The eyeing of a shift to T+1 settlement around the world in recent years has represented an almost inevitable evolution of market structure in the never-ending search for efficiencies and risk reduction. The move – essentially, the shortening of the equities settlement cycle to one day, as opposed to the current standard in most major markets where trades are settled two business days after they occur – is a contentious one, despite the aforementioned inevitability.
Earlier this year, the US Securities and Exchange Commission (SEC) voted to shorten the settlement cycle to one business day, with the implementation date set for 28 May 2024. The move will have numerous benefits but will also pose various challenges for the industry as a whole, not just with regards to a rapidly ticking clock, but also operational changes, technology overhauls and process adaptions for a leg of the trade lifecycle which is already wrought with challenges.
But it’s not just a post-trade issue, as multiple experts from the front-office have highlighted the shift as having a major impact on trading desks. With the US set to transition to T+1, the impact on European markets cannot be ignored – both in terms of the implications of the US move and the prospect of a potential shift by Europe and the UK to the same cycle.
A logical progression
“Historically, settlement cycles have been getting shorter over time. If you look back to the aftermath of the 1989 stock market crash it was decided that there needed to be a shortening of the settlement cycle to reduce risk, the amount of open exposure in the system and the impact of counterparty defaults,” says Peter Tomlinson, director of post- trade and prime services at The Association for Financial Markets in Europe (AFME).
“Since then, US markets have gone from T+5 to T+3 to T+2 and from that perspective, T+1 is the next logical sequential step.”
Looking at what sparked the push to accelerate settlement cycles to T+1, the meme stock mania in early 2021 has been attributed as one of the reasons behind this transition – not that this is something the DTCC are keen to admit, as they insist they were eyeing the change regardless of the saga. On 27 January 2021, day traders on Reddit and other social media networks responded to hedge funds that had been short selling the stock of gaming company GameStop by purchasing the ‘meme stock’ en masse, resulting in its share price being inflated by 12,500%. As a result, some retail brokerages temporarily prohibited certain trading activity, with some funds also incurring hefty losses due to being forced to close out their short positions in meme stocks. But will T+1 help mitigate future issues?
“The move [to T+1] came about in rather a strange manner, given that it arose from the meme stock discussions back in 2021. There seems to be some assumption at the SEC that if the US was on a T+1 settlement cycle, then firms such as Robinhood wouldn’t have struggled so much with risk management and margining requirements,” says Virginie O’Shea, founder and CEO of Firebrand Research. “While the move will certainly reduce the amount of margin that will be required to be posted for clearing, it won’t protect investors against brokers with poor risk management and planning.”
Instead, a more tangible benefit of the shift to T+1 would be its ability to help reduce counterparty risk – the risk that one party to a transaction will default or fail to fulfil its obligations. With settlement being accelerated to one business day, in theory, the risk of default is minimised, with transactions being able to be completed quickly. T+1 could also improve liquidity in the market. With trades settling more speedily, investors have the ability to use their funds to make new trades, ultimately increasing trading volume and liquidity in the market. In addition, accelerated settlement times could bring potential cost savings for the market through reduced margin requirements.
The possibility of T+1 in Europe
Following the US SEC’s confirmation that the US will transition to T+1 next year, all eyes are on the UK and EU to see whether they will follow suit. Time zones are undeniably a huge factor when it comes to accelerating settlement times, and given the location of Europe, a shift to T+1 could arguably be less strenuous than what we may see happen in the US.
“The impact is different on European markets to North America. On one hand, Europe benefits as it sits in the centre of the follow-the-sun model, whereas the US is at the western end of that cycle,” says Adam Conn, head of trading at Baillie Gifford.
“Therefore, at the end of the US day, you are already into the next trading day. One of the advantages of Europe and the UK, is that you have time to fix a problem or you have time for a trade to match. You will not necessarily get that time in the US. On the other hand, the post-trade world, from the sheer number of CCPs and CSDs even down to the delivery of paper share certificates, needs addressing. The good news is, we might finally get more simplified and efficient post-trade processes. To start with, I believe there is a greater risk of a spike in trade fails in the US and Canada, given there will be less time to settle those trades.”
Europe’s position in the centre of the follow-the-sun may be advantageous, however, introducing mismatched settlement cycles – which were previously harmonised – could present various risks. “Europe in particular faces hurdles to catching up to the US T+1 adoption, given the fragmentation of the market,” notes Joe Urban, managing director of electronic trading at Clear Street. “In October 2014, the central securities depositories regulation (CSDR) mandated 29 European markets move from a T+3 to a T+2 settlement cycle. This simultaneous, hot cut-over was unprecedented in scale and breadth. Repeating this exercise will require tremendous coordination, although a precedent has been set.”
