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The exchange traded fund (ETF) industry is preparing for the costly transfer of risk from US retail brokers, like Robinhood, as the US plans to implement T+1 settlement in May 2023. This move aims to reduce credit, market, and liquidity risks for market participants, according to the US Securities and Exchange Commission.
However, critics argue that the additional costs associated with T+1 settlement will disproportionately affect non-US investors, as most of the world operates on a T+2 basis. The European Fund and Asset Management Association, for instance, has voiced concerns about the burden on ETFs, citing the heavy investment in US equities by non-US investors.
ETFs rely on authorized participants (APs) who take advantage of price discrepancies between underlying securities and ETF prices. With T+1 settlement, European-listed ETFs will settle in T+2, while US-domiciled securities within those ETFs will settle a day earlier. This timing mismatch poses challenges and costs for APs, which are ultimately passed on to investors through wider spreads or ETF issuers relying on overdrafts with brokers to maintain T+1 settlement.
The transition to T+1 settlement has been discussed since the meme stock frenzy in January 2021, which caused regulatory concerns. While some believe T+1 will improve risk reduction and margin efficiencies, others like Joachim Tigler, former head of ETF trading at ADG Securities, do not expect significant changes in overall ETF adoption and liquidity.
In addition to increased trading costs, FX markets will also face operational challenges due to the shorter settlement cycle. Managers outside the US currently complete trade matching processes and settle FX orders on T+1. However, the reduced timeframe will hinder settlement through the primary payment-netting platform, leading to an increase in bilaterally settled trades. This carries greater operating and settlement risks.
Overall, the transition to T+1 settlement will impact EU firms, which will need to extend working hours to align with T+1 cut-off times. For Asia-based managers, settling within the US T+1 timeframe may pose insurmountable challenges due to time zone differences.
While there are differing opinions on the extent of the impact, the general consensus is that EU funds will experience higher trading costs, potentially affecting the appeal of US securities from an EU perspective. Industry organizations, like the Investment Association, are working with their members to find practical solutions to the challenges posed by T+1 settlement.
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While there are concerns about the impact of T+1 settlement, some experts believe the costs will be manageable and borne by brokers or incorporated into spreads shown to investors. However, the burden will be greater for non-US investors, especially as European Ucits have a larger proportion of AUM invested in US securities compared to US ETFs invested in international securities.
The potential fallout of T+1 settlement remains uncertain. EU firms will experience increased trading costs, and there may be an impact on the appeal of US securities from an EU perspective. The Investment Association is actively working with its members to find solutions to this challenge, particularly in relation to settling FX trades within constrained timelines.
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