Part of what makes an exchange-traded fund (ETF) efficient and easy to use is that it has characteristics of both stocks and mutual funds. Think of a Venn diagram for a moment where the sweet spot, the place in the middle where a stock and a mutual fund overlap, is an ETF. Now enter T+1, which beginning May 28 in the United States and May 27 in Canada and Mexico will require settlement to occur the next business day after a trade. This change poses potential challenges for ETFs. To understand why, go back to that idea of a Venn diagram.
 

How ETFs trade

ETFs trade like stocks on exchanges and, like stocks, are owned in brokerage accounts. Yet ETFs also benefit from professional management like mutual funds. In fact, ETFs are part of two distinct markets: the primary market, where new shares of ETFs are created and excess shares are destroyed (think of this as subscription/redemption direct with the fund at Net Asset Value or NAV), and the secondary market, where ETFs are bought and sold by individual investors.

So how does an ETF operate efficiently in these two markets concurrently? First, there’s a little more explanation needed around the mechanics of trading before arriving at an answer. And that answer gets to the heart of where the challenges from T+1 lie.

There are two specific roles in the ETF ecosystem called Market Makers (MMs) & Authorized Participants (APs). When there is a misalignment of inventory in the secondary market (i.e. too many buyers and not enough sellers), you might think the ETF would then trade at a premium, and if the misalignment continued, the premium would grow. That logic is only partially correct. Are there premiums in ETF market prices? Yes. Do they continue to grow until the buyers and sellers become naturally aligned? No.

This is where an MM will step in and pick up the slack for the lack of sellers. The MM will pair off with each buyer, effectively selling the buyer shares of the ETF at the market price (bid/ask). The MM will then contact their AP to create or mint brand new shares of the ETF, with the Fund Sponsor in the primary market at the next available NAV. The AP will deliver to the ETF all the underlying securities the ETF owns.

In return, the ETF will provide the AP the newly minted ETF shares. The AP delivers to the MM, and the MM makes delivery to their end client (the buyers). All of this, with real dates for a generic global equity ETF, can look something like this:

• Buy on exchange late in trading day on April 24, 2024
• AP creation with fund occurs on April 25, 2024 with shortened settlement of T+1
• The settlement date of AP creation and the date MM is expected to settle up with the buyer is April 26, 2024 (or on T+2 of original ETF trade in the secondary market).

This relationship between ETF, MM, AP, custodians and the exchange that occurs across two marketplaces is one of the key reasons ETFs are so efficient.

The mechanics of ETFs and a shortened settlement cycle

Now, what happens when we shrink the settlement cycle by one day as required by T+1? Sometimes, nothing. But occasionally — and this is where it gets challenging — costs will increase due to a new misalignment between the secondary market and primary market settlement.

To understand why, we go back to the earlier example of the relationship between the secondary market and primary market. Using the same example of a generic global equity ETF: There are more buyers than sellers, the premium starts to increase and an MM steps in and takes the other side of the buyers. The “buyers” are now expecting ETF shares in their brokerage account in one business day given the shortened settlement cycle. The MM will communicate with the AP to create new shares of the ETF with the fund. The AP subscription will take place the next day in some circumstances, meaning the settlement date occurs one day later than the MM is expected to deliver ETF shares to the buyer. With settlement failing in the expected time frame, this creates a negative client experience for the buyer.

Some may ask, why doesn’t the MM keep some inventory on hand to avoid this situation? There are two problems with that: First, the MM is not going to keep inventory in 3,000 ETFs in case of a misalignment or circumstances where the AP creation cannot be done same day. Second, the cost to carry that additional inventory would be borne by individual investors (buyers or sellers).
 

Overcoming the challenges to ETFs

At State Street, we saw this potential challenge from T+1 coming. And we’ve been working with the ETF industry to design and implement the necessary operating models and technology to support a “just in time” expedited ETF share minting and settlement in the primary market.

ETFs are becoming the go-to investment wrapper for the industry, mainly because they are both efficient and cost effective. Had our firm and the ETF industry not made any changes, the ETF would still function, but not as efficiently or cost effectively – and that alone may have been enough to knock ETFs off their growth trajectory.
 

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