The ETF industry is preparing itself for the implementation of the Central Securities Depositories Regulation (CSDR), now due for roll out in February next year. It is an important development, and here is why industry participants should take note.
First and foremost, CSDR is set to alleviate settlement fails by streamlining settlement standards across the European market. The resulting diminution in un-settled positions will be a positive change for the industry and is warmly awaited.
This is to be achieved via cash penalties and mandatory buy-ins whereby, in the instance of a failed delivery of securities, the buyer can source the securities from a third party. Instead of delivering the securities, the original seller is obliged to pay any difference in the cash value.
These tools will be accompanied by the implementation of common features across markets such as partial settlement and ‘hold and release’ (the former reduces penalties by delivering any securities that are available, while the latter lets participants instruct as either ‘on hold’ or ‘released’, allowing settlement instructions to be matched without completing settlement – this complements a mandatory buy-in as, once initiated, it is imperative that settlement does not complete).
Harmonisation will be especially beneficial to European-listed UCITS ETFs. Being an international wrapper covering a wide variety of investor bases, UCITS brings an inevitable element of market fragmentation, with multiple share classes typically existing for single ETFs across different central securities depositories (CSDs). CSDR will provide a common set of requirements for CSDs operating across Europe, which will streamline the market.
Some have questioned the knock-on effect of settlement failure penalties. Owing to the twofold nature of ETF settlement, featuring both an ETF leg and a securities leg, primary market trades are particularly exposed to these.
For example, in the event of failing to successfully settle either leg in a timely manner, a buy-in of the ETF leg could catalyse the creation of ETF shares in the primary market. This would incur a potentially hefty creation fee, ultimately borne by investors.
Given the heavily intertwined nature of the primary and secondary market, it is natural for this risk to be reflected in a widening of spreads in the secondary market. A greater pool of balance sheet inventory could be used as a precautionary measure, but this would come with its own price tag.
Market participants have also flagged other issues. ETFs come under the generalised ‘Illiquid Share’ category. As MiFID II and its tick regime reminds us (with trading venues required to adopt a minimum incremental amount at which a security can trade), it is reasonable to ask whether a non-specific categorisation merely creates additional burdens for no practical gain.
As always, the devil is in the details, yet questions and concerns preceding the introduction of a new directive are to be expected. Overall, it is reassuring to see that at the core of CSDR is a push for timely and smooth settlement. This will be welcomed by all.
Keshava Shastry is head of capital markets at DWS, chair of ETF task force at EFAMA and chair of the ETF committee at the Investment Association
This article first appeared in ETF Insider, ETF Stream's new monthly ETF magazine for professional investors in Europe. To access the full issue, click here.