In brief
- The settlement cycle has evolved from T+5 to T+2 and is now moving to T+1
- Regulatory bodies, including the SEC, are promoting the shift to T+1 to reduce market risks
- Multiple countries, such as Canada, Mexico and the UK, are considering or implementing a T+1 settlement cycle
- Advantages of T+1 include risk mitigation, increased efficiency, expanded scope, and future innovation
- The move to T+1 also poses challenges such as global time constraints and technology upgrades
The settlement cycle for securities has undergone a remarkable transformation over the years, transitioning from T+5 to T+3 in 1995 and further to T+2 in 2017, all driven by the pursuit of reducing risk and operational efficiency within the financial services sector. Regulatory bodies, notably the Securities and Exchange Commission (SEC) in the United States, have played pivotal roles in facilitating these changes. The industry now stands on the brink of yet another significant leap, advancing toward a T+1 settlement cycle, propelled by the same core principles. The journey to T+1 represents a pivotal stride toward a more agile and responsive capital market, it does however present a number of challenges that market participants must navigate to thrive in this accelerated settlement landscape.
The transition: T+2 to T+1
For several years now, the standard settlement cycle for most securities transactions in the U.S. has stood at T+2. This means that when you executed a trade, the settlement, or the actual exchange of cash for securities, occurs two business days after the trade date. This settlement cycle is undergoing yet.
Regulatory impact: SEC is driving change
Regulatory bodies worldwide play a pivotal role in shaping the financial landscape. In the United States, the Securities and Exchange Commission (SEC) adopted a rule amendment on February 15, 2023, to enforce the transition from T+2 to T+1. This regulatory change is part of the SEC's strategy to address recent episodes of market volatility, including the "meme stock" events of 2021 and the disruptions brought about by the COVID-19 pandemic.
Expanded scope
The new rules also broaden their scope. They shorten the settlement cycle for firm commitment underwritten offerings for securities that are priced after 4:30 p.m. Eastern Standard Time (ET). Previously, these offerings were permitted to settle to four business days after the contract date. However, as common practice dictated, most settled within three business days. Under the new rules, these offerings are now required to settle on the second business day after the contract date. In instances where offerings price before 4:30 p.m. ET, an even shorter one-business-day settlement is mandated.
Flexibility maintained
While promoting a shorter settlement cycle, the SEC's rule amendments do not eliminate flexibility. Parties can still vary settlement dates through express agreements at the time of the transaction. In cases where an alternative settlement cycle is required, it is customary to provide disclosure to investors through offering documents and free writing prospectuses or pricing term sheets.
Example of regulatory impact in the United States:
The SEC's rationale for this transition is clear. Shortening the settlement cycle from T+2 to T+1 is anticipated to yield several benefits. It will notably reduce credit, market and liquidity risks associated with unsettled securities trades. This reduction in risk exposure is critical in an era where market stability is paramount.
Global regulatory impact
The transition to a T+1 settlement cycle is not confined to the United States. Regulatory bodies in various countries are considering or are implementing similar changes. For instance:
Canada: Following the United States' lead, Canada has reaffirmed its commitment to aligning its settlement cycle with the U.S., moving from T+2 to T+1.
Mexico: The Mexican securities market is evaluating the impact of a T+1 settlement cycle and is considering its own transition.
United Kingdom: The UK is also exploring the possibility of moving to a T+1 settlement cycle, influenced by global trends.
Effective date and compliance deadline
The new rules, as adopted by the SEC, are set to become effective 60 days following the date of publication of the adopting release in the Federal Register. However, market participants have a window to adapt; the compliance date for the rule change is May 28, 2024.
Foreign exchange impact on international participants
T+1 will remove some market risks, but risk won’t disappear completely; it simply moves them to another area, and right now, it looks like that area will be back-office operations. Foreign exchange (FX) transactions traditionally settle on a T+2 basis. For international participants wanting to buy US securities, prefunding the transaction with USD, or arranging for a short-dated T+1 FX settlement will be required. The effect of prefunding could potentially impact other investments, resulting in an investment manager being out of the market for a whole day. This is of particular concern to investors in Asia-Pacific markets, given the time zone differences.
This addition provides context regarding the impact on international participants and how prefunding and FX settlement play a role in the T+1 transition.
Advantages of a T+1 settlement cycle
The move to a T+1 settlement cycle offers several advantages:
1. Risk mitigation:
One of the primary reasons behind this transition is risk reduction. Shortening the settlement cycle from T+2 to T+1 significantly reduces the credit, market and liquidity risks associated with unsettled securities trades. A shorter settlement cycle ensures that transactions are settled promptly, reducing the potential for market disruptions and failed trades.
- Counterparty risk: With shorter settlement times, there is less time for a counterparty to default on a trade, reducing counterparty risk
- Credit risk: The risk of credit default between trade execution and settlement is minimized
- Market risk: The shorter settlement cycle means that market fluctuations have less time to impact unsettled trades, reducing market risk
- Liquidity risk: Market participants are exposed to less liquidity risk as funds and securities are exchanged more quickly
2. Increased efficiency:
A T+1 settlement cycle enhances market efficiency by minimizing the time between execution and settlement. This results in fewer unsettled trades and less exposure to unsettled trades, thus mitigating potential price movements in the underlying securities. Investors benefit from quicker access to funds, enabling them to make timelier investment decisions.
