US move to T+1 settlement puts pressure on UK and EU markets
The US move to trade settlement T+1 has been well flagged, with industrywide testing beginning on 14 August 2023. While the official switch from T+2 to T+1 settlement will not occur until May 2024, the move places significant pressure on the UK, EU and Swiss markets to follow suit.
There are already timing issues between the EU and the UK concerning the EMIR Refit, and the market does not need any more challenges. So, what are the pros and cons, and potential dangers, of a move to T+1 settlement?
Why is the move to T+1 settlement so important?
To quote a phrase by the former SEC commissioner, J Carter Reese: “Nothing good ever happens between the trade date and settlement date.”
Since “Big Bang” in the 1980s, electronic settlement and trade reporting systems have been moving towards shorter settlement periods. The basic premise is simple: to reduce counterparty risk, make markets more efficient and reduce the overall cost of trading. Many believe that, ultimately, we will move to T+0, what is commonly referred to as instant or atomic settlement.
They say that history repeats itself in investment markets. Well, if we look back to 2017, the US SEC led the way again, moving from T+3 to T+2 settlement, forcing a host of markets to follow suit. While first discussed by the US regulator in 2022, have the EU, UK, Swiss and other international markets been too slow to react?
EU and UK respond to US move
On 5 October 2023, the European Securities and Markets Authority (ESMA) released a “call for evidence” on shortening the settlement cycle in line with US moves. While market participants have until 15 December 2023 to make their views known, feedback won’t be considered until the first quarter of 2024, with a final report towards the end of the year. Considering the US will be moving to trade settlement T+1 in May 2024, even a relatively quick response to the ESMA report would see EU settlement changes in 2025 at the earliest.
Looking towards the UK, the authorities responded directly to the US move when Jeremy Hunt, Chancellor of the Exchequer, launched an “Accelerated Settlement Task Force” on 9 December 2022. This will look at the practicalities of a move to T+1 and also investigate the potential to move to T+0. Split into four different sections, the report, expected towards the end of 2023, will look at:
- Consequences for different stakeholders
- Cost-benefit analysis
- Stakeholder feedback
- Potential legal and regulatory changes
Some observers believe that the UK will look to take a more proactive approach than their EU counterparts as a means of demonstrating the “Brexit dividend”, which was promised at the time of the referendum. While the authorities have the same concerns as their EU, Swiss and broader global counterparts, it will be interesting to see the various timelines emerging.
Pros and cons of T+1 settlement
Akin to many new trends and regulations in investment markets, it is only when you begin to dig a little deeper that the real impact becomes more evident. It is clear that the EU and UK regulators will not be rushed as there are many obvious and not-so-obvious issues to consider.
For example, despite the vast technological advancements in recent years, it is easy to forget that not all domestic and international bank transfers are instant, and credit card payments can often take more than 24 hours to register on your account. Therefore, attempting to move investment markets to T+1 or even T+0 globally is unlikely to be straightforward!
Before we look at the pros and cons in more detail, there are many other activities which will be impacted. These include:
- Stock lending
- Listed/OTC derivatives
- Collateral processing
- Foreign exchange
- Cash borrowing
- Corporate actions
The more complex the transaction, the more moving parts, the greater the danger that one or more delays could lead to a settlement failure. We will now look at the pros and cons of settlement T+1, beginning with the benefits.
Reduction of risk
The shorter the settlement period, the lower the potential counterparty, market and credit risk, which is especially prevalent in volatile markets.
The less time a position is “open”, the less risk, which translates into a reduced margin call. This allows companies to better manage their capital and risk profile.
The US Depository Trust & Clearing Corporation believes a one-day reduction in the settlement process will result in a 41% reduction in the volatility element of Central Counterparty (CCP) margin obligations.
Liquidity is the key to any successful investment market; the ability to buy and sell in significant sizes during any market conditions. The more liquid the market, the more efficient and reflective asset prices will be of the underlying situations.
As you would expect, with such a monumental change in settlement procedures, there are some issues to be aware of. These include:-
Compressed settlement process
A move from two-day to one-day settlement would suggest a reduction of 50% in the processing time. However, data from the Association for Financial Markets in Europe (AFME) suggests an 83% reduction in the processing timescale, from 12 to 2 hours of post-trade operation time.
While there are significant challenges with domestic trading, regarding the switch to T+1 settlement on a global basis, further issues will arise. Something as simple as different time zones could reduce communication times and, in some cases, the opportunity for next-day settlement.
