ETFs HAVE OUTGROWN THEIR HOMES.
The growth of the European ETF market looks assured, but it is not without significant challenges as Mo M’Rabti, director of product management, Euroclear explains.
Clearly, investors are starting to buy into the European recovery story, and are putting their money into European-focused exchange traded funds (ETFs). Funds concentrating on developing markets are also seeing solid interest levels. That said, the operational challenges and inefficiencies associated with ETF trade settlement remain largely unaddressed and are likely to impair future growth.
It has become increasingly evident that cross-border transfers of listed ETF shares are among the most pressing challenges that the European ETF industry faces today. Currently, ETFs are “fungible” between European stock exchanges, but there is no single settlement location where ETF trades on different stock exchanges in Europe are processed. ETFs are treated like equities, which means they follow the same local post-trade processes as equities and settle in each stock exchange’s national central securities depository (CSD).
The domestic post-trade structure was the right solution when ETFs were first launched in Europe in the early 2000s, as most of the trades were done within a given national market. For example, ETFs traded on the London Stock Exchange are settled via Euroclear UK & Ireland, the UK’s electronic settlement system, while ETFs traded on Deutsche Bšrse must be settled via Clearstream Banking Frankfurt.
The European ETF landscape has since evolved to cater for the interests of non-domestic investors, where the same ETFs are now traded on multiple national exchanges. In effect, European ETFs have rapidly become international securities. But the post-trade infrastructure for cross-border ETF trading hasn’t evolved to accommodate their international nature and growth in volumes. ETF settlement remains fragmented, which has a negative impact on ETF trading liquidity in Europe and is constraining further growth.
For example, the same ETF product could have multiple securities reference identifiers, depending upon where it is listed, e.g. a “DE” ISIN code for Germany or an “IE” for Ireland. The codes may be different, but the underlying ETF is one and the same. A source of confusion? Absolutely.
Moreover, under the existing regime, broker/ dealers buying ETFs on one exchange and selling the same ETFs on another face the cumbersome process of ETF realignment from one CSD to another, converting or re-registering their ETFs from one European market to another. In addition, because market rules and practices are not harmonised across Europe, dealers are often faced with managing different corporate action record dates, not to mention FX exposures on market claims.
Brokers use multi-location ETF inventories to mitigate settlement failures, which can result in large financial penalties. Rather than constantly converting or re-registering ETFs, brokers maintain buffer ETF inventories in multiple CSDs, which is extremely costly.
The international ETF – the industry responds
Clearly, it is time to create a more efficient post-trade structure to increase capacity for the ETF market to grow further. We need a post-trade infrastructure that is geared for cross-border ETF trading. The market believes the solution is an ETF structured as an international security.
There is already an equity-linked product – depositary receipts – which is traded on several trading venues and settles very efficiently in the ICSDs. The established working relationships between infrastructure providers – stock exchanges, MTFs, CCPs and ICSDs – are easy to extend to the ETF industry.
BlackRock and Euroclear, together with stock exchanges and CCPs, have been working together for some time to come up with a way to address the above issues impacting the liquidity of ETFs in Europe. The solution is to issue ETFs under an international structure for settlement at an ICSD – like Euroclear Bank. Effectively, the scheme provides ETF investors, regardless of their geographic location, with a single settlement location to process cross-border trades in these products. BlackRock will issue an iShare ETF using the new structure with Euroclear Bank in 2013. It is envisaged that other ETF issuers will benefit from ICSD settlement of their ETFs.
Under this new scheme, for broker-dealers which previously had to manage multiple CSD relationships, the benefit is obvious. The management of ETF inventories will be much more efficient and straight forward. And, we will see a significant reduction in settlement fails.
ETF transaction costs borne by brokers will plummet, which we expect will translate into compressed trading spreads for investors. This has important ramifications for the European ETF landscape when compared with the US. For example, BlackRock’s flagship MSCI Emerging Markets ETF, the EEM, trades with a spread of around two basis points (bp) in the US, whereas the same product is bought and sold in Europe at a spread of approximately 20bp.
This market-driven solution heralds a new dawn in ETF issuance, trading and post-trade processing. It is very likely that ETF issuers across Europe will continue to cross-list their ETF securities, and liquidity in these instruments will certainly improve by addressing the cumbersome operational issues. The growth potential of the European ETF market can climb to more than USD1 trillion in the coming three to five years, as leading ETF issuers now expect.©Best Execution 2013