ETFs in what?
We all know ETFs settle like a share. Once traded it gets cleared and settles in a CSD. ETFs traded on Xetra settle in Clearstream FFT, ETFs traded on Borsa Italiana settle in Monte Titoli and so on.
This creates a problem. ETFs are cross listed on many different exchanges in Europe (same ISIN, just different exchanges). Each exchange has a different way of clearing and settling trades and as a result the total position of an ETF is fragmented throughout Europe as it gets settled in different CSDs.
An theoretical simplified example might clarify the problem. You buy 2000 Shares of ETF abc 1000 on LSE and 1000 on Xetra. You end up with a position of a 1000 in Crest and 1000 in Clearstream FFT. Say that you want to sell 1500 shares on Xetra. You will need to transfer 500 shares from Crest to Clearstream FFT. Let's now say that you've instructed your bank to do so and that you've sold the shares on Xetra. You now have a delivery obligation towards the clearing in Germany. However, for one reason or the other, the transfer is not settling. As a consequence you can not settle the sale of 1500 and you get faced with a buy in.
This is the sort of problem ETF market makers are facing every day. The risks an costs associated are enormous. Why? Here are a few reasons:
- The international transfer of positions (ETFs) is time consuming and difficult. NO guarantees that transfers will settle.
- The fragmentation of trading has led to fragmentation in positions leading to market makers holding technical inventory for settlement purposes. Holding (and paying) for technical inventory like that is better then facing buy ins.
- Costs of borrowing in the ETF market can be high as inventory is scarce
The solution is actually conceptually very simple. Connect all CCPs to the same ICSD and settle everything in one central depository. To do this a new way of issuing ETFs needed to be developed: the International ETF. Over the past few years many issuers have been working with the ICSDs to get this going and a few have actually started with issuing ETFs in ICSDs. So far the AUM gathered has been small. However, it now looks like BlackRock is making a push. It will convert a nice scope of ETFs to the ICSD structure. Still not the big funds but it's a start. It has taken that long because the switch from CSD to ICSD is very, very, very complicated. A lot of technical stuff has to be arranged (e.g. how to handle corporate actions).
So, is it all good then? Are we going for a DTCC-like settlement environment for ETFs in Europe? I don't think so. Not all issuers are interested in the ICSD solution as they only have local ambitions and are very happy with the local structure. Often this is a lot cheaper for them. The international ETF is going to be just another way of settling an ETF. ETF traders and there service providers will keep the old structure and will need to adapt to a new additional one for the international ETF. And then the next question pops up. Which ICSD to work with? Euroclear Bank or Clearstream Luxembourg ?
Question is also if this is the only solution possible. I don't think so. The ICSD environment is very competitive. New ICSDs will pop up as an alternative for Euroclear Bank or Clearstream Luxembourg. Big ETF service providers like State Street of Bank of new York could start servicing ETF issuers through their own ICSDs and provide a true all-in service.
Finally, the last question that needs to be answered is costs. Is this really cheaper for everybody?
List of iShares impacted. Maybe there is more...