Nicholas Pratt looks at the international settlement model for ETFs and asks whether the structure has lived up to its promised benefits.
Back in 2013, the world’s two international central securities depositaries (ICSDs), Euroclear and Clearstream, announced plans to introduce a new settlement model for exchange-traded funds (ETFs) in Europe. The ambition was to create a more efficient trading structure for European ETF issuers, more in line with the much bigger US market.
Up to that point, anyone trading ETFs across borders – buying an ETF in one market and selling it in another – had to deal with multiple exchanges, central securities depositaries (CSDs) and settlement bodies, all of which created complexity and cost while increasing the risk of settlement failure.
By using an ICSD structure, Euroclear and Clearstream claimed, ETF issuers would be able to settle all of their ETFs in one place, removing post-trade friction. This would create a more cost-effective and less complex market structure that would in turn increase liquidity and growth and the international appeal for Europe’s ETFs.
So, six years on, has the model delivered on its promises? Euroclear and Clearstream would argue that it has. “The model has been widely adopted,” says Stephanie Lermusiaux, head of FundsPlace at Euroclear. At present there are 17 ETF issuers using Euroclear’s model; a major migration will take place in November when Vanguard moves its Irish range of ETFs.
Brexit has helped drum up more interest in the international issuance model in the past 12 months, especially around the time of the original March deadline for the UK’s withdrawal from Europe, when it looked like UK-based settlement bodies might not be able to settle transactions from Ireland as well as the rest of Europe.
Lermusiaux therefore expects adoption to further accelerate in 2020 as Brexit plans intensify and the vast majority of Irish ETFs migrate to the new structure. “We currently have 54% of the ETF market migrated and we expect this to increase further in 2020 as 90% of the Irish market migrates.”
Clearstream is similarly positive. “Adoption has gone beyond our expectations,” says Bernard Tancré, head of Investment Funds Services, Clearstream. In the past five years, the ETF market has grown considerably in Europe (as of September 2019, the market was worth €800 billion) and the proportion of those ETFs settled via an ICSD has also increased, accounting for almost half of the ETFs issued in Europe.
Furthermore, a number of ETF issuers are now looking to move their Luxembourg-based ETFs to the new model.
Law and operations
So, what does a migration involve and how long does it take? There are two elements – legal and operational – says Lermusiaux. The legal aspects (setting up a general meeting to get the vote of shareholders and going through a scheme of arrangement with the court) typically takes three months. The operational aspects (training the issuers on structural changes and carrying out the actual migration) takes a similar time, creating a six-month process in all.
Lermusiaux says that the new model has delivered on its promised benefits, citing the experience of the early adopters who have seen settlement performance increase from 60% to 90% and spread reduce by 40%.
Operational performance has also improved, says Tancré. However, there are still some further enhancements that can be made. For example, Clearstream is looking to improve some of the connections it has with European CSDs that don’t have a direct link to either Clearstream or Euroclear. “The more complex the connection, the more complex the path of that ETF through the European system,” says Tancré.
Clearstream is also looking to develop similar links with CSDs outside of Europe, in South America and Asia, raising the possibility that the ICSD issuance model may become more than a pan-European project. “There is not a lot of technical work involved. It is more about education and awareness,” says Tancré.
Euroclear is similarly looking to extend the model beyond Europe after signing agreements with the stock exchanges in Israel, Hong Kong and Mexico. It is also looking to target more retail investors, promoting its FundSettle platform as a way to access the ETF market. And a final focus is on adding more exchange-traded products besides ETFs, namely exchange-traded notes and exchange-traded commodities.
State Street Global Advisors (SSGA) was one of the first providers to use the ICSD issuance model and the first to migrate existing and domestically listed ETFs. That process started in 2014 and was completed early in 2018 when the remaining SPDR range was migrated in March 2018, bringing the then total to 75 ETFs. Following new fund launches, the total number of SPDR ETFs on the model now stands at 110, including new share classes.
“Firstly, we wanted to see if the benefits were there before we migrated the entire range,” says Mark Harris, capital markets strategist for SPDR ETFs. “This was a large project, so we had to line up resources internally and externally to help deliver the full migration.”
In addition to the operational and legal legwork, there was some early concern from market participants about the potential impact of the ICSD issuance model on domestic markets, says Harris. For example, some of the smaller and domestically focused wealth managers in the UK were concerned about the costs involved in transacting and holding positions via the ICSD platform. It took some time for some intermediaries to align their pricing and to pass on the benefit to end investors.
Once all of these issues were worked through, the added value was “tremendous” says Harris. On-time settlement has risen from 65% of transactions to 87% and operational complexity has been reduced, especially for market-makers who previously had to manage positions across several domestic CSDs for a single ETF.
Another benefit that may be realised in the future is enhanced international distribution via the links forged between ICSDs and other CSDs outside of Europe – for example, Euroclear’s links with Mexico, Hong Kong and Israel.
Slow to take off
One benefit that was hoped for but is yet to be fully realised is an increase in the use of ETFs for securities lending. “It should have invigorated this market. It is easier for lending agents to manage their inventories via this model. But it has been slow to take off and it’s difficult to identify what the impediment is,” says Harris.
“Lenders have been slow to identify and add ETFs in size to their inventories, so where you can find availability, they can tend to price at a premium.”
Have the benefits made their way to end investors yet? “It is very difficult to quantify,” says Harris. “Spreads have roughly reduced from 10bps to 7bps over the past five years. But that is not all down to the ICSD issuance model, although it has undoubtedly provided us with a strong foundation.”
Invesco launched its first ETF to the ICSD model just over a year ago. Now almost all of its ETFs have been migrated to the model, with the remaining funds due to move in 2020, says Jim Goldie, EMEA head of ETF capital markets, Invesco.
In addition to being a “tailor-made solution to potential Brexit implications”, Goldie says that the ICSD model will also help to spread Ucits ETFs beyond Europe, especially with Euroclear and Clearstream looking to sign up more international exchanges.
“The Ucits ETF industry has grown exponentially in recent years, with clients across Latin America, the Middle East and Asia all adopting them. However, without an efficient means of moving ETF shares from one settlement venue to another, liquidity providers are less able to manage inventory in a cost-effective manner,” says Goldie.
“The ICSD model helps reduce settlement fails and penalties, as well as the need to maintain a local inventory buffer in some of the more settlement-sensitive regions, such as Latin America and Asia. This allows liquidity providers to offer tighter spreads in the ETF, which in turn can help promote the growth of Ucits ETFs as an international wrapper,” he adds.
At present, only Euroclear and Clearstream offer international ETF issuance. Nor is it clear which other bodies would have the capability to do so. There is, of course, Target2Securities (T2S), the ECB’s project to provide a single settlement body for euro-denominated cash equities.
“We looked at T2S but it would not help us serve our key markets. Crest was not in scope, nor would it support our multi-currency products,” says Harris. “It is a good model but it does not serve us holistically.”
So what does Harris and SSGA want to see in the future from the ICSD model? “I want to see an increase in securities lending activity for ETFs, as this will help increase overall liquidity, and I hope the ICSDs will help that happen. I want to see more international distribution and I want to see a continuation of the improved settlement rates, into the 90% range.”
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