T+1 and FX: The opportunities and challenges of a shorter settlement cycle
28 May 2024 is set to be a pivotal moment in the history of securities trading.
From that day, traders in the US must settle transactions in cash equities, corporate debt, and unit investment trusts in one business day (T+1) rather than the usual two (T+2).
The change promises to be one of the most challenging for cross-border trading. While India switched last year, and Canada will switch on 27 May, the big test is the US, the largest and most liquid global market across all asset classes.
What are the implications of shorter settlement times for trades with a foreign currency component, and how are market participants preparing for it?
5, 3, 2, 1, 0: Evolving settlement
Until 1993, the settlement period for trades in securities was five business days. It was then shortened to three days until 2017, when the US Securities and Exchange Commission (SEC) cut it to two.
The driving force behind compressing settlement times is safer and more efficient markets because the gap between acquiring a security, say, a stock, and taking possession of it is filled with risk. Market participants mitigate the risk of a trade falling through by posting margins (that is, collateral) with clearinghouses, the intermediaries in transactions who play an essential role in ensuring the stability and efficiency of global financial markets.
According to the Depository Trust and Clearing Corp (DTCC), whose National Securities Clearing Corporation (NSCC) settles most securities trades in the US, “risk model simulations have shown that the volatility component of NSCC’s margin could potentially be reduced by 41% by moving to T+1, assuming current processing and without any other changes in client behavior.”
In India, securities regulator SEBI said in its 2022/23 annual report that the South Asian market’s transition to T+1 in equities trading in January 2023 has increased efficiency and reduced the risk of outstanding trades to be settled. Aiming to stay ahead of other markets, the watchdog is working with stakeholders to bring same-day settlement a step closer.
Settlement cycle contraction is also gaining traction elsewhere. The European Securities and Markets Authority (ESMA) launched a consultation last autumn to shorten the settlement cycle in the European Union.
In October, Val Wotton, managing director and general manager of the DTCC’s institutional trade processing, said that the tighter settlement window in the US means trade allocations should be completed by 7 PM Eastern Time (ET). Moreover, the US post-trade processing requirement is that trade confirmation and affirmation must meet the 9 PM cutoff time on the same day to settle within the timeframe.
This combination poses challenges for market participants, with a greater risk of settlement fails and, consequently, penalties.
The pressure is acute for international brokers and investors who manage cross-currency transactions and cash positions across settlement jurisdictions and time zones. Also, some Asia countries don’t allow trading of their currencies freely offshore.
Funding generally takes place once the process of matching, allocating, confirming, and affirming trades is complete, as this informs participants of the exact transaction values.
According to an RCB report, while many foreign exchange (FX) transactions already settle on T+1 or even the same day, the reduced settlement timetable “creates an added layer of complexity in matching equity trades and generating FX to fund the trades.”
… and risk shift
As with many process changes in capital markets operations, risk can be displaced rather than eliminated. In a T+1 environment, the risk for foreign investors is not receiving their US dollars in time to finalize their transactions.
Most cross-currency settlement is addressed within the Continuous Linked Settlement (CLS) system, a lynchpin of the FX ecosystem. If the CLS system cannot process and settle FX trades in T+1, investors might opt to settle bilaterally and pre-fund their transactions.
Such a move could generate more counterparty and risk exposure for foreign investors, and ”negate the benefits” that CLS’s multilateral netting mechanism provides, the DTTC’s Wotton said.
CLS Chief Executive Officer Marc Bayle de Jessé said CLS supports T+1, but time zone or operational constraints may force some cross-border participants to accelerate FX execution to secure the required liquidity. To this end, the entity is considering whether and how to adapt its services.
His colleague, Chief Product Officer Keith Tippel, said that the CLS cutoff for settlement services is 6 PM ET (midnight Central European Time), and that one potential avenue being explored is to adjust this timeframe. However, given the systemic importance of CLS, with USD 6.5trn cleared daily, any change needs careful consideration.
Market preparations: an uneven landscape
Preparations have gathered pace since the SEC confirmed its shift to T+1 in February 2023. However, the extent of the market participants’ preparedness, strategically and technologically, is patchy.
According to the DTCC’s testing program launched in August, firms are increasingly leveraging the industry’s environment to administer end-to-end post-trade testing and to assess readiness. A September survey by the ValueExchange also pointed to progress in preparedness but with several telling gaps.
With input from more than 300 participants split almost evenly between investors, brokers, and custodians/administrators, the poll showed that close to three-quarters of participants were mobilizing. However, most Asian players were yet to prepare for the impact of T+1.
Two concerns cited were securities lending and borrowing, and affirmation of US trades, with one-third of Asian respondents unsure if they could affirm after 28 May.
Work to be done
Industry leaders concur that all participants, from international investors and custodians to counterparties, should streamline and improve their processes for managing FX trades to ensure funds are at hand to settle transactions within the new framework.
The ValueExchange report showed that 66% of investor projects to prepare for T+1 had no close date. Only 40% of investors and custodians had plans to run end-to-end testing before May.
Some 26% of all investors’ projects are earmarked for FX/funding. A popular planned change for investors, though still largely unscheduled, is to move the FX to their custodians or change their FX brokers.
For investors, moving FX booking from T+2 to T+1 and/or pre-funding blocked 13% of respondents from being ready for the switch. A further 47% said it slowed their progress. For intermediaries, the figures were 12% and 26%, respectively, according to the survey.
Some firms consider opening offices in the US and extending office hours to meet the compressed settlement deadline. But industry experts agree that manual legacy systems and adding more staff will be insufficient in a T+1 scenario.
Lessons learned from India
The Securities and Exchange Board of India (SEBI) was the first to migrate to a T+1 settlement. The migration is considered a success overall, though it did have challenges that others can learn from. There was an increase in late settlement rates as not all market participants were able to make the necessary changes in time for the migration. The phased approach that India took kept the disruptions to a minimum, allowing laggards not to fall far behind. The phased implementation is seen as key in the transition.
Legacy out, automation in
T+1 is an enterprise-level project requiring significant investment in technology and personnel. Most participants know that more automated processes are critical to operating successfully.
As Broadridge noted recently, firms will have no choice but to apply technology to maximize returns and handle more loads efficiently. End-to-end automation will reduce human error and, therefore, the risk of trade fails.
Investing in and harnessing technology, including artificial intelligence, will also help future-proof systems and processes as more markets and jurisdictions potentially move to a T+0 settlement process.
Road to T+0
One benefit of the T+1 adoption is that it will better prepare most market participants for T+0 adoption.
India’s securities regulator SEBI has already proposed introducing the “facility for clearing and settlement of funds and securities on T+0 and instant settlement cycle on an optional basis in addition to the existing T+1 settlement cycle in secondary markets for equity cash segment”.
The DTCC also believes that we shouldn’t stop at T+1, but rather continue to look forward to T+0. It has begun working on a proof-of-concept product to advance the possibilities of a netted T+0 solution using distributed ledger technology (DLT) called Project Ion.
Yet, not everyone believes the world is ready for T+0. According to SIFMA, the risks of T+0 are greater than the benefits. Kenneth E. Bentsen, president and CEO of SIFMA, stated that “moving to T+0 or end of day would require fundamental and costly changes in market operations affecting institutional and retail customers and actually increase risk.”
Achieving T+0 will certainly not be easy, but as technology continues to advance at growing rates, it is feasible. Innovation is what brought us to T+1, and innovation is what will drive us to T+0.
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