On 22 January 1993, State Street Global Advisors issued the first ever exchange traded fund (ETF) – the SPDR S&P 500, which tracked the performance of the popular US index. Following a relatively low-key start to life on the markets – opening with just $6.53 million in assets – the fund has seen tremendous growth in the last 10 years, topping $450 billion in assets under management in January this year.
Interestingly, the performance of the SPDR S&P 500 is analogous with the performance of the wider global ETF market. Investors were quick to identify the clear benefits that an ETF offers – lower-cost, transparency, tax benefits, liquidity, diversification – skyrocketing the popularity of the investment vehicle, which saw global inflows reach an all-time high of $900 billion in 2021. Total AUM for the global ETF market also surpassed the $10 trillion mark in 2021, representing a 42% increase on 2020 and a tenfold increase on 2010.
So, why the significant growth? Aside from the material benefits of an ETF, a shift in the way ETFs are traded is also contributing to the growing popularity of the product In the US, where the majority of the world’s ETF activity takes place, the majority of transactions occur on-exchange, meaning trades are centrally cleared and regulated. In Europe and the UK however, ETF transactions have historically been settled over the counter (OTC), typically on request-for-quotation (RFQ) platforms. The latest estimates from within the industry suggest around 65-70% of ETF activity in Europe occurs OTC, meaning a significant portion of trades in the European market remain uncleared.
A streamlined approach
Before assessing the reasons why so few European ETF trades currently go through CCP clearing, let us consider the benefits that clearing provides – namely centralisation, standardisation, risk reduction and operational efficiency. “Centralised guaranteed clearing offers huge benefits to firms,” says Bill Kapogiannis, executive director, equities clearing services at the Depository Trust and Clearing Corporation (DTCC). “NSCC’s guarantee and associated risk management services, as well as netting the primary and secondary market activities, are some of the additional advantages.” Processing ETFs through central clearing means investors are guaranteed a level of settlement efficiency. Trading OTC means settling against multiple bilateral counterparties, managing a complex web of operational activity, and managing the counterparty risk themselves. By bringing that into clearing, the process is simplified with the central clearing house taking on the management of that risk and providing a series of operational efficiencies, enabling the trade to settle in a timely manner and reducing cost and operational risk for the investor.
Kapogiannis continues: “It’s a more streamlined approach, versus going broker-to-broker and being exposed to an individual counterparty. What we constantly hear from our clients is that we need to continue to expand clearing capabilities to capture as much activity as possible in a centrally-cleared CCP. “Because of the value of netting, cleared activity nets away over (on average) 98% of traded activity and the risk of fails associated with bilateral, non-guaranteed settlement. Additionally, by renetting fails day over day and repricing to the market, the greatest level of efficiency can be realised.” The technology is clearly there, particularly in the US where DTCC has operated as a settlement and clearing platform for ETFs since it launched to market back in 1993. In Europe however, the landscape is very different.
A fractured continent
On this side of the Atlantic, there has perhaps been a hesitancy to adopt CCP clearing avenues due to the fragmented nature of the ETF market and the lack of co-operation among market participants. In the US, all ETF trades are cleared and settled by the DTCC. In Europe by contrast, the European Central Securities Depositories Association (ESCDA) encompasses 39 national and international central securities depositories (CSDs) across 35 countries. “Each country’s issuer tends to issue the ETFs in different CSDs, so you end up with different versions of the same ETF across the continent,” explains Cecile Nagel, chief executive of EuroCCP. “In terms of trading and clearing, it’s very siloed and fragmented. “Because of the fragmentation, there are a lot of fails where ETFs don’t settle on a T+2 basis like they are supposed to. Bringing some of that activity into clearing will mitigate the risk of fails.” In its Unlocking the full potential of ETFs report, PwC states that for ETFs to flourish in Europe, “pragmatic solutions are needed to address some of this fragmentation and its impact on the smooth executive of ETF trading”. The report stresses that there must be greater harmonisation and co-operation among the European markets, and has highlighted key areas where the European trading infrastructure could be enhanced – transparency, venue choice, clearing and settlement, and ETFs for collateral and lending.
