Listed Equity Securities and Exchange-Traded Funds - An Operational Observation

Exchange-traded funds (ETF or ETFs) are presented as securities with the same trading, clearing and settlement features as listed equity securities. The CFA Institute Research Foundation A Comprehensive Guide to Exchange-Traded Funds (ETFs) notes: “…Confusion abounds about how ETFs work. Claims have even appeared in the popular press that somehow ETFs are a special class of securities subject to different rules when it comes to the back-office processes. Although ETFs are truly unique, the reality is that from the perspective of an investor buying them on the open market, they go through the same settlement and clearing process as any other stock listed on the US stock markets….” As such, the expectation is that operational overhead associated with ETFs would not produce an operational outcome pattern different from the operational outcome pattern of listed equity securities. However, using available public fails-to-deliver data, the data demonstrates ETFs have an operational outcome that is not comparable to the operational outcome pattern for listed equity securities groups. Organizations such as The CFA Institute Research Foundation and Blackrock believe “…a market maker can benefit from delaying settlement for as long as possible…” or “…higher failure-to-deliver rates in ETF shares may merely represent greater market making activity….” A "market maker" is a firm that stands ready to buy or sell a stock at publicly quoted prices . On June 7, 1995 when T+3 settlement came into existence, bona fide market making was allowed an additional 3 days after contractual settlement date to close-out a position. The additional 3 days were to allow for the physical processing and movement of securities by couriers carrying satchels of physical securities. On September 5, 2017, T+2 settlement took effect to reduce settlement risk by a shortened period to convert market liquidity into settlement liquidity. Despite with the change to T+2 settlement, bona fide market making was allowed to continue an additional 3 days to close-out a position. Currently, DTCC is considering a change from T+2 settlement to T+1 settlement to improve liquidity, margin usage, and risk control. White papers from organizations such as DTCC and SIFMA make no mention of improvements to market making close-out efficiency to accompany overall settlement and clearing process improvements. Even with the technological advances in trading, clearing, and settlement since the mid-1990s, market maker close-out efficiency has not improved. This suggests market making close-out efficiency, in particular with respect to ETFs, is a matter for consideration to accompany overall settlement and clearing process improvement efforts.