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.
Unfortunately, the list that the SEC publishes daily on failed trades for all securities doesn’t capture this important distinction for ETFs. As a result, ETFs are often cited on the fail list more frequently than other securities. It doesn’t mean that ETF trades fail more frequently; it simply means they may settle outside of the traditional 3-day cycle (and still inside the window that is permitted by existing regulations for authorized participants).
As a result, the higher instance of reported fails for ETFs may not reflect actual failures at all.
BlackRock has found no trading irregularities that suggest investors are at risk due to failed ETF trades in the secondary market. And in our experience the occurrence of TRUE failed trades by authorized participants (where they’ve exceeded their permitted 6-day window to settle a trade) is virtually non-existent.
We don’t believe that SEC data on ETF failed trades indicates a flaw in the ETF structure or risk for ETF investors. But, as a company, we fundamentally believe in making investing clear and transparent for investors. Better transparency into the nature of failed trades on the daily list could help investors understand failed trades of all kinds. Especially because, in most cases, “failed” ETF trades aren’t failures at all.
Joseph Cavatoni, Managing Director, is a member of the iShares Group within the Global Client Group. He is responsible for the management of all iShares Capital Markets relationships for the Americas region, which includes the US, Canada and Latin America.