Exchange traded fund (ETF) industry participants are bracing themselves to take on a costly transfer of risk from US retail brokers, such as Robinhood, when the US unilaterally implements T+1 settlement in May next year.
What is T+1 Settlement and Why Does It Matter?
T+1 settlement is a shortened trade settlement cycle that reduces the time between the execution of a trade and the delivery of the securities and cash. Currently, most US trades are settled on a T+2 basis, meaning two business days after the trade date.
The Securities and Exchange Commission (SEC) has proposed to shorten the settlement cycle to T+1 by May 2023, citing benefits such as lower counterparty risk, reduced margin requirements, and increased operational efficiency.
However, some industry experts warn that the move could have unintended consequences for ETF investors, who could end up paying for the reduced risk exposure of retail brokers that facilitate meme stock trading.
How Meme Stock Trading Affects ETFs
Meme stocks are stocks that have become popular among online communities of retail investors, such as Reddit’s WallStreetBets, who often coordinate to drive up the prices of heavily shorted or undervalued stocks. Examples of meme stocks include GameStop, AMC Entertainment, and BlackBerry.
Meme stock trading can create significant volatility and liquidity challenges for market participants, especially during periods of high trading volume and price swings. Retail brokers, such as Robinhood, have to post collateral with clearing houses to cover their exposure to potential losses from unsettled trades. This can strain their balance sheets and force them to restrict trading or raise capital.
ETFs, which are baskets of securities that track an index or a theme, can also be affected by meme stock trading. Some ETFs may hold meme stocks as part of their portfolio, either by design or by rebalancing. This can expose them to higher volatility and tracking error, as well as increased trading costs and operational risks.
Why ETF Investors Could Pay the Price
According to a recent article by the Financial Times1, ETF investors could bear the cost of helping reduce meme stock risk when the US moves to T+1 settlement next year. The article cites a report by Jane Street, a leading market maker for ETFs, that estimates that the move could cost ETF investors up to $12 billion a year in lost returns.
The report argues that the move would shift the risk from retail brokers, who would benefit from lower margin requirements and less collateral pressure, to ETF investors, who would face higher transaction costs and lower liquidity. The report also claims that the move would create an uneven playing field between the US and other markets that have not adopted T+1 settlement, such as Europe and Asia.
The report suggests that a better solution would be to adopt real-time settlement, which would eliminate the need for collateral and margin altogether. However, this would require significant changes in the market infrastructure and regulatory framework, which could take years to implement.
How ETF Investors Can Protect Themselves
ETF investors who are concerned about the potential impact of T+1 settlement on their returns should be aware of the risks and opportunities associated with meme stock trading. They should also monitor their ETF holdings and performance closely and adjust their strategies accordingly.
Some possible steps that ETF investors can take include:
- Choosing ETFs that have low exposure to meme stocks or avoid them altogether.
- Diversifying their portfolio across different asset classes, regions, and sectors.
- Seeking out ETFs that have lower fees, higher liquidity, and better tracking accuracy.
- Taking advantage of arbitrage opportunities that may arise from price discrepancies between different markets or settlement cycles.
- Using limit orders or stop-loss orders to control their entry and exit points and limit their losses.
ETF investors should also keep in mind that meme stock trading is not necessarily a bad thing for the market. It can create new opportunities for innovation, competition, and democratization of finance. It can also challenge the status quo and force market participants to adapt and improve their services and products.