Eamonn Ryan at Euroclear looks at the post-trade challenges for ETFs in Europe
Many of the advantages ETFs have over traditional mutual funds derive from the similarities they share with equities in terms of liquidity, flexibility and a range of other factors. Yet in Europe, ETFs suffer from substantially more post-trade challenges than equities, to the point where these problems are beginning to hinder their growth as a financial instrument.
A clue to the origins of these operational issues can be found in the different patterns of stock exchange listings used by ETFs, compared with equities. Whereas most equities are listed only on the stock exchange in the home market of the issuer, it is rare that an ETF is not listed on several exchanges.
As Europe’s post-trade infrastructure is fragmented, it is often the case that ETFs must be moved in and out of the Central Securities Depository (CSD) linked to each stock exchange where it is traded in order for settlement to take place.
Managing deposits of the same security in multiple locations can pose challenges at the best of times, but with ETFs there is an additional factor to consider. When a broker finds itself unable to deliver equities that it has sold for whatever reason, the broker will usually borrow the missing stock so that it can fulfill its obligations.
However, for ETFs, there are limited opportunities for stock borrowing because liquidity is so fragmented across multiple markets and because it is relatively easy to go back to the primary market and create more of the same ETFs instead.
Original and supplementary issues of ETFs are always created in the ‘issuer’ CSD of the ETF, which is often not the market where the broker is trying to deliver the ETF it has sold. Furthermore, because ETFs are typically multi-listed securities, a broker will frequently have holdings in the needed ETF in another market.
In either case – whether creating new securities or using securities held in another market – the broker will need to transfer ETFs from one market to another as quickly as possible. Otherwise, it will face penalties such as settlement fines or find itself being ‘bought in’ by the trading counterparty or the central counterparty involved in the deal.
Transferring ETFs from one market to another is surprisingly difficult. The main reason is that not all ETFs use the same depository holding structure, as do equities. Three of the most commonly used ETF holding structures, which co-exist simultaneously across markets, include the classic multi-deposit structure, depositary receipt-type structure and the split structure.
In the classic multi-deposit structure, the ETF issuer, or rather its transfer agent/registrar, has a relationship with only one ‘issuer’ CSD. One or more remote CSDs, known as ‘investor’ CSDs, may hold the ETF via settlement links with the issuer CSD. This means that the investor CSDs have an account with the issuer CSD and hold the ETFs through this account structure.
Or, they may hold the ETFs through an intermediary; in other words, an international CSD such as Euroclear Bank via what is sometimes called a relayed link. In either case, ETF transfers are normally very easy and efficient, with only one settlement instruction needed between CSDs. The transaction is usually done on a straight-through process (STP) basis. This is the same structure used by most equities that are multi-listed across Europe.
The depositary receipt-type structure is based largely on German legal requirements. It is used to facilitate a listing in Germany for ETFs that are issued in the Irish CSD. It involves the issuance of new securities, called Global Bearer Certificates, which are assigned a different International Securities Identifying Number (ISIN) than the original ETF issued in the Irish CSD.
The fact that the same ETF carries two different ISINs obviously complicates the management of securities reference databases, making cross-market transfers more complex while adding cost. In addition, transfers are less instantaneous than in the multi-deposit structure, although a high level of STP is still possible.
The split structure differs as the link between the issuer and investor CSDs are not made via cross-CSD links, but via a third party such as a transfer agent or registrar. In effect, these ETFs have more than one issuer CSD. So, in order to execute a transfer from one CSD to another, the ETF must be withdrawn from one CSD and deposited in the other, which is not usually executed on an STP basis. This invariably takes several days and requires special, extra instructions – often by fax – to the third party.
This structure is particularly onerous for brokers needing to transfer ETFs across markets because of the time lag involved. Moreover, if they suffer a penalty due to late transaction settlement, they have no recourse against the third party. Transfer agents and registrars work on behalf of the issuer and have service level agreements only with them.
Because of the growth in ETFs, large international broker/dealers are now actively looking for ways to minimise operational problems. They have little choice but to better understand the different holding structures to avoid future settlement penalties. Some are going so far as to create a blacklist of difficult-to-manage ETFs.
If at all possible, split structures should be avoided in favour of the more efficient multi-deposit structure. Consideration should also be given as to which CSD – or international CSD – should play the role of issuer. If a new ETF is not issued in the local CSD of the issuer, a split structure may later be needed in order to make the appropriate transfers.
Post-trade challenges, such as those described, may influence both the liquidity of an ETF and its appeal within the trading community. For ETFs, the devil is hiding in back office details.
BiographyEamonn Ryan is director of European equities product management at Euroclear, where he is responsible for identifying and marketing new products and services for equities. Prior to joining Euroclear in 2007, Ryan was a product business owner at Reuters Financial Software, based in Paris.
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