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A New SEC Rule Could Jeopardize $1 Trillion of ETFs

November 6, 2023
minute read

US regulators are undertaking a significant effort to accelerate the settlement times for securities trades. This initiative is aimed at enhancing market efficiency and safeguarding investors against potential losses. However, this move is causing concerns for the ETF (exchange-traded fund) market, particularly for the more than $1 trillion in assets that encompass at least 500 US-listed ETFs holding overseas assets. The issue arises from a discrepancy in settlement times between ETF transactions and the underlying assets.

The impending overhaul will lead to a reduction in the settlement period for ETF shares, from two days to one. But, the underlying assets, depending on their international location, will still take two to five days to settle. This misalignment creates challenges for authorized participants (APs), who play a pivotal role in ETF operations. APs act as intermediaries between the ETF and its investors, profiting by arbitraging price differences between the ETF and its assets.

For domestically-focused US-listed ETFs, this process works smoothly. However, it becomes complex when dealing with overseas assets. In cases of high demand for an ETF holding international securities, an AP might need to provide shares to the investor within one day, while acquiring the basket of foreign stocks required for the ETF manager will take at least two days. This results in the AP having to post an additional day's collateral for the ETF manager to receive the shares.

In outflow situations, the mismatch poses an even greater challenge. The exiting investor expects cash within one day, but the AP's sale of the underlying international stocks will take at least two days to settle. To meet this obligation, the AP might have to tap short-term borrowing facilities, which can be costly, especially in a rising interest rate environment.

These complications are likely to lead to increased costs for liquidity providers and, ultimately, investors. The higher creation and redemption costs for APs could potentially be passed on to investors in the form of secondary market transaction costs. This shift may also result in wider spreads in ETFs to accommodate the financing costs.

Financial industry professionals, including buy-side and sell-side participants, along with organizations like the Securities Industry and Financial Markets Association (SIFMA), the Investment Company Institute, and the Depository Trust & Clearing Corporation, are actively preparing for this transformation. A dedicated group within this effort, focusing on ETFs, is discussing the challenges posed by this transition.

While there are concerns about the potential increased costs and disruptions this change may bring, some market participants believe these concerns might be overblown. They point out that the financial industry has had time to prepare for this shift, with discussions on moving to a T+1 settlement cycle starting as early as 2020. The Securities and Exchange Commission's proposal in February 2022 to accelerate the settlement cycle is part of an effort to reduce risks, following the meme-stock frenzy experienced about a year earlier.

It's difficult to quantify the exact costs that end-investors will face as spreads widen, and it's too early to determine which regions will experience more significant friction due to this change. However, some anticipate that the global acceleration of settlement times, as seen in the past, could ultimately ease the burden for many ETFs. This is because other markets might follow suit and move toward T+1 settlement, as was the case when the SEC transitioned from a three-day settlement cycle to two days in 2017, prompting global markets to follow suit.

In conclusion, the acceleration of settlement times is set to affect ETFs with overseas assets, posing challenges for authorized participants, and potentially leading to increased costs for investors. While there are concerns, the financial industry has been preparing for this change, and a global shift toward faster settlement may help mitigate the impact on ETFs.

John Liu
Eric Ng
John Liu
Editorial Board
Bryan Curtis
Adan Harris
Managing Editor
Cathy Hills
Associate Editor

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