3. Less margin requirement:
Reducing the settlement cycle from T+2 to T+1 also leads to a reduction in margin requirements. According to estimates by the Depository Trust & Clearing Corporation (DTCC), a one-day reduction in the settlement cycle results in a 41% reduction in the CCEP (Counterparty Credit Exposure Policy) margin. This reduction allows firms to better manage liquidity and capital.
4. Future innovations:
The SEC sees this shift to T+1 as a precursor to future innovations in settlement cycles. Looking ahead, the Commission envisions the potential for a T+0 or instantaneous settlement cycle. It is actively exploring the feasibility of such a paradigm shift, emphasizing its commitment to fostering an agile and efficient capital market ecosystem.
Challenges across the trade lifecycle
Transitioning to a T+1 settlement cycle brings many advantages, yet it introduces challenges that reverberate across the entire trade lifecycle. Banks need to meticulously assess these impacts, considering the level of complexity and maturity of their existing technology stack. The shift promises efficiency gains, but the nuances of real-time settlement demand a thorough evaluation of potential pitfalls. From post-trade processing to risk management, each facet of the trade journey must be examined in light of this accelerated settlement pace.
1. Time constraints across the global market:
Managing time constraints becomes crucial, especially in the context of global trading. Trading counterparties may be in different time zones, limiting the available time window for communication and issue resolution. Organizations must effectively coordinate and communicate globally to prevent settlement delays and ensure smooth operations across borders.
2. Reduced settlement window:
With T+1, there is significantly less time to match trades with counterparties, source the necessary cash and securities, and execute transactions. Organizations need systems capable of processing trades in real-time rather than relying on batch processing. This challenge becomes even more pronounced in cross-border and cross-market settlements.
3. Increased pressure on technology:
The shift to T+1 places additional pressure on existing technology systems. Organizations must ensure that their systems can handle increased batch frequency, provide an optimal user experience, and avoid hard-coded data that requires manual overrides and additional steps in the process. Technology upgrades and vendor discussions become essential to meet these requirements.
4. Risk and control frameworks:
While controls may be robust in a T+2 environment, their effectiveness may diminish in a T+1 landscape with more frequent risk reporting and additional layers of checks. Organizations must validate the resilience of their risk framework to handle increased pressure on processes and potential mistakes.
5. Impact on ancillary services:
The effects of a shortened settlement cycle extend beyond trade matching and settlements teams. Corporate action, cash management, securities lending functions, and more also feel the impact. A comprehensive assessment should consider the broader implications on various ancillary services.
6. Operating model evaluation:
Organizations should evaluate the impact on their workforce in a compressed timeframe. Simply increasing headcount or altering working patterns may not be effective solutions. Consultation with employees and understanding their current challenges is crucial to ensure a successful transition to T+1.
7. Corporate actions and ex-date challenges:
T+1 will remove some market risks, but risk never goes away; it is simply deflected, and right now, it looks like that area will be back-office operations. Corporate actions customarily have an ex-date one day prior to the record date, enabling more trades to settle in advance of the record date cut-off. The US market change will mean that the ex and record dates will need to be the same day, which will undoubtedly lead to more reconciliation issues and subsequent market claims.
8. Data-driven decision-making:
Data plays a vital role in assessing the impact of a T+1 settlement cycle. Having the right Management Information (MI) systems in place is essential for forecasting and managing potential pain points. Accurate data is the foundation of an effective impact assessment.
What is required to go from T+2 to T+1
- Assessment: Banks, brokers, and investors should assess their current post-trade technologies and processes, spanning from the front-office to the back, to ensure readiness for T+1
- Accuracy: Foundational account and standing settlement instruction information must be 100% accurate and readily available to counterparties. In a T+1 settlement environment, there is no room for error
- Operational preparedness: Firms need to be operationally prepared for the T+1 transition. Inadequate post-trade processes could lead to challenges and expenses once T+1 becomes standard.
- Technology upgrade: Financial entities will need to consider replacing legacy technologies and processes with a comprehensive open platform and integrated post-trade framework. This proactive approach will help future-proof the organization
- Real-time processing: Real-time processing should become the norm, operating 24/7 to ensure efficient and error-free settlement in the T+1 environment
To wrap up, the shift to a T+1 settlement cycle marks a significant advance toward a more agile and responsive capital market. While it does come with its challenges, especially for legacy platforms, it also paves the way for the exploration of even shorter settlement cycles, potentially leading to instantaneous settlement (T+0). With the SEC at the forefront of this transformation, market participants must adapt their operations and strategies to thrive in this accelerated settlement landscape. This represents a pivotal moment in the evolution of capital markets, signifying progress toward safer, more efficient and responsive financial ecosystems.
Ritu Suri
With over 14 years of experience in capital markets, Ritu has worked as an interbank trader, gaining valuable insights into both sides of the market. She has since held diverse roles, including SME in application maintenance, Murex pre-trade developer, and senior business analyst. She is leading the front office horizontal stream. Ritu is also dedicated to learning and development, contributing significantly to training and extracurricular activities in addition to her project work.
