Countdown to T+1

Firms worldwide are waking up to implications of next day trade settlement in the US

The US and Canadian financial markets are set to shorten the settlement cycle for equities, corporate debt, and unit investment trusts to one business day after trade, or T+1, next year. This has global implications, impacting financial firms beyond North America.

The US Securities and Exchange Commission (SEC) voted this February to target the shorter cycle for May 28, 2024. The vote was close, three to two. The two nays were in favour of implementation in September 2024, but all agreed that the transition from the current T+2 settlement would be highly beneficial to the markets and the industry.

While acknowledging that T + 1 can potentially increase some operational risks, “these arguments and considerations, however, do not ultimately weigh against shortening the settlement cycle, but they provide reason for ensuring readiness among market participants”, the SEC said in a statement after the vote.

The US Depository Trust and Clearing Company (DTCC) welcomed the clarity on the target date and assured the industry that it “recognises that significant challenges remain towards implementation and will continue to partner closely with market participants, as well as regulators, Securities Industry and Financial Markets Association and the Investment Company Institute, to promote a successful transition to T+1 and to safeguard the stability of the markets”.

Two days later, the Canadian Capital Markets Association announced that Canada will also move to next day settlement for equities on May 28 next year to be in sync with the US.

Major impact

The length of the settlement cycle is highly important to financial markets because of the risk that a counterparty to a trade may not fulfil its obligations in the time between trade execution and settlement. The longer the time, the greater the risk, which becomes elevated during times of high volatility and stressed market conditions.

A T+1 cycle is not revolutionary. US and Canadian money market funds and options, and government bonds and commercial paper are all settled one day post-trade.

In Asia, China’s equity markets, the second largest in the world, have been operating on a T+1 cycle since they re-opened to the world three decades ago. India’s equity markets, the sixth largest in the world, began transitioning to T+1 in phases in early 2022, and completed moving over 6,800 listed stocks to the shorter cycle this January.

But given the scale and reach of US equities markets, the shift to T+1 will have momentous impact on both US and global investors.

According to data provider Statista, US equity market capitalisation was US$39 trillion as of end-2022, accounting for 42.4% of the $92 trillion global total. Data from the US Treasury Department shows that foreign holdings of US equities amounted to $12.2 trillion as of June 2022, or around 30% of the market total.

Based on data as of end-2022, US and Canada market capitalisation, combined with that of China and India which are already operating on T+1, represent over 62% of the global total.

The US move to shorten the settlement cycle has spurred other major markets into action to decide whether they should follow suit.

The UK launched the Accelerated Settlement Taskforce in December to explore the potential for faster settlement of financial trades.

This March, the Association for Financial Markets in Europe announced the launch of an industry taskforce to consider whether Europe should also move to a shorter cycle. However, Pete Tomlinson, its director of post trade, warned that “a rushed approach is likely to result in increased risks, costs and inefficiencies, given the unique nature of European markets which have multiple different market infrastructures and legal frameworks”.

More jurisdictions are expected to initiate similar moves while closely watching implementation in the US and Canada.

Many still unprepared

In spite of the fact there is only a little more than a year for the US shift to T+1, many market participants remain unprepared. It doesn’t help that the market slump in 2022 prompted many financial firms to cut budgets for technology and middle and back office staff.

A recent survey of over 280 industry participants globally by Canadian consulting firm The ValueExchange and sponsored by the DTCC and its Canadian counterpart found that some 41% have yet to begin preparations to move to next day settlement. The buy-side is particularly challenged, with 61% unprepared for the transition, primarily across mid-tier and boutique organisations.

T+1 will impact the middle office, settlement, management of trade fails, securities lending, and corporate action segments of the trade lifecycle. The challenge is not just related to upgrading legacy systems and replacing manual processes. There are also time zone considerations on issues such as cross-border trades and cross-currency liquidity, among other things.

Time zone issues will weigh heavily on companies in the Asia Pacific region which are active in the US and Canadian markets.

It may seem that moving from T+2 to T+1 just halves the trade settlement time; in reality companies will have to work on a much tighter timeline. Since US markets are at the end of these firms’ follow-the-sun trading and processing cycle, they will have difficulty sorting out any problems related to matching and reconciliations on the trade date, unless they have a global operational presence. Existing systems need to be able to support real-time processes. Batch processing simply won’t work.

In addition, outstanding issues related to cash and stock liquidity will require a concerted effort to resolve with the capital and foreign exchange markets at the industry level.

T+1 will very likely lead to an increase in the frequency of trade fails, at least in the short term. Same-day stock lending to cover trade fails and automatic buy-ins are well-established market practices, but they put pressure on the cost of operations.

The need for same-day foreign exchange also becomes acute in a T+1 environment. Although technically feasible, liquidity is poor in all but the major currencies, resulting in wider spreads for their conversion to US dollars. There is a strong risk that prefunding will become the norm for many currencies, adding to the overall transaction costs.

According to The ValueExchange survey, more than 50% of European and Asia Pacific market participants have yet to define how they will manage critical areas such as foreign exchange and securities lending. As a result, they may struggle to scope, fund and deliver the required changes to their core systems in the run-up to May 2024.

Many jurisdictions around the world still operate on T+2, so global firms will need an effective back office platform that is flexible enough to handle multiple settlement regimes and different asset classes. But there is little time to specify, build and implement all the components of the technology to fully meet their needs for conversion by next year. There will probably be a considerable amount of time needed for tactical patching of systems and their capabilities.

The DTCC has scheduled industry testing to begin on August 1 through to May 2024. Testing cycles will begin each Monday or the first business day of the week, with a total of 21 test cycles over a nine-month period. These tests will be a reality check for firms and the industry as a whole on whether they are T+1 ready.

“Now is the time for market participants to advance preparations for T+1, regardless of geographical location, to ensure readiness by the May 2024 deadline,” Matthew Stauffer, managing director, head of institutional trade processing at DTCC, warned following the SEC vote in February.

*This article was published in Asia Asset Management’s April 2023 magazine under the same title.