Repo market ponders its future as Europe plots tricky path to T+1

Key Takeaways

• Europe edges closer to T+1 but not all participants are won over
• Market association fears permanent effect on settlement fail rates
• Automation must do the heavy lifting in compressed transaction periods

As markets digest the shorter settlement cycle (T+1) introduced in the US, Canada, and Mexico, European regulators are assessing whether they should be following suit.

The primary goal of regulators in reducing settlement periods is to enhance market security. The interval from purchasing a stock to its actual receipt carries inherent risks, which could result in the failure of a transaction. To counteract this, market players provide collateral to clearinghouses. Decreasing the duration of transactions should lead to cost-savings and increased efficiency.

Nevertheless, if the responses to the European Securities and Markets Authority (ESMA) consultation are anything to go by, participants are not totally convinced it would be the right move for them, especially in securities lending and repo, a fundamental market where financial institutions and central banks borrow and lend money, often overnight and backed by government securities.

Operational impact

In a nutshell, ESMA’s Call for Evidence report found that asset managers, banks, and trade groups are worried that settling trades on a T+1 basis — half the time it currently takes — could potentially prove disruptive. “Although T+1 is technically possible … mandating a harmonized shift from T+2 to T+1 in the EU would have considerable operational impacts and could even negatively affect the market if not organized properly,” it said.

Two main concerns signposted were a loss of liquidity and a rise in settlement failures. Separate data from Firebrand Research shows that firms globally spent $914.7bn in the last decade addressing settlement fails with increased expenses emanating from fines, surplus work hours, and the higher cost of securities lending – for both equities and fixed income. For equities in 2023 alone, the cost to the industry was placed at $96.6bn

Less time to repo deals

The consultancy estimated that settlement failures could rise by as much as 30% after the US transition to T+1 on 28 May. Although the country does not have a penalty regime like the Central Securities Depositories Regulation in the UK or EU, the view is that the additional costs would stem from elevated funding activity to address fails through stock borrowing and lending.

This was a particular red flag raised in the Association of Financial Markets in Europe’s response to ESMA. AFME believed that the potential impacts of T+1 on the cost and availability of borrowing securities could result in a more permanent effect on settlement fail rates. Moreover, there would be extra pressure on securities financing transactions because they frequently settle on a shorter cycle than the underlying cash trades.

Meanwhile, the International Capital Markets Association (ICMA) highlighted the threats to repo activities. “Earlier settlement will narrow the window within which the repo market has to fund most cash transactions to only one day,” it said. This means that a substantial part of the market will have to move to overnight or even same-day settlement. It would represent a significant change as currently a large chunk is still settled on a T+2 basis.

ICMA said a T+1 settlement cycle was also likely to result in virtually all repo settlement changing from the night-time batch settlement cycle (NTS) into real-time settlement (RTS) during the day, which would be a “significant step backward in terms of efficiency in terms of settlement and intraday liquidity management and system resiliency.”

ICMA warned that pressure on repo and securities lending markets along with the increased risk of settlement fails could damage market liquidity, in general as investors might be dissuaded from lending securities for fear of them not being returned.

The waiting game

At the moment, there are still several unanswered questions and ESMA is evaluating the responses with securities lending and repo as well as FX trading; cross-border activities and corporate actions standards are of particular concern. Its plan is to deliver the final edict to the European Parliament and to the Council before 17 January 2025.

Although few expect the region to move to T+1 in the near term, many believe it is only a matter of time. Mairead McGuinness, EU financial services commissioner, summed up the situation at a recent conference by saying, “The question is no longer if, but how and when it will happen in the EU.”

Meanwhile, in the UK, the Accelerated Settlement Taskforce has recommended a two-phased approach, beginning with operational changes in 2025 and a full transition by the end of 2027. The first stage would initially see some operational and behavioral changes mandated next year to enable the market to prepare in advance of the formal move. However, the group said that if the EU commits to move to T+1 within a timeframe that aligns with the UK’s plans, simultaneous adoption should be considered.

Automation is key

Although the two regions may move at a different pace, there is no doubt that technology will play a major role in facilitating the transition when it happens. Respondents in the ESMA report highlighted several operational impacts that “go beyond simple adaptations”. The key pain points are legacy technology, manual processes, counterparty risk, time-zone synchronization, inventory management issues and complexities involving cross-border transactions.

Unsurprisingly, as with many regulatory changes, automation needs to take center stage. This is especially true in a T+1 environment which places a greater strain on manual procedures. Market participants will need to find solutions that can replace antiquated legacy systems and enhance workflows across the trade lifecycle processes, such as confirmations, affirmations, and allocations.

Blockchain also offers the potential to facilitate T+1 or even real-time settlement by offering an efficient and transparent means of recording and settling transactions. However, many projects are still works in progress, but distributed ledger technology is definitely one to watch in the future as market participants adjust to regulatory and operational developments, from T+1 to more central clearing of repo transactions.