As more investors have discovered the benefits of ETFs, they’ve also asked good questions about how they work. A recent area of focus is the issue of how so-called “failed trades” may affect ETFs.

The simple answer is this: failed trades in the secondary market do not put fund investors at risk, and “failed” ETF trades may not actually be failures at all.

For a deeper understanding, it’s worth backing up to review the facts.

First, a definition: A failed trade is a trade that doesn’t settle by the contracted date. Trades for most US securities, including ETFs and bonds, settle 3 days after the trade date.  If either the buyer or seller fails to deliver (payment or shares) the trade is considered “failed.”  The key for investors of all kinds is that principal is protected.  If a trade fails, it just means the trade didn’t go through that day.  The buyer didn’t lose his payment if the seller didn’t deliver the shares, and the seller didn’t lose his shares if the buyer didn’t pay.  Most “failed” trades (for securities of all kinds) settle efficiently at a later date with no effect to the investor.  Because ETFs make up a relatively high volume of trades in the secondary market (20-30% of daily trades in the US), it stands to reason that ETFs tend to represent a higher proportion of failed settlements.

A key difference between stocks and ETFs causes confusion about ETF failed trades in particular (and goes back to the unique creation/redemption process that makes an ETF an ETF).  Large financial firms called “authorized participants” use the creation/redemption process to match ETF supply and demand and to maintain fair and efficient ETF markets.  In the process, these authorized participants are allowed more time to settle trades – three more days, in fact.

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