T+1 Settlement Cycles: The Plato Partnership Position
With global policy makers looking to reduce unnecessary risk and improve efficiency in Capital Markets, there is increased regulatory focus on shortening the settlement cycle. The Securities and Exchange Commission (SEC) has already announced securities settlement in the United States will move from two business days after the trade date (T+2) to one (T+1) by May 2024.
The UK is set to follow suit, with the Accelerated Settlement Taskforce launched by the Chancellor of the Exchequer in December 2022 to guide and advise HM Treasury on shortening settlement cycles.
In response, Plato Partnership commissioned a piece of research from Rebecca Healey of Redlap Consulting on the impact of the US shift to T+1 and subsequently assembled a Working Group comprised of researchers and market participants from the Buy and Sell Side to explore the key considerations and market impacts of T+1.
The Context: T+1 and the Global Shift
The Plato Partnership has concluded that it would be impossible for the UK and European marketplaces to align their adoption of T+1 with the US given the short implementation timeframes. However, Plato believes that the US shift to T+1 means that the UK and Europe will need to move to follow suit to maintain their position as leading global markets.
It is also aware that some of the challenges associated with the shift to T+1 will become more evident during the US’s shift to T+1. However, the challenges facing European markets are unique to those in the US, namely that there are a far greater number of market infrastructure providers in Europe including CCPs, CSDs and custodians meaning that the scope and scale of market fragmentation is far greater than in the US.
T+1 will help improve efficiency, reduce settlement risk, and remove barriers between global and European markets. As a result, it will ensure a more integrated and resilient European marketplace, improving its global positioning.
Key Considerations for Regulators and Market Participants
Buy-Side Cash Management
The introduction of T+1 in the UK and Europe will cause significant funding issues for the Buy-Side while other regulatory jurisdictions continue to operate a T+2 settlement cycle. In this instance, the Buy-Side will need to cover the funding shortfalls when purchasing T+1 securities while waiting for the cash proceeds to settle from the sale of T+2 securities.
As a result, Buy-Side firms will need sufficient time to implement the right solutions. They must ensure that they have enough liquidity to cover their daily settlement obligations, which will require a greater focus on cash management. Buy-Sides will need to establish and utilise broker and/or custodian overnight funding facilities, which may not be provided en masse - particularly to smaller Buy-side firms - to cover funding shortfalls. Therefore, Buy-Side firms may also need to change fund mandates to allow them to hold a higher percentage of cash in their portfolios to cover these funding shortfalls, which will take many months of operational and legal work as well as end investor engagement. This may also have an impact on fund strategy and alpha as more allocation is held as cash and the cost of funding impacts the cost of trading and overall fund performance.
The Buy-Side cash management challenge is also further complicated by its fund subscription/redemption cash cycle operating on a T+3 basis. The expectation is that this cycle will need to move to a T+1 / 2 basis to prevent further liquidity issues, however, the implications will require detailed assessment by buy-side participants.
Buy-Side cash management issues will ultimately dissipate once all major global markets are operating on the same T+1 settlement cycle. However, cash management issues for European (EU27) asset management firms are likely to be made worse in a situation where the US and UK markets are operating on a T+1 settlement cycle and the EU27 is operating on a T+2 settlement cycle.
The move to a T+1 settlement cycle in European markets may also have several implications for best execution. Best execution refers to the obligation of brokers and investment managers to obtain the best possible outcome for their clients when executing trades.
It may increase the cost of borrowing securities and limit the use of automated execution. The need for quicker execution may reduce algorithmic trading and increase reliance on block trading and derivatives. This could introduce additional risks and complexity to the trading process, requiring brokers and investment managers to carefully manage their execution strategies.
Securities Lending
The Securities Lending space globally represents EUR2.7 trillion in value according to a recent study by the International Securities Lending Association.
Post-trade securities workflows are improving, with greater standardisation in the netting and allocating of trades as well as the adoption of automated alerts for outlier trades to be addressed. However, while there is work currently underway within the FIX Post Trade Working Group, these workflow improvements have yet to extend to securities lending in Europe.
In the US, buy-ins currently operate on a T+1/0 basis. In Europe, the standard securities lending contract operates at a minimum of 48 hours, making it impossible to arrange the return of lent assets without being in breach of timely settlement. The difficulty in managing this process in Europe is due to the manual nature of the transactions. As a result, it will be impossible to move securities lending in Europe to a T+1 settlement cycle without significant technology improvements by market participants including custodians, Buy-Side, Sell-Side, and third-party lending agents.
The introduction of FIX standards for inventory to understand Loan and Lender availability, Short Sale availability, standards for new loans, loan recalls, returns, and buy-in notices will enable information flows to occur on a much quicker basis and help to automate the Stock Lending/Borrowing workflow process. This would include the real-time status of new loans, return messages containing Unique Trade Identifiers, loan modifications and cancellations, and the securities available to lend or put out on loan at the end of the day.