The ability to lend securities not only enhances liquidity but also allows holders to create additional income and enhance returns. Reducing the timescale to arrange and complete lending procedures will likely increase the number of failed trades using the current system.
In a perfect world, when it comes to trade settlement and transaction reporting, all major financial markets would be on the same page. However, this is one of the most competitive industries in the world, and each market is looking to gain an advantage over the other. Eventually, trading processes and procedures tend to merge, but this can take some time.
The US leads where the rest follow
There is no doubt that the proposed move to T+1 (and eventually T+0) by the US authorities has spurred others into action. This is a reflection of the global power and influence of the US markets:-
- The US accounts for 46% of the global equity market
- International investors own about 40% of corporate US value
- Foreign share purchases in the US totalled $30 trillion in 2021
On the one hand, international investors have a significant say in the US markets, while on the other, US market operators can dictate changes in settlement procedures. In reality, if the US markets say jump, their global counterparts are prone to say how high?
Is the technology available?
It is no secret that the FinTech market has disrupted many areas of the financial services industry, bringing a new lease of life to what was, in the eyes of many, the last bastion of tradition. Similarly to Moore’s Law about microchips, the number of transistors will double every two years while the cost of computers halves; settlement processing is subject to ongoing improvements.
Experts believe that Distributed Ledger Technology (DLT), of which blockchain technology is a subset, together with smart contracts, will become central to the ever-improving settlement process. In theory (more likely in practice), these two technologies will allow for the synchronising of digital data across multiple locations, sites and institutions and the real-time settlement of transactions.
When you incorporate artificial intelligence and machine learning, with new technology able to learn on the job, the question is surely not if, but when real-time settlement will emerge?
Could EU institutions move to the US?
While much of the focus is currently on the US market, switching from T+1 to T+2 settlement, it is important to recognise that India and China already operate some stock dealings on same-day settlement. In reality, the US will lead the way, dictating regulations and changes in settlement procedures due to it’s influence over the global market. However, there may be a downside for the EU and UK financial sectors.
There is little sign yet, but some experts are concerned that European financial institutions could look towards the US as their future base. As a consequence of delays with the EU and the UK adopting the move to T+1 settlement, and various costs and regulatory challenges, some companies may decide to move their headquarters.
While global regulators have the legal powers and the obligation to protect investors, there is one overriding principle: to ensure market integrity and efficiency. A switch to a reduced settlement timetable before the participants are ready could have damaging long-term consequences. Who would be a regulator stuck between a rock and a hard place?
Will T+1 settlement become the worldwide standard?
Interestingly, several experts have highlighted the challenges of the jump from T+2 to T+1 as very similar to the eventual move to T+0. Therefore, in theory, yet to be discussed in real detail, would it not be worthwhile for European/UJK regulators to consider skipping the T+1 stage and going straight to T+0?
As we touched on above, China and India, as two examples, are currently operating on same day settlement for a select group of securities. It is possible, they have proven it, although to roll this out on a global scale would require regulators to work together. However, looking back at the technological advances over the last 100 years is like looking at night and day.
Trade reporting and settlement
As a provider of cutting-edge regulatory compliance solutions for the financial services industry, we fully appreciate the challenges of reduced settlement times. Central to the success of this ongoing change is the trade reporting process, the ability to cross-check for potential fraud and bring all of the elements of individual trades together promptly.
In a similar fashion to the different timelines of the EU and the UK regarding the EMIR Refit, this will be an issue as the US moves to T+1 settlement potentially up to a year (or more) in advance. The situation in the EU is relatively complex because of the number of markets, governments, regulators and additional bodies which need to work together. The US situation is less complicated due to the overarching power of the SEC and the ability to move relatively quickly.
Even though the US is the leading global investment market, it is crucial to recognise that it is not the first to switch to a shorter settlement period. China and India have made progress towards T+0, atomic settlement, although this is still an ongoing process, with more stocks being added to the new system on a regular basis.
The US is by far and away the most influential market, and therefore, the move to T+1 settlement next year will see others inevitably follow. The difference in timescales will cause issues with trade settlement, which is where services provided by eFlow will prove invaluable. Using the latest technology, we can collate all of the required information very quickly, running the relevant checks and speeding up the settlement process.
Whether you are switching to the new settlement timetable or faced with a two-tier approach to trade reporting on different timescales, we would welcome the opportunity to discuss your needs in more detail. Please feel free to call our team of experts at your convenience.