T+1 will not be a ‘slam dunk’ for ETFs, industry insiders warn

The exchange traded fund industry faces a perfect storm on May 28 when the US cuts trade settlement times — with the transition occurring over a public holiday weekend and amid a series of major index rebalancings.

Gerard Walsh, who heads Northern Trust’s global banking and markets client solutions group, said he was having urgent last-minute talks with asset management clients, some of whom still seemed oblivious to the looming task at hand.

“Our key thing at Northern Trust is we’re talking to as many people as we possibly can to at least raise awareness of the fact that this is not a slam dunk. This is not going to be something that has limited-to-no-impact on portfolio managers in the front office,” he said.

The US Securities and Exchange Commission said in February 2023 that it would require trades to settle one day after trade agreement (known as T+1, a change from the current T+2 regime) by May 28, but Walsh is among industry figures who say this has not given the ETF industry enough time to thoroughly assess and prepare for all the risks.

Walsh pointed out that most ETFs are passive index trackers and will therefore have no choice but to trade in their underlying constituents in order to align themselves with the forthcoming index changes.

“I seem to have been the only one worrying about ETF trading, but I’ve seen lots and lots and lots of people pick up on it in the last month,” he added.

The choice of transition date might seem particularly ill advised. Announcements of the Russell Annual Reconstitution and the semi-annual rebalancing of the FTSE All World index will be made after the US market closes on May 24, which is also the last day that the US will trade on T+2.

The US then heads into a long weekend, but Canada and Mexico will move to T+1 on Monday, May 27 (a public holiday not only in the US but also in the UK).

When the US reopens on May 28, settlement staff will still be dealing with the last trades from Friday on the old T+2 schedule and any outstanding problems from the Canada and Mexico moves. However, at the same time they will be hit by a tidal wave of new T+1 orders due to the index announcements.

To cap it all, said Walsh, before the new system has had a chance to bed in, May 31 is MSCI rebalance day — “typically one of the largest trading days of the year”.

“The real crunch is those rebalances. Those rebalances happening around that week will put stress on the system immediately,” he said.

Sarah Simmonds, partner at Alpha FMC, a global consultancy whose client base includes the 20 largest global asset managers, said she too had concerns.

“The public holidays will mean this is happening at a time when staff aren’t working,” she said, adding that many clients had already responded by cancelling holiday for support staff.

“We are expecting to see a higher volume of settlement failures,” she said, adding: “I do agree that [the rebalancings] will only increase the problems.” In addition, she pointed out, additional cash that European Ucits ETFs take on in order to be able to bridge the period before the ETF wrapper settles could mean that the funds hit cash limit rules — which would incur a fine.

ETFs face particular difficulties because of the potential mismatch if their underlying constituents — traded on the so-called primary market by authorised participants who create and redeem ETF shares to match demand in the secondary market — settle at a different time to the ETF wrapper itself.

A European ETF, for example, has to wait up to two days after a buy order for payment from the ETF investor, but if it has US constituents, it will have to pay for the constituents a day earlier.

Walsh explained that some ETF managers might not be in a position to take on risk or to fund the risk that their authorised participants will have to adopt, particularly over the looming 72-hour long weekend.

James Pike, interim chief executive at Taskize, a web platform owned by Euroclear that aims to solve problems quickly between counterparties, said there were also technical difficulties to contend with.

He said the manual routing of exceptions, for example mismatches of trade information such as name of custodian, remained far too prevalent and would not be scalable to handle a jump in trade failures.

“Non-US-based market participants also need to implement the ability to ‘pass the book’ internally to other operations teams [in different time zones] so issues don’t persist beyond the end of the trading day,” Pike said.

Worst of all, Walsh pointed out, was a potential capacity issue, even if managers move fast to try to iron out last-minute problems.

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“The industry has deep pockets, but they’re not unlimited,” he said, adding that all managers should be asking themselves if they have adequate lines of credit, overdrafts and access to cash-like instruments, and the cost of these if they are suddenly needed in the dead of night.

Not all industry participants are so worried. Frank Koudelka, global head of ETF solutions at State Street, said there had been a significant amount of planning and while there were mixed views there would be an “element of wait and see over the first couple of months”.

But even Koudelka said that from a custodian perspective State Street was “reliant on investment managers” to get ready for May 28 and ensure they had updated their settlement cycles and have adequate funding in place.

“The thing that we won’t be able to see until it’s in the rear-view mirror is the rate of failure and the impact of those failures,” said Walsh, noting that failed trades incur fines in Europe and that some Asian markets are “no fail” markets, which means the trade voids if it does not settle in time.