This will be a significant industry undertaking that will require sufficient timeframes and investment; however, it is Plato’s view that, unless policymakers mandate that market participants (in particular custodians) must address efficiencies, securities lending will be unable to move to a T+1 settlement cycle.
The negative impact on Buy-Side cash management and ETFs would be very significant if securities trading moves to T+1 but securities lending remains on T+2. Due to the operational and financial risks involved, this strategy would not be feasible for the Buy-Side. The Buy-Side would need to borrow securities every time they recall their lent-out securities to account for the gap between the securities sold T+1 and recalled T+2, resulting in substantial costs and settlement risk.
Post-Trade Workflows
Rebecca Healey’s paper states that several major Sell-Side firms estimated that only 25-30% of their Buy-Side clients were using real-time FIX reconciliation processes. According to the paper, most still use end-of-day/overnight matching processes, resulting in allocations occurring on T+1 and settlement on T+2. In order to move to T+1 settlement, all trade allocations will need to take place on T+0 to complete trades by T+1.
This will require Buy-Side firms to move to real-time FIX for allocations. The technical and operational effort that this will require cannot be understated, with significant time and investment needed from market participants, and will likely impact smaller Buy-Side firms the most that may require them to consider alternate solutions such as outsourcing operations.
ETFs
When Exchange Traded Funds (“ETFs”) hold securities from various jurisdictions with different settlement cycles (some T+1, others T+2) they will only be able to settle on a T+1 basis if the ETF provider pre-funds any cash shortfalls and/or borrows the necessary underlying securities. In the case of Global ETFs, any large trades executed in Asia must be settled T+1 to meet T+2 settlement. However, moving the settlement cycle forward by 24 hours will require shares to be settled on T+0 instead of T+1. This is not currently possible at a large scale with any of the major transfer agents.
In the recent US T+1 settlement policy announcement, while the SEC recognised that settling trades in US-listed ETFs with baskets that contain foreign securities may become more costly to ETF providers under T+1 settlement, their belief is that moving to T+1 will reduce some costs - such as margin charges - which will offset any additional costs. However, liquidity in the European ETF market is already hampered by the number of different markets, currencies and CCPs relative to the US. For UCITS ETFs, there will also inevitably be an increase in inadvertent regulatory breaches due to temporary cash balances in funds with different settlement cycles in the basket or between basket and wrapper that will require addressing by Regulators. It is also important to note that UCITS ETFs are fungible between venues at ISIN level that results in different listings of the same security, therefore if the UK and EU27 move to T+1 at different times this fungibility will create additional operational complexities and further increase the cost of trading for investors. If accurate and timely settlement becomes more problematic and expensive, the appetite to offer inventory, particularly in less liquid assets, will become significantly more challenging, leading brokers to pass on these costs through wider spreads.
Given the significant challenges of moving ETFs to a T+1 settlement cycle, Plato Partnership believes that policymakers must consider applying certain exemptions to enable ETFs to settle on a T+2 basis, especially for those ETFs that hold underlying securities across multiple jurisdictions with different settlement cycles.
Foreign Exchange
The impact of T+1 on Foreign Exchange (“FX”) in the context of securities trading focuses on cross-currency securities trades where the settlement of these trades requires FX conversions. Currently, most funds do not complete their securities-related FX conversion transactions until the securities trade confirmation is received. This may be T+1 after end-of-day FX netting processes are implemented to avoid having to constantly cross the FX spread for every cross-currency trade. To facilitate T+1 securities settlement, firms will need to move their FX practices to T+0 either using real-time FX or intra-day netting with custodians. Suitable timeframes will be required from T+1 policy announcement for firms and their custodians to implement revised FX processes and technology.
It is worth noting that this may lead to increased FX transaction volumes: With a shorter settlement cycle, there may be an increase in the volume of FX transactions required to settle securities trades. This could lead to changes in FX pricing and liquidity.
Plato’s Conclusion
All the key considerations outlined above may also necessitate that non-European-based Asset Management firms that trade European securities have an operational staff presence in Europe or in an offshore location that covers European hours in order to effect T+1 settlement in an efficient manner, whether that will be their own firm’s staff or outsourced staff. Therefore, as part of policymakers determining a sufficient notice period, this factor should also be considered.
Plato Partnership endorses the need to move to T+1 settlement cycles in the UK and Europe but believes that it is crucial that policymakers and regulators continue to engage with market participants to understand key considerations and establish suitable policy and implementation timeframes for market participants to address key considerations.
The Partnership believes that, when policymakers release policy regarding T+1, they must provide market participants with a sufficient notice period to make the necessary technological, operational, and legal changes to facilitate the shorter settlement cycle. We would expect this will be no less than 18 months from policy release but may require a longer period to address post-trade workflows and securities lending. If given less time, there is a risk of causing significant disruption, increased costs to funds and end-investors, and damage to best execution.