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ETF Settlement Delays: No Cause for Alarm

Sometimes hidden risks really are not risky after all.

Ben Johnson, 03/14/2011

The Ewing Marion Kauffman Foundation recently produced a paper that called settlement failures in securities transactions "canaries in the coal mine," concluding that they pose systemic risk to financial firms and investors. The report's authors trained their sights on exchange-traded funds, citing eye-opening statements including that "ETF fails account for approximately 60 percent of the nearly $2 billion of daily equity trading fails reported to the [Securities and Exchange Commission], and on some days they account for 90 percent of all exchange-traded fails."

While the Foundation's bold statements grabbed our attention, we believe that it overstated the potential risks. The report neglects to explain why settlement failures tend to occur in ETFs, why the instance of settlement failure is far more frequent in ETF shares than stocks, and the actual (and largely nonexistent) implications of settlement failures for investors. While we would agree that there is room for improvement within the existing settlement framework for clearing ETF trades, it is quite a stretch to conclude that delays in the settlement of trades somehow pose "systemic" risk to the financial system.

In order to better understand this phenomenon, let's walk through the basics.

What is a settlement failure?
A settlement failure occurs when a buyer or seller in a securities transaction fails to deliver either cash or securities to the opposite party in the transaction within the specified settlement period. Equity trades--and these include ETFs because ETFs are considered equities--settle on what is referred to as a "T+3" basis--three days after the transaction occurs. If sellers fail to deliver securities or, less frequently, buyers fail to deliver cash within the specified time frame, the settlement is said to have "failed"--though, as we will discuss in more detail, "delay" may be a more appropriate term than "fail."

Why do settlement failures typically occur?
Contrary to the claims put forth within the Kauffman paper, fails tend to result from back-office delays and not deliberate "gaming" of the system. We'll discuss some of the reasons for failures that are unique to ETF shares later in this article.

How are settlement failures ultimately resolved?
Settlement failures usually are resolved when the seller delivers securities or the buyer delivers cash. As we stated previously, the term "fail" is somewhat misleading. While an equity trade that settles on a T+4 basis might be labeled a "failed" trade, it still is ultimately completed, just not within the stipulated time frame.

Even in the case where either party truly fails to deliver either cash or securities, the counterparty to the transaction will still be made whole. In these instances, collateral posted by the parties in the transaction will be used to settle the transaction, whether by purchasing the relevant security for the buyer or delivering cash to a seller.

What are the implications of settlement failures for investors?
Let's ask a question: In all of the time that you have been investing, have you ever been adversely affected by a settlement failure? Odds are that most investors will respond "no" to this question. This is because the settlement process is something that goes largely unnoticed by investors. Investors gain (or cede) economic exposure to securities at the time a transaction is completed, at what we can describe as "T=0." Whether a trade ultimately settles at T+3 or T+4 will have no impact on an investor's returns or access to cash proceeds. And, in fact, investors virtually never even see in their accounts that any trade ever "failed" to settle.

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