CSDR
Looking specifically at the clearing and settlement side of the market, perhaps the most significant attempt to co-ordinate a pan-European approach has been the introduction of the Central Securities and Depositaries Regulation (CSDR). After two delays to its introduction due to the pandemic, the legislation was ratified on 1 February 2022. The regulation is designed to be an “effective deterrent” against market participants from causing settlement fails, and to encourage trades to be settled in a timely manner.
The rules stipulate that: Central securities depositories (CSDs) impose cash penalties on participants to their securities settlement systems that cause settlement fails.
Greater pressure on the market to settle trades in a timely manner could mean we see an increased amount of ETFs going through CCP clearing – resulting in the levelling of the playing field between cleared and uncleared trading. With that playing field now levelled, whether an investor trades OTC, on a central limit order book, or in a cleared RFQ, the same penalties will apply irrespective.
The introduction of CSDR has, in effect, tidied up a market where there has been little settlement discipline in the past. A London Stock Exchange Group (LSEG) spokesperson explains that previously some market makers would, in the interests of their clients, price trades very competitively and as a result fail on the trade.
With CSDR coming into play, participants now risk a cash penalty when trading OTC, meaning we could see a significant shift toward centrally cleared ETFs to avoid that risk of failure and the subsequent fine.
A shift to clearing
Facilitating that switch to CCP clearing is now the important task facing the industry. “There’s demand for that CCP clearing to drive ETF trading,” the LSEG spokesperson tells Global Custodian. “Around 40% of the market is bilateral RFQs which are outside of CCP clearing – that is obviously operationally cumbersome. It’s not efficient for the market in terms of market makers to manage that in terms of bilateral settlement, for the buyer, and the balance sheet impact.”
To help accelerate this move, the likes of the LSEG and EuroCCP have launched products and services to help bring more RFQ trades into clearing.
In September 2019, EuroCCP announced a partnership with Tradeweb, one of the world’s largest RFQs, to bring more of its European OTC activity into central clearing. At the time, Tradeweb said the collaboration will streamline the settlement process by facilitating pre-settle margin and netting of exposures, while still offering the transparency and benefits afforded by the RFQ process.
In a similar move, LSEG launched RFQ 2.0 in December 2020, a CCP-cleared RFQ that also interacts with the order book. Uptake of the service has so far been strong, according to LSEG, with £1.2 billion worth of business being conducted since launch, with users seeing an average of 2.6 basis points in savings.
Such partnerships do well to standardise the clearing process for European investors, addressing potential risk and reducing trading costs. The development of these relationships and forming of new, similar tie-ups, will certainly help to drive more ETF activity through clearing channels.
When the going gets tough
In times of volatility, many investors will look increasingly to safer and lower-risk avenues to house their money. The global pandemic had a significant impact on every industry and every sector around the world, and the European ETF market was no different.
“If we cast our minds back to March-April 2020, when we obviously had a significant amount of volatility in the market due to COVID, we saw the LSEG order book market share jump from around 14% to 20%,” the LSEG spokesperson reveals. “And we sustained that market share pretty much for the rest of 2020, into 2021 and now into 2022.
“Many participants were looking for increased settlement certainty which CCP clearing provides. At times of market stress, clearly trading bilaterally has more risk attached to it than finding a way to trade using a central counterparty, especially on anonymous venues.”
As we warily move from one global crisis to another in the shape of a Russian invasion of Ukraine, market participants may continue to seek more security in their investments – further driving the adoption of centrally cleared ETF trades.
A long road ahead
“Change is always difficult,” concludes Nagel. “I think it will take time, but CSDR coming into force puts a lot more emphasis on efficient and timely settlement. As people start realising that, it will encourage more central clearing.”
In 2020, the London Stock Exchange reported a 50% year-on-year rise its order book volume for ETFs, commodities and notes to £154.8 billion, while Germany’s Deutsche Börse reported a 58% rise in exchange traded product turnover to 214.4 billion. So while the figures of CCP-cleared ETFs in Europe remain relatively low, they are growing every year.
The responsibility currently seems to fall on investors to choose whether they go through CCP clearing or not, but more needs be done on the market infrastructure side to make the choice a more palatable one. Consistency and interoperability among the clearing houses, regulators and trading venues is key to that.
Partnerships such as the Tradeweb-EuroCCP tie-up and the launch of LSEG’s RFQ 2.0 are a good start, but more can, and should be done to encourage the switch.