Esma advisory group warns ETFs will be hit by T+1 move

Exchange traded funds will be particularly vulnerable to settlement fails when the EU moves to shorten its two-day trade settlement cycle (T+2) to T+1, an advisory group to the European regulator has warned.

The Securities Markets Stakeholder Group has called on the European Securities and Markets Authority to consider excusing the ETF industry from trade penalties, pointing out that due to the complexity of the European post-trading landscape “the move to T+1 in the EU could result in a temporary increase in settlement fails”.

“This effect could be particularly pronounced for certain classes of instruments that present specific features, notably bonds and ETFs,” the SMSG said in its advice.

The group includes consumer, academic and financial services representatives. A move to T+1 in the EU is being discussed and a potential transition is mooted for 2028 at the latest.

This follows a move by the US to switch from T+2 to T+1 settlement in May this year.

Both bond and ETF markets are particularly reliant on market makers borrowing inventory to fulfil their role, the SMSG said.

“Market practice and availability of overnight borrowing could take some time to adjust, leading to more frequent fails in that period. A temporary suspension in cash penalties might be considered to avoid a negative impact on the willingness of market makers to provide liquidity,” it added.

The advisory group argued the regulator should consider individual investors and should try to shield them from any negative impacts arising during the transition, pointing to the possibility of increased costs, widened spreads or liquidity shortages.

The SMSG also alluded to the difficulties ETFs experience with the current misalignment for European listed ETFs that contain US securities. European funds still settle in T+2, despite their US holdings settling a day earlier.

“The current misalignment appears to impact the ETF market itself, with wider spreads, ETFs trading at premiums to their fair value, volumes being determined by the day of the week, different prices for T+1 vs T+2 settling in the same ETF, and potential underperformance in Ucits (not just ETFs) due to the funding gap caused by misaligned settlement,” it said.

However, it added that, in the long run, “settlement quality could be expected to improve” when the EU does move to T+1 and the misalignment is addressed.

Esma did not immediately respond to requests for comment.

James Pike, interim chief executive of Taskize, a financial services group owned by Euroclear that helps resolve discrepancies between counterparties, agreed that any move to T+1 in Europe would initially exacerbate current inefficiencies, such as wider spreads and pricing inconsistencies between T+1 and T+2 settlements.

“These misalignments could lead to increased premiums and diminished liquidity, as seen in current market trends,” Pike said.

However, he too forecast a marked improvement in settlement quality in the longer term, with reduced spreads and enhanced market efficiency. “But getting there will require significant co-ordination among market players to avoid disruption during the transition,” he added.