A fundamental challenge when trying to understand what’s going on in the world of exchange traded funds is that no generalisations can be made.
Not only is every ETF structured differently — it can depend on the asset classes it tracks or which provider it’s issued by — there are also major differences related to the markets they trade in.
So, what is a given in the United States, must not necessarily be taken as such in Europe, or for that matter Asia.
In Europe, in particular, there are many additional factors to be considered. Legal differences in what providers can and cannot do, are one major factor. There is for example no law that stands in the way of an investment bank also being an asset manager. We call that little peculiarity ‘vertical vertigo’.
But another major difference is the tendency of providers to list the same ETFs across multiple European jurisdictions. While on the surface it appears to be the same ETF on the label, in the world of back offices and settlements you simply cannot treat a UK-listed FTSE 100 ETF as the same thing as a FTSE 100 Paris-listed ETF, even if it’s offered by the same provider.
The two are not fungible.
And even though this has always posed a challenge for settlement efficiency in Europe, it’s only recently that these back-office peculiarities have really begun to be understood.
An excellent account of the current state of the settlements of European ETFs was recently provided by Eamonn Ryan, product manager at Euroclear Bank.
As he noted in February (our emphasis):
“There are some difficulties in the post-trading area, particularly settlement in the secondary market,” says Fernandes. “Unlike most equities, ETFs tend to be multi-listed, typically in around five different markets, so you have several CSDs settling the same ETF and sometimes the links between them do not work smoothly.”
Euroclear Bank’s EquityReach team has been working with key players in the ETF business to look into solving some of these settlement issues. “Brokers need to be constantly realigning ETFs between markets, should they be needed for settlement or other business purposes,” explains Eamonn Ryan, Product Manager at Euroclear Bank.
“There can be several different routes by which a security is transferred from one market to another (at least four between the UK and Germany, for example) and it is not always clear which one to use. Sometimes an extra faxed instruction to a transfer agent is required, while in other situations an instruction on a separate ISIN is needed.
“You would not imagine that to move an Irish ETF from the Dutch to the Italian market, you would need to go through Germany, but this really does happen in some cases. “The result is that market participants run the risk of incurring penalties for failed settlement.”
So the fact we live in a world of high-frequency computing power when it comes to trading markets, simply doesn’t translate to back-office systems at all. In the world of settlements, things are still seemingly operating a la mode de “fax”.
Of course, not that the two worlds don’t collide. In a conversation FT Alphaville had with Ryan last month, he told us there was plenty of pressure for traders on the front-office side to learn and understand what might and might not impede settlement.
After all, what might look like a money-making trade on the surface, might end up being exactly the opposite once settlement costs are accounted for.
As Ryan told us:
“The organization’s back office that manages the ETF inventory need to know key information,” said Ryan. “And the trader should be made aware of certain trading strategies which should be avoided on certain ETFs, so as to avoid post-trade problems.”
“Some markets have more severe penalties than others so you can have situation where a broker who has sold the same stock in two different markets, but if he’s encountering delivery issues might opt to deliver to the most severe penalty system and fail in the other,” said Ryan.
So what are the critical factors that traders and back-office personnel have to understand?
According to Ryan, it’s the fact that there are three common types of approaches to listing ETFs in Europe, each one bringing its own particular set of settlement issues.
To operate efficiently a good understanding of all three has to be had.
As he notes:
Short term – gain a better understanding
All market participants can increase their efficiency immediately by ensuring they have the following knowledge of the ETFs in which they deal: In which of the three issuance and CSD holding structures is the ETF held?
* Multi-listed? – understand the links between the Home and Remote CSDs.
* Depository Receipt-like structure? – who is the third party issuer? What is the ISIN code and format of the securities?
* Split structure? – who is the relevant transfer agent? What communications formats are required?
The multi-listed option creates additional costs everytime you move shares across jurisdictions from one depositary to the next.
A good way to think of the depository receipt structure, meanwhile, is through the mirror of traditional equity cross listings. For example, the way traditional American depositary receipts (ADRs) work — very loosely speaking — is that a sponsored American custodian bank purchases a large number of shares in a particular European stock, locks them away in a depository and then issues so-called depositary receipts to American investors.
While the investors are often extended the same rights as shareholders, they don’t technically (in terms of custody and inventory) own the stock. The receipts are thus not always fully fungible when it comes to exchange.
Since the inventory in the depository hardly ever changes — since corporates on the whole don’t change the public float too much– the prices run in tandem unless demand in one locality surpasses the other. It’s then the job of the custodian (in some cases) to purchase more or less shares (or convert) to recalibrate the equilibrium.
In ETFs the tracking issues are hightened by the fact that ETF outstanding inventory changes all the time, That means these costs of conversion or reissuance are ongoing.
A split structure, meanwhile, is a hybrid of the two.
Confused? You’re not the only ones.
As Ryan concludes, the problem is that currently there is no one solution that suits everyone. And also not enough understanding of the issues.