ASSET SERVICING: The right tools for the job?

The servicing requirements of ETFs differ to those of a traditional passive funds business. Nick Fitzpatrick looks at ETF operations.

What happens if a large pension fund wants to trade an ETF on the index that its own sponsoring company is part of? If regulations prevent it from investing in the pension fund’s sponsoring employer, then that stock is a restricted name and a potentially convoluted process begins so that the ETF sponsor can get its client exposure to the desired market without infringing laws.

As well as the ETF sponsor itself, the process will also include market makers who trade the stocks that make up the underlying index on which the ETF is based.

The work can be manually intensive, which is why State Street’s asset servicing business upgraded its ETF trading service in the US recently to automate such processes. The move by State Street is a sign of how asset servicing firms are dedicating more attention and resources to ETF sponsors against the background of a booming ETF market, which now holds over $1trn in assets globally.

But doesn’t the same scenario of restricted shares affect ordinary passive fund managers when a pension fund wants exposure to an index in which their company sits? Yes, but asset servicing providers say providing investor services to ETF sponsors is not just a case of extending their ordinary asset servicing capabilities to wider investment managers. This is because the asset service provider has to deal with more market participants, such as ETF sponsors themselves and market makers. They also have to tackle different fund structures and work in different jurisdictions.

“Providing asset servicing for the ETF market is fundamentally different to providing services to the mutual funds market in general,” says Paul Heffernan, head of UK & European business development at Bank of Ireland Securities Services (Boiss). “ETFs trade exactly like equities in the secondary market, and so an ETF asset servicer processes and systems should compliment equity features.”

This shouldn’t be surprising, of course. ETFs are marketed often on the strength of their liquidity – their tradability is supposed to be just like that of equities.

Equity ETFs are usually described as baskets of shares that can be traded as a single share, so there’s no reason why they shouldn’t they be treated like shares by the asset servicers who work away in the background.

This implies taking account of all the differences there are between investing directly in shares and investing in ordinary funds. For example, providing more regular net asset values (Navs).

Jason Kennard,  of ETF Securities, an ETF sponsor, says: “Accuracy is of the utmost importance when it comes to producing Navs.”

ETF Securities uses BNY Mellon Asset Servicing for its asset servicing functions, covering custody, fund administration, and trustee services.

Joe Keenan, head of global ETF services at BNY Mellon Asset Servicing, says: “There are some fundamental differences in processes between funds and ETFs and so there is a need for more front-end consulting and education.

“One example of the differences is that ETFs are traded intraday at the quoted price versus the NAV at the end of the day, which would happen with a conventional fund.

“To support the intraday valuation there are indicative NAVs – or iNAVs – that have to be updated constantly throughout the day. You do not have this with ordinary funds.”

He adds that in US, an iNav would be delivered by a stock exchange, but in Europe it is more usual for the service provider to deliver it.

There is more involvement with the ETF sponsor’s front office, too, says Keenan.

“Unlike in the traditional fund space where  asset service provider would carry out post-trade functions like clearing and settlement, with ETFs we are more involved in the front office, typically helping clients with data and distribution. We also have to deal with  the authorised participants, like the broker-dealers, whose job it is to help establish a fund by setting it up in the primary market and to maintain liquidity once the funds are live on the exchange.”

It is in this primary market activity where State Street’s automated trading service to deal with restricted shares comes in. State Street believes it is the first to automate this service.

Frank Koudelka, senior vice president at State Street Global Services, says: “Servicing ETFs calls for conventional fund services like NAV accounting, for example. But NAV accounting becomes more specialised in the ETF world where you are creating a basket of securities.  The transfer agent function is highly specialised with ETF dealing. There is more contact and the need to educate authorised participants as to the dealing and settlement processes.”

Authorised participants, typically market makers or specialists who obtain the underlying assets to create ETFs, can simultaneously enter the ETFs they want to trade and identify any restricted shares using State Street’s FundConnect ETF trading platform.

Restricted shares are securities that are not eligible for proprietary trading and change daily based on underwriting, mergers, investments and other activities. 

“We send those trades to State Street Global Markets who will execute them, so that when the basket of securities is delivered the restricted names are included. In the past the participants would need to request manual custom baskets or send cash in lieu of those shares and the sponsor would then go to market to get full replication, but we’ve simplifies the process so the sponsor no longer needs to do that.”

Koudelka says that the method for identifying restricted shares within ETFs was previously manual and intensive.

Structures & markets
The complexity involved in servicing ETFs has increased significantly as they have been expanded to cover different assets classes. Their structures can also differ from one sponsor or fund to the next, using either physical securities, swaps or a hybrid of the two in order to replicate an index.

And in Europe a further challenge is posed by the different market regimes.

ETFs in Europe can also be listed on multiple exchanges and according to Koudelka of State Street, education for authorised participants as to the mechanics of different funds, such as where delivery should take place, is another function of service providers.

“In Europe we find we have to educate the authorised participants about how settlement has to take place in a particular ETF depending on where it’s listed,” he says.

Heffernan, at Boiss, says: “The requirements can be different. There are wide variety of structures and clients need to understand the different secondary market landscapes, their exchanges and settlement systems.”

Off the sidelines
Asset servicing firms are investing more in their ETF service capability in part because their old clients are becoming interested in entering the market, not just as investors, but as ETF sponsors.

Keenan, at BNY Mellon, says: “Many large firms were on the sidelines until they realised exactly what kind of proposition ETFs presented. Initially they thought that launching ETFs would cannibalise their own funds business.

“But the industry is at a tipping point now because many firms have seen how popular ETFs are. Many managers in the US, both active and passive, see ETFs as a vehicle that is growing quickly among certain distribution channels in the US.”

Kenan says there is a lot of interest from potential sponsors, including in the Middle East, Asia and Latin America.

Boiss has rolled out its ETP Direct platform to Asia and the Middle East and it is now also looking at certain frontier markets, says Heffernan.

“For Irish-domiciled ETFs we have a settlement infrastructure to allow managers to distribute, settle and trade ETFs in over 35 countries and plans to extend it to 50.”

©2011 funds europe



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