‘Very careful thought’: T+1 will introduce costs, complexities for ETF traders

The upcoming shortening of settlement cycles from T+2 to T+1 in the US has already highlighted a host of “unintended consequences,” particularly for firms in Europe and Asia. Some of those issues relate to managing FX risk or hedging. But in the world of exchange-traded funds, where global trading volumes reached nearly $45 trillion in 2023, the US moving to a T+1 settlement cycle could have far-reaching impacts on firms’ exposure to the underlying securities in an ETF.

ETFs comprise a basket of underlying securities, often from several jurisdictions. Settlement delays already happen in a T+2 environment due to time zone differences, market holidays, and cross-border settlement complexity. These challenges, according to the Association for Financial Markets in Europe, would be even more pronounced in a T+1 environment. 

Peggy Vena, head of ETF services at Citi Securities Services, tells WatersTechnology that the biggest challenge overall is the various vendor ETF portals in the market. Citi has ACES—the Advanced Citi ETF System, its online, global ETF portal that automates the entire ETF process—and other custodians also have their own portals, she says. From the perspective of an authorized participant (AP)—typically a bank that manages the creation and redemption of ETFs—processing create or redeem orders requires traders to log into a multitude of portals. 

It is this “creation” and “redemption” process that allows ETFs to trade on exchanges like individual stocks. Creation involves buying the underlying securities and wrapping them into the ETF structure, while redemption is where the ETF is then unwrapped into the individual securities. The APs work with ETF issuers—otherwise known as ETF sponsors—who create and launch ETFs, to manage the creation and redemption process. 

“When I talk to our Markets colleagues who are authorized participants—they actually sit on the other side of the floor—they all have multiple electronic tokens for all the different portals because they have to log into different portals to trade different ETFs, and it quite frankly is just time consuming and inefficient,” she says. 

This led Citi to launch FIX API connectivity on its ACES platform to normalize the experience for APs so they don’t have to log into the portal and key in an order; instead, the instructions are communicated by FIX message, which is much faster. The integration offers more simplified order management and onboarding, and allows APs to connect directly to the ACES platform and manage ETF share creation and redemptions more seamlessly. 

It’s a pretty hard fact that NYSE will close at 4 pm on a Friday and the New York foreign currency exchanges will close at 5 pm on a Friday. So that needs very careful thought.

Gerard Walsh, Northern Trust

Vena says most orders for ETFs happen around market close, typically resulting in an uptick 90 minutes before the close. If processing orders manually, APs must allow themselves time to enter all those orders into the various portals they use. With the FIX API, they can now do that much faster.

“But it also allows them some efficiency so they can hook up to us, and they can hook up to other custodians who offer this in the marketplace, too,” Vena says. 

While automation is key, streamlining any processes that need to remain manual is also important, Vena adds. So, Citi designed its portal to minimize the number of keystrokes required when orders are keyed in manually. 

In the case of a global ETF that holds US securities, the considerations firms need to make are around pre-funding, she adds. “There are examples in the US today where a fund holds Indian or Chinese securities and before you release the ETF shares to the authorized participant, you have to collect an estimate plus the markup because the money has to be there for settlement,” she says. 

Vena believes that will happen more and more, especially in Asia and Europe when funds hold US securities. “There’s potential for the authorized participants to have to put up money ahead of time to facilitate the settlement of the US securities. And there’s a cost to that, right?”

Careful thought

This is one reason why the capital markets need to reimagine the entire trade lifecycle for the impacted assets—which includes ETFs, as well as stocks, bonds, municipal securities, and certain mutual funds—says Gerard Walsh, global head of capital markets clients solutions at Northern Trust.

But there’s another reason—and another cost resulting from the move to T+1, which could require firms to make cash available early to coordinate differing settlement cycles. With thousands of ETFs listed in the US subject to T+1 settlement, but which contain foreign underlying securities subject to different settlement schedules, a misalignment in terms of settlement cycles could emerge, Walsh says.

For example, if an ETF listed on the New York Stock Exchange invests in emerging markets in Asia-Pacific, many of the underlying components of that ETF will be on T+2 and T+3 settlement cycles. 

Walsh explains that particularly if the firm is selling an ETF, it’ll be expecting to receive the funds for the ETF itself into the fund or portfolio. But the other components that underlie that will mean the firm has got more cash in the fund than it expected to have, due to the misalignments in settlement cycles. 

“It’s something managers will need to monitor very closely in case they end up with more cash than they need, or need to use an overdraft to ask for liquidity in ways they didn’t think to ask before if they’re on the buy side of an ETF trade. And if they’re buying something, they’ll need access to liquidity over a multi-day period. So they need more cash at the front end of that trade than they would expect to deploy. Because in the old days, you’d wait until the last component of the underlying components was ready to settle,” he says. 

Firms that have exposure to any of the impacted assets in the US will now need to regard 9 pm in New York as the “sun at the center of the solar system,” and think about where they are in reference to that sun. 

This could mean that trading towards the end of the week from Asia or Europe with ETF exposure in US securities may get a little tricky, Walsh says. 

While it is unlikely that people will stop trading on a Friday, those trading—especially from Hong Kong, Sydney, or Tokyo—will require more careful thought on when those trades are put in, especially if the intention is to sell something non-US to buy something in the US because of the FX leg related to it.

“Firms need to think about the full lifecycle, including the trade-related FX in their time zone versus New York,” he says. “And then they need to think about all of the components of that, particularly as they get to the end of the working week and what it might cost to fund liquidity across a weekend if you miss the cut-offs.” 

Again, the key is to lessen the need for manual processes. 

Northern Trust offers its Supplemental Trading Solution for US dollar asset trading, which connects all elements of a trade—including execution, the full settlement cycle of the trade, and the trade-related FX—together as immediately as possible. Walsh says more than 100 managers and almost $500 billion of AUM are already on the platform.

“That said, it doesn’t mitigate the Friday trade-related FX issue. That remains a challenge for managers to think about very carefully as the weekend approaches,” he adds.  

Asset managers need to work closely with brokers, custodians, and asset servicing firms to make sure their standard settlement instructions and allocation models are as automated as possible. However, as the T+1 go-live approaches, firms may need to ask employees in Asia to check things at 4 am Hong Kong time, Walsh says. 

“We’re seeing a lot of industry chatter around whether or not cutoffs … will be moved to accommodate, and whether the liquidity profile of available FX trading will change,” he adds. “But it’s a pretty hard fact that the New York Stock Exchange will close at 4 pm on a Friday and the New York foreign currency exchanges will close at 5 pm on a Friday, New York time. So that needs very careful thought. There’s not yet any indication that the currency markets will stay open later, and there’s definitely no talk whatsoever of the markets themselves staying open beyond 4 pm New York time.”