Bill Kapogiannis, DTCC Executive Director, Equities Clearing Services writes that there is nothing like a crisis to help put things into perspective, and the market volatility that ensued as a result of the pandemic has placed a spotlight on the operations of the ETF market, especially as it relates to the need to increase operational efficiency while removing as much counterparty risk as possible.
The ETF industry in the U.S. has seen significant growth since DTCC’s National Securities Clearing Corporation (NSCC) cleared and settled the first trades placed on ETFs in 1993. Nearly 30 years later, the ETF industry has matured, both in terms of product availability and assets under management. As exchange-traded products continue to grow in popularity, with more asset classes becoming available, such as fixed-income ETFs, there are three areas the industry should prioritize: attaining greater participation in central clearing, adopting streamlined collateral management processes, and achieving further transparency into this evolving market.
Leveraging Central Clearing for ETFs
The central counterparty (CCP) clearing model of ETFs continues to offer the same essential benefits it has always provided, including standardization, risk reduction, and operational efficiency. Central clearing allows ETF Agents, Authorized Participants (APs), sponsors, exchanges, buy-side firms, and others to receive all U.S.-listed ETF creation and redemption baskets in one standard format.
A CCP, like NSCC, can also provide operational efficiencies and balance sheet savings during the creation and redemption of ETFs. Firms that centrally clear ETFs benefit from netting, an automatic process that offsets trades down to one position per client, by reducing the value of payments that need to be exchanged and minimizing security movements and costs.
The central counterparty clearing model of ETFs continues to offer the same essential benefits it has always provided, including standardization, risk reduction, and operational efficiency.
At the same time, the more that ETF clearing, and settlement can be managed by a clearinghouse, the more counterparty risk can be reduced. That is because trades that are cleared through a CCP receive a trade guaranty, or the assurance that the trade will be completed by the CCP, even if a counterparty to the trade defaults on its obligation. Therefore, it is extremely important that the industry continues to move towards a centrally cleared model.
Streamlining Collateral Management
The collateral management process has for years relied on manual workflows, which can cause reconciliation issues and delays in the return of collateral, leaving market participants out of cash, even after the ETFs have settled. This is unacceptable, especially during times of market turbulence and uncertainty.
A fully automated process offered by a CCP can take instructions in, process the payment order, and pass collateral from the APs to the ETF Agents on behalf of the fund – all within a no-touch process. Doing so simplifies collateral management from a processing standpoint by removing the need for a manual workflow, increasing efficiencies by resolving reconciliation issues and delays, and allowing firms to free up capital by reducing the amount of collateral required on orders. Firms should assess their current processes and determine if further automation in the collateral management process is needed.
While recent regulatory changes, including Rule 6c-11 under the Investment Company Act of 1940, have made it easier for new ETFs to come to market, they have also called for increased transparency, requiring funds to publicly disclose information to help facilitate greater competition and innovation among ETFs. A CCP can offer increased transparency for firms by providing support for ETF Agents to publish pricing baskets that include industry-requested features, such as additional data elements across all basket types. As firms consider regulatory obligations around disclosure, it is important to also consider how utilities and, more specifically CCPs, can help in this area.
As ETF portfolios become more complex and diverse, and market volatility continues, the industry has three clear priorities that will help support the ETF industry for the coming years by reducing risk and providing balance sheet relief. DTCC believes firms who take advantage of centralized post-trade services will be better positioned to not only seamlessly support future ETF growth and diversification, but also increase transparency in this important market and allow for more efficient, automated post-trade processes. The time to re-assess and invest in this part of operations is now.
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