Although it is the US that is transitioning to T+1, it is worth noting that capital markets are global and whatever changes happen in a major market, will ultimately impact investors and counterparties across the globe. Essentially, the further away the market and the greater the time zone difference, the harder it will be to manage this shift to accelerated settlement times.
“Europe is a very different kettle of fish. There are at least 18 to 20 exchanges, multiple clearing routes and multiple currencies. The US, with a single currency and relatively few exchanges and clearing structures, has a marked advantage in planning to move to T+1,” says Gerard Walsh, global head of capital markets client solutions at Northern Trust.
“Europe would be a much more challenging proposition given the use of multiple currencies, multiple exchanges and the fact that quite significant amounts of European stock trading is done in markets at the eastern edges of the time zone like Sweden and the Nordics. There is quite a lot of smaller hedge fund type activity as well. Europe would be a much more challenging proposition to get a commonality of outcome than say the US, with its single currency and its extremely liquid listed securities market based on exchanges on the eastern seaboard.”
In addition, Urban highlights potential hurdles that could arise amongst exchange-traded funds (ETFs). “ETFs present a specific complication that arises with different settlement cycles. Many ETFs that trade in the US and will now be cleared on a T+1 basis, are composed of (foreign) stocks that will continue to be cleared on a T+2 basis.”
Cross-currency challenges
The issue of foreign stocks and foreign exchange is an element that will be hugely impacted by the US’ transition to T+1 settlement. The move will result in less time for firms to interact with any US-based counterparties. A shift to T+1 essentially means that if there are any breaks or exceptions to manage in the trade settlement process, there will be less time to engage with counterparties to settle those.
“Firms will need to have funding in place to settle their obligations, ideally by start of business on T+1. That means, if you have any cross-currency transactions, FX bookings will need to have been completed. All of these post-trade processes will have to be completed at an earlier point, ultimately compressing the time frame in which you have to do this post-trade activity,” notes AFME’s Tomlinson.
“That applies universally, but the particular challenge for non-US counterparties is having that time zone difference, meaning that there is less overlap with your US-based counterparties. Essentially, that window after market-close on trade date will be extremely important.”
Baillie Gifford’s Conn warns that there isn’t necessarily an appreciation for the way that FX settles – with less attention being placed on this aspect when discussing T+1. “There are several issues to consider with a fund that does not use USD as its base currency. Will there be sufficient time post the US equity market close to match trades and generate, then buy any USD needed for settlement? Will there then be sufficient liquidity (size and tight spreads) at that time of the US day, especially on a Friday or leading up to a public holiday, to execute these trades? Lastly, what happens if it’s a bank holiday in the base currency of the fund investing in US securities.
“This brings in the fundamental issue of how to modernise the FX settlement process. Rather than two sides of a spot FX trade settling in different time zones, payment mechanisms need to be updated. A way round this could be the eventual introduction of central bank digital currencies which will allow instantaneous ledger-based settlement as standard. On the basis that it still takes days to clear a cheque or make a BACS payment, is the system going to work well in Europe, particularly with CSDR or CSD fines?”
A structured approach
Consequently, it is essential that the potential adoption of T+1 in the context of the UK and EU is approached in a structured and coordinated way – especially given the CSDR settlement discipline regime put in place to penalise settlement fails on the continent. With such penalties in place, costs of trading could ultimately increase to factor in penalties.
“In EU markets, policymakers are still considering how to penalise and disincentivise settlement fails, including the possible introduction of mandatory buy-ins, which the industry has opposed due to the potentially very serious negative consequences from a market liquidity perspective. If mandatory buy-ins come in, that will be on the basis of there being increases in settlement fails. We do not want to implement T+1 in a way which causes more settlement fails and leads to mandatory buy-ins being implemented,” stresses Tomlinson.
“T+1 is a driver for the industry to start investing more in post-trade processes. We could ultimately see a longer-term reduction in settlement fails through increased levels of automation. But the risk is doing it too quickly, you will end up with a lot of short-term pain as firms struggle to adapt to the new requirements.”
The impact on smaller firms
The shift to T+1 is expected to have varying impacts depending on the size of firms. Smaller firms are more likely to see an increase in settlement fails, simply given the disparities in the size of teams who will have to deal with reduced settlement times. In addition, smaller firms generally have legacy batch overnight systems that will not be able to cope with increasing volumes that will come as a result of T+1 – meaning added costs to implement new systems to avoid settlement fails.
