ESMA Advisory Group Flags ETF Risks in EU's T+1 Settlement Push

The Securities Markets Stakeholder Group (SMSG) has cautioned the European Securities and Markets Authority (ESMA) about potential disruptions in exchange-traded fund (ETF) and bond markets as the European Union (EU) considers transitioning to a one-day settlement cycle (T+1). This move, potentially slated for implementation by 2028, follows the United States’ shift to T+1 in May 2024.

In its recent advice to ESMA, the SMSG highlighted that the complexity of the EU’s post-trading landscape could lead to a temporary increase in settlement fails during the transition. The group emphasized that ETFs and bonds are particularly vulnerable to these disruptions due to their unique market structures.

“This effect could be particularly pronounced for certain classes of instruments that present specific features, notably bonds and ETFs,” the SMSG stated in its advisory document.

The stakeholder group pointed out that both ETF and bond markets heavily rely on market makers who often need to borrow inventory to fulfill their roles. The transition to T+1 could strain the currently underdeveloped EU overnight borrowing market, potentially leading to more frequent settlement fails.

To mitigate these risks, the SMSG has proposed considering a temporary suspension of cash penalties for failed trades. This measure aims to prevent negative impacts on market makers’ willingness to provide liquidity, which is crucial for maintaining efficient markets.

For corporate treasury departments, this transition could present several challenges. The potential for increased settlement fails and liquidity constraints may necessitate adjustments to cash management strategies and short-term investment choices. Treasury teams may need to reassess their approach to ETFs and bonds as short-term investment vehicles during this transitional period.

The SMSG also highlighted the current misalignment affecting European-listed ETFs containing U.S. securities. These ETFs are experiencing wider spreads, premiums to fair value, and volume fluctuations tied to settlement cycles. While the transition to T+1 is expected to eventually resolve these issues, the initial period of adjustment could exacerbate these effects.

“The current misalignment appears to impact the ETF market itself, with wider spreads, ETFs trading at premiums to their fair value, volumes being determined by the day of the week, different prices for T+1 vs T+2 settling in the same ETF, and potential underperformance in UCITS due to the funding gap caused by misaligned settlement,” the SMSG noted.

Despite these short-term challenges, the SMSG anticipates long-term benefits from the T+1 transition. Once fully implemented and aligned across markets, the shorter settlement cycle is expected to improve overall settlement quality, potentially leading to reduced spreads and enhanced market efficiency.

The advisory group emphasized the importance of protecting individual investors during this transition, calling on ESMA to ensure that retail participants are shielded from negative impacts such as increased costs, widened spreads, or liquidity shortages.

As discussions around the EU’s move to T+1 continue, ESMA is expected to play a crucial role in addressing these operational challenges. Corporate finance teams, particularly in treasury departments, are advised to closely monitor these developments and prepare for potential adjustments to their investment and cash management strategies.

The SMSG’s advice to ESMA underscores the complexity of this transition and the need for careful consideration of its impact across different market segments. As the financial industry prepares for this significant change, ongoing dialogue between regulators, market participants, and advisory groups will be crucial in ensuring a smooth transition to the new settlement cycle.