The Securities and Exchange Commission (SEC)'s initiative to accelerate the settlement cycle for securities trades could inadvertently escalate expenses for a significant segment of the ETF market. The forthcoming transition, slated for May next year, presents a logistical conundrum for U.S.-listed ETFs with foreign assets, totaling over $1 trillion. The crux of the issue lies in the settlement discrepancy: ETF shares will settle in one day, but the settlement for the international assets they hold could take two to five days. This mismatch necessitates authorized participants (APs)—key market makers in the ETF industry—to front collateral for an additional day during inflows and possibly resort to borrowing during outflows, leading to increased costs likely to be passed on to investors.
Over 900 industry specialists are actively engaged in discussions to navigate the potential challenges of the SEC's settlement adjustment, which is expected to mainly affect ETFs with international holdings. APs play a critical intermediary role, profiting from arbitraging price discrepancies between an ETF and its underlying assets. Typically, APs create or redeem ETF shares in exchange for the underlying assets, depending on the demand. However, the new settlement rule complicates this process for ETFs with foreign assets, potentially imposing additional financial burdens on APs.
For example, heavy demand for an ETF holding Asian securities might require an AP to deliver ETF shares to an investor in one day, whereas acquiring the necessary basket of stocks to exchange with the fund manager would take a minimum of two days. This results in APs having to provide an extra day's worth of collateral, increasing the operational costs. State Street Global Advisors' market structure specialist, Kimberly Russell, warns that these heightened costs in the primary market could translate into higher transaction fees for investors in the secondary market.
The implications of outflows under the new settlement rule are even more problematic. APs might be compelled to use short-term borrowing to fulfill cash obligations for redeemed ETF shares, given that the proceeds from the sale of international stocks will not settle until at least two days later. In the current climate of rising interest rates, such borrowing could become notably more costly. Andrew Lekas from Old Mission highlights the potential for financial misalignment, as APs will need to disburse cash before receiving the settlement from sold assets.
