either the primary or secondary markets. When an investor places a buy order, the shares of the ETF are purchased at the prevailing market price.

Conversely, a sell order results in the sale of existing ETF shares from an investor’s portfolio. 

Once the trade is executed, the details of the transaction are sent to a clearing house, which acts as an intermediary between the buyer and the seller, facilitating the efficient transfer of securities and funds.

The transfer of ETF shares will then take place from the seller’s brokerage account to the buyer’s account via a central securities depository. The transfer of cash to the seller’s account will take place simultaneously.

Within this process, authorised participants support the creation and redemption of ETFs by providing the underlying securities or cash to the transfer agent in exchange for the units of the ETFs.

Settlement fails

ETF settlement fails can happen for several reasons including incomplete or inaccurate standing settlement instructions, the securities have been sold but are not available for delivery or the trade is not matched by the counterparty.

The global composition of ETFs – which contain underlying securities from different jurisdictions – can also lead to delays in a T+2 environment.

The fragmented nature of the European market and trading inefficiencies also pose challenges to settlement timeliness. 

Move to T+1 settlement

In May 2024, the US market will move to a T+1 settlement cycle which is expected to have a major impact on settlements globally.

The proposed move is designed to drive more efficient use of capital across markets by reducing credit, market and liquidity risks, but in markets such as Europe where fragmentation is high it is likely to introduce increased inefficiencies.

Other jurisdictions are expected to follow suit, with Europe’s settlement cycle currently under consideration by the European Commission.

Regulatory impetus

Over the past couple of years, global regulators have implemented several initiatives in a bid to boost settlement efficiency and reduce the number of fails.

In Europe, the flagship regulation introduced by the European Commission was the Central Securities Depository Regime (CSDR).

CSDR was first established in 2014 to increase the safety and efficiency of securities settlement across the European Union while also looking to increase harmonisation.

In February 2022, the European Commission introduced the cash penalty regime to improve settlement fails. Initially, the regime had several key issues but since then, settlement fails have gradually improved.

It has also led to concerns investors were facing higher costs when trading ETFs due to CSDR, as authorised participants pass on the cost of settlement fails with wider bid-ask spreads.