Sometimes hidden risks really are not risky after all.
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.
What explains the fact that ETFs seem to be disproportionately affected by settlement failures?
There are a number of reasons why ETFs are disproportionately affected by settlement failures. First among these is the sheer velocity of some ETFs' share bases relative to those of most traditional equities. For example, over the past three months, an average of 19% of the shares of the popular ETF SPDR S&P 500
More important still, investors should understand the identities of the various parties in an ETF trade and how they might differ from those involved in a typical equity transaction. Most stock trades take place between two investors: a buyer and a seller. This makes sense given that publicly traded companies have finite numbers of shares outstanding at any time. ETF trades are very different. More often than not, there is a market maker that is party to a transaction in ETF shares. Market makers actively participate in the ETF market to arbitrage away any discrepancies between the price of an ETF's shares and its net asset value. These market makers can create and redeem ETF shares at any time, based on market demand. The creation/redemption mechanism means that the number of shares in a given ETF always is in flux.
Given the nature of ETF trading, market makers often will need to create new ETF shares to settle trades. Oftentimes the process to create new shares will not be initiated until two days after the transaction occurs, or "T+2." Then, this process often takes two days to complete once it has been initiated, meaning that newly created ETF shares won't be delivered until T+4 or later. So, by that point, the trade's settlement would be defined as having "failed," even though it simply has been delayed and fully settles at T+4 or T+5. The ETF creation/redemption mechanism, along with the very high velocity of many ETFs' share bases, explains why settlement failures are more frequent in ETF shares than in common equities.
Is there any incentive that would lead to intentional failures to deliver?
Yes. There is a financing rate that is implicit to the settlement process. If this financing rate is lower than the cost of borrowing securities or cash to settle a transaction, there may be some small incentive for a party to temporarily delay delivery (the difference between these two rates). However, this financing rate nonetheless does represent an actual cost to sellers and ultimately acts as an incentive for them to deliver their securities to the buyer. We would note that, unlike for pure equities, where the only way to create more shares is to issue a secondary offering, an ETF issuer easily can create more shares to remedy the situation fairly quickly.
Why do some ETFs experience more-frequent settlement failures than others?
As we stated earlier, the degree to which ETFs are affected by settlement failures is positively correlated with the velocity of their share bases. For instance, the aforementioned example of SPDR S&P 500 accounts for more than a fourth of the value of all ETF settlement failures.
Does this issue pose a systemic risk? Why or why not?
No. To say that settlement failures represent a potential source of systemic risk grossly overstates the potential problems they pose. Settlement failures in ETF shares more often than not are the result of back-office inefficiencies that result in minor delays to the ultimate completion of ETF trades. There is one point on which we can agree with the Kauffman Foundation: There is room to improve the settlement process for ETF shares with the aim of reducing the number of settlement failures. But this is a process that is best undertaken by initiating a constructive dialogue with the relevant parties (the Depository Trust & Clearing Corporation, exchanges, market makers, ETF providers, and investors) and not through conjuring fears of systemic failure resulting from delays in settling trades.
Ben Johnson is a European ETF strategist for Morningstar. ETF analyst Robert Goldsborough contributed to this article.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.
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