“T+1 benefits will be perhaps harder to see in smaller firms with smaller operational footprints. Mitigating settlement fails depends on the efficiency of multiple operational teams working together to make the matching-clearing-settlement cycle hang together,” explains Northern Trust’s Walsh.
“I do not think you would necessarily see increased fails at the heavyweight Tier 1 institutional level. Those big operations teams are used to coping with change and embedding new processes, technologies, et cetera. With US market settlement times being shortened to 24 hours, we might see an increased risk of failed trades and compulsory buy-ins due to reconciliation breaks and post-trade error fixes in static data – or where there is a smaller or less robust operations process than perhaps in a Tier 1 institution.
“That’s especially true for teams in a non-US location working outside US market hours. The entire industry is and has been for many years, focused on avoiding committing parties in the settlement cycle to a compulsory buy-in. So anything that raises the risk of compulsory buy-ins, will see firms think carefully about structuring their operational capacity to make sure that does not happen. T+1 in the US makes that even more important.”
Trading desks
In the past, settlement has widely been considered a post-trade issue, an issue that doesn’t necessarily directly impact the trading desk. However, the acceleration to T+1 could have an impact on the full lifecycle of trading to settlement, with settlement fails contributing to increased cost of trading and, ultimately, a decrease in profitability.
“Traders will be a key part in the solution and will no doubt pass on a standard message: if you are asking for extended settlement, there will be a charge for that extended settlement, because your instructions will create a failed trade penalty. There is likely to be an increase in pre-trade communication between firms. Managers seeking to liquidate positions in order to buy other positions will need to be advised of the T+1 cycle elements of doing so. Traders will have to tell the firm originating the order that in order to do that, we are going to have to extend your settlement window outside T+1 and therefore, there will be a fee for doing that specific trade,” highlights Northern Trust’s Walsh.
“In general, traders will work quite closely with operations teams to ensure that data that flows through DTCC is completely accurate and trade data is correct. This is where being able to spot timing issues, data mismatches and even fat finger errors quickly, will be paramount.”
Baillie Gifford’s Conn stresses that the impact from the shift to T+1 is something being underestimated by both trading desk and their operational parts of the business. “If you operate in one country, in one region and one time zone, you may need to think about the cost of setting up in a second time zone or appoint an agent to do it on your behalf. The other point to consider is that it assumes that all clients and funds operate in the base currency of the market that’s moving to T+1. For example, in the case of the US, in certain time zones it will be challenging to settle all of your accounts on a T+1 basis.
“The way we work, traders are responsible for managing the cash positions for an account to make sure that the client does not go overdrawn or conversely, does not build up too much cash. With different settlement cycles, and cross-border settlement cycles, it becomes a more complicated calculation. For example, what are the options if you’re selling in a T+2 regime and reinvesting in one that settles T+1. There are solutions, but most involve a degree of change and added complexity.”
Tech trend
With the shift to T+1 now confirmed in the US, and its impacts likely to be felt globally, technology is an aspect worth considering to help ease this transition.
“Technology will be paramount in meeting the demands required to support the T+1 clearing cycle. A shorter settlement period inherently means less time to correct mistakes. Systems that successfully address this change will prioritise automation and resiliency. If implemented properly, these attributes can effectively reduce failure and error risks while supporting increased processing demands. The devil is in the (implementation) details,” emphasises Urban.
To cope with this new transition to T+1 settlements, a review of the entire front-to-back process across the trade life cycle – including everything done on trade date, immediately after trade, through to settlement – is required. Root cause analyses need to occur to identify inefficiencies and what can be to improve them.
With the US confirming its move to T+1, the UK and EU taking a similar approach – strategically coordinated and thought through – could potentially be favourable for the industry as a whole.
“Now we know the US is moving to T+1, there is also a potential benefit to Europe of maintaining that global alignment and maintaining, on a more abstract level, the competitiveness and attractiveness of EU markets, both with US and global peers, but also again new and emerging types of asset classes,” says AFME’s Tomlinson.
“If you think about crypto and blockchain, a lot of these products provide instant settlement and there is a risk that staying on T+2 will look quite archaic or old fashioned versus the expectations of a new breed of investor who is familiar with T0 instant settlement. As well as the tangible benefits, such as reducing risk or margining costs, it’s also about these more nebulous, abstract ideas of progression and keeping up with the times.”