Euroclear: CSDR directive to cause ETF settlement inefficiencies

A consortium of European ETF issuers have made a submission to ESMA highlighting a number of potential unintended consequences from CSDR

Tom Eckett

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The Central Securities Depositories Regime (CSDR) is set to have a number of impacts on the European ETF market including settlement fragmentation and the impact of settlement penalties on the ETF primary market, according to a Euroclear report.

The report, entitled Europe’s ETF industry geared for the next level, warned ETF issuers are particularly concerned about the potential impact of the CSDR directive which comes into effect on 1 February 2022 following a 12-month delay last year.

CSDR is designed to harmonise settlement standards and improve settlement efficiency across the European market by implementing penalties to participants that fail to settle on time.

While ETF issuers are widely supportive of moves to tighten settlement discipline, the report revealed a European ETF issuer consortium made a submission to the European Securities and Markets Authority (ESMA) highlighting a number of potential unintended consequences from the directive.

One area of particular concern, the report highlighted, was around settlement penalties for the primary market.

As Paul Young, senior ETF capital markets specialist at Vanguard, explained: “This involves two settlement legs, ETF shares and a basket of securities.

“A failure of either leg could result in a fine or potential buy-in. Primary market trades take place when the availability of shares is exhausted in the secondary market, and a buy-in of the ETF leg could trigger the need for another primary market trade.

“This unnecessary churn in the ETF primary market would put more costs into the secondary market for the ETF shares and would likely increase the cost of trading for the end-investor without an obvious improvement in settlement discipline.”

‘More questions than answers’: CSDR impact divides ETF industry

Furthermore, Chancellor Rishi Sunak made the decision for the UK to not participate in the CSDR directive which has the potential to lead to fragmented settlement.

When CSDR comes into effect, ETF trades on the London Stock Exchange (LSE) and settled in Euroclear Bank are still in scope however those executed over-the-counter (OTC) and settled in CREST will be out of scope.

Where this could become complicated is CREST is owned by Euroclear so there remains a question mark over whether the Brussels-based firm will allow a subsidiary to be outside the scope of CSDR.

The report added: “Could this lead to settlement arbitrage where dealers choose to trade off-order book to avoid the CSDR regime?”

Overall, the report stressed the European ETF industry is in “rude health” after passing another stress test during the extreme volatility seen in the market last March.

With record trading levels among fixed income ETFs, in particular, institutional investors are starting to turn to the ETF wrapper as a liquidity management tool, as highlighted in ETF Stream's Under The Spotlight with BlackRock.

“While there is a harmonisation agenda to pursue, the market is in rude health, having gained a mass of new converts,” the report continued.

“Recent events have highlighted the resilience and robustness of Europe’s ETF market. The message that the largest ETFs – especially fixed income ETFs – offered an oasis of liquidity in an otherwise barren desert has clearly got through to institutional investors.”

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