We explore some potential strategies to overcome challenges arising from the transition to a T+1 settlement cycle.

The move to T+1 in North America could trigger a number of operational challenges for ETFs holding foreign shares and those pursuing active management strategies. Though the first challenge – the misalignment in settlement cycles between the markets following T+1 and the others who are still in the T+2 settlement cycle – is well known, the second one – operational interplay between primary and secondary market dynamics – is less understood.

Misalignment in settlement cycles

The shares listed in Canada and Mexico started to settle on a T+1 basis on May 27, and the US followed a day later on May 28 due to a public holiday. With this transition to the shortened settlement cycle, the US Securities and Exchange Commission aims to reduce latency, lower risk, improve efficiency and boost market liquidity. However, overseas markets, such as Europe and Asia Pacific, will remain on T+2 for the foreseeable future. This indicates that as ETF shares are traded, the underlying foreign securities in the portfolio and cash will not be exchanged simultaneously and the time gap will, in many cases, need bridging with collateral.

With misaligned settlement timings due to T+1, some market makers and authorized participants risk not having the inventory to make timely deliveries. As a result, they will need to provide collateral of an equal amount as the value of the transaction a day in advance to bridge the gap in settlement times – and that comes at a cost.

Unfortunately, there is no comprehensive solution to this challenge until global markets align to T+1. But the end result will be an increase in costs for market participants, which are ultimately passed on to ETF shareholders through wider bid-offer spreads.

To help support the industry, we have developed a range of solutions. These include implementing a facility allowing same-day collateral returns, which benefit market makers and authorized participants by minimizing the opportunity costs associated with the collateral outlay.

Even though this isn’t the perfect solution, it is still better than the traditional approach of placing collateral based on a “one-time” calculation that returns on a scheduled date (usually next day) as long as the shares are delivered. With “same-day” collateral returns, market makers and authorized participants can see their capital held for a shorter period of time.

In an effort to mitigate these challenges, we collaborated with other industry participants to organize – with the help of the Securities Industry and Financial Markets Association – a series of industry meetings to find ways to reduce frictions from the change in settlement times ahead of the T+1 transition. The outcome of these meetings was an agreed upon industry roadmap to an offering that would allow an ETF to continue to trade as efficiently as it has historically

Primary and secondary market challenges

The second challenge revolves around the operational interplay between primary and secondary market dynamics.

In a primary market, authorized participants are responsible for creating and redeeming ETF shares at net asset value (NAV), while the secondary market involves trading these shares during market hours.

However, the primary market doesn’t operate during the same hours for all product types, complicating matters for US-listed ETFs with international holdings. This can also pose an issue for ETFs with active management strategies.

Passive US ETFs investing in US equities typically have order windows open until 4 p.m. ET every day, ensuring that timely settlement can happen between primary and secondary market transactions throughout the day. However, actively managed ETFs – involving actual decision making around stock selection and those holding global securities – often shut their order windows earlier than 4 p.m. ET.

When transactions happen late in the trading day, the market makers will need to create those shares on the next trading day. This is where T+0 is a very useful functionality, especially as actively managed ETFs are gaining popularity in the market, indicating that this issue will become more common. While spreads might widen in the short term, ongoing industry efforts and adaptations to reduce settlement frictions should help mitigate this impact over time.

To help you effectively manage this challenge, we offer an accelerated settlement solution – effectively T+0. At State Street, we were able to design, enhance and quickly implement changes to our ETF support architecture. Our ETF technology stack is global and proprietary technology, which allows for faster internal decision making by eliminating the need to negotiate with third-party providers before implementing a new solution.

Meanwhile, ETFs will benefit from any innovations that can lead to cost savings to help sustain profit margins. Tackling these operational issues is also an area where ETF managers can positively influence the bid-ask spreads of their funds.

Nonetheless, the introduction of T+1 necessitates that all ecosystem participants – market makers, authorized participants, custodians and exchanges – collaborate to streamline operations. It is expected, in time, that these innovations and adaptations will ultimately narrow spreads and maintain the competitiveness, efficiency and liquidity of ETFs.

At State Street, we have built the necessary infrastructure to help the industry manage timing misalignments for settling securities transactions and the associated costs. As the ETF sector becomes more comfortable with these new capabilities, it should get better at mitigating them, while continuing to provide efficient and cost-effective products for investors.

Find out how our T+1 settlement solutions can help you navigate the transition.