Shorter settlement cycles could hit non-US firms hard

The Depository Trust & Clearing Corporation (DTCC), the Investment Company Institute (ICI), and the Securities Industry and Financial Markets Association (Sifma) are currently engaged in a joint effort to shrink the settlement cycle for US securities from T+2 to T+1. Moving to a shorter settlement cycle will entail a lot of preparation on the part of market participants—and there are fears that it could place additional burdens on firms outside the US.

In April, the group announced that it would be working with members and other stakeholders on an analysis that will finalize the steps required to achieve T+1. The group aims to complete its analysis by the third quarter of this year, after which it will develop a timeframe for the shift.

Condensing existing processes in the move to a shorter settlement cycle could result in more trade fails, and firms taking on more risk, says Denis Orrock, head of capital markets at GBST, an Australian technology provider for brokers, custodians, investment banks, and fund managers. Shortening the cycle could also impact liquidity and trade volumes in the market. If every trade has to be pre-funded and the stock has to be available, it will take a lot of liquidity out of the market that trades intraday or end-of-day.

“You might have a global fund manager that’s trading out of Italian manufacturing stock and buying into New Zealand dairy, for example. So, all of a sudden, before they can buy the dairy stock, they’ve got to sell the Italian manufacturing stock first, get the funds from that, and send them through the custodian or broker to execute the New Zealand trade. So they’re losing days, and that’s opportunity cost as well,” Orrock says.

Broker dealers might find that they need to extend working hours to accommodate the shift. “You’ll probably see an extension of workdays, and large broker dealers moving to almost a 24-hour day with continuous shifts cycling in and out to get the two days into one with multiple teams,” he says.  

This could place a lot of strain on firms, especially smaller ones. As the head trader for derivatives and foreign exchange at a tier-one global bank says, “If you’re a Goldman Sachs or a JP Morgan, it’s less of an impact for you because you have the technology and the resources. Start moving down to medium-sized and smaller broker dealers, and they will feel the pressure from the technology build and requirements. This could lead to some consolidation in that space.” 

Other sources agree that the shift will require re-engineering the current settlement model. 

A custody product manager at a securities services firm in Asia says, “There would have to be a lot of progress in the technology of how the operational flow works,” and that without it participants will be unable to accomplish the same processes within the shorter timeframe. 

Much of Southeast Asia has only recently moved from T+3 to T+2. If everyone’s now forced to move again to T+1 to stay aligned with the US, this could become quite problematic

Lyndon Chao, Asian Securities Industry and Financial Markets Association

For GBST’s Orrock, the re-engineering process is a matter of bringing everything forward. Simply put, today firms have “T” to allocate and confirm orders. T+1 is about managing exceptions, and making sure of what is coming in, what stocks will be placed, and priming for T+2.

“Essentially, for T+1, I need to be primed for settlement on T. On T, I need to know what my exceptions are, so—let’s say it’s for an 11am settlement cycle—tomorrow at 8:30am, I have two-and-a-half hours to fix any exceptions. That’s why I’m saying you’ve got to have people working all night, particularly in timezones like Australia and Asia, where we’re in the wrong time,” he says.

The DTCC says shortening the settlement cycle could reduce the risks that drive margin requirements. A DTCC whitepaper published in February says its risk models show a 41% reduction in the volatility component of margin held in its clearing and settlement subsidiary the National Securities Clearing Corporation (NSCC), with a move to T+1, assuming no other changes to client behavior.

Does this reduction offset the cost to capital requirements and the potential increases in labor costs to condense that trade settlement process into a 24-hour block? Again, the large investment banks might find it so, but it could pan out differently for smaller and local brokers.

Smart contracts use case

Lyndon Chao, managing director and head of equities and post-trade at the Asian Securities Industry and Financial Markets Association, says the move to T+1 makes sense for US investors trading US markets, as there is a mature DTCC and NSCC framework in place.

It’s a different story for firms in Asia, though. “Much of Southeast Asia has only recently moved from T+3 to T+2. If everyone’s now forced to move again to T+1 to stay aligned with the US, this could become quite problematic for market participants employing the current legacy infrastructure,” Chao says.

Forcing a T+1 settlement cycle on global markets could introduce significant risks and costs. “For example, many markets in Asia are ID markets, without the flexibility of fungible assets across an omnibus account. Many also operate within a no-fails environment where penalties are high, so the complexities for global investors trading across timezones and geographies should not be underestimated,” he says.

“If you have to do all that within T+1, you’re pretty much looking at needing to pre-fund and pre-deliver shares. That would greatly increase the cost of investing outside the US. I think that would be a bad outcome for Europe and Asia.”

However, things could change if Hong Kong Exchanges and Clearing (HKEx) proves that the smart contracts model for the proposed HKEx Synapse platform works.

“If HKEx and the Synapse project can better streamline the needed handshakes between the various market participants to facilitate a faster settlement process, that could become a solution to consider for other markets to explore a shorter settlement cycle,” Chao says.

That said, it would still require significant levels of investment. So it’s likely that the industry in Asia and Europe would prefer to stay on the current T+2 settlement cycle, he adds.

Leveraging previous work

The initiative by the DTCC, Sifma, and ICI follows work in 2017 to shorten the settlement cycle from T+3 to T+2. 

Michele Hillery, general manager of equity clearing and DTC settlement service at the DTCC, tells WatersTechnology that the group is focusing on 12 areas that require further discussion and review with industry participants. The areas are “largely the same” as those in the move to T+2.

“For a number of them, we’ll be able to leverage the work done in the T+3 to T+2 move in either process changes or testing. However, there are some areas where the move to T+1 presents a different set of challenges for the industry,” Hillery says.

These discussions are underway and the findings will be presented in the group’s analysis later this year. “Similar to 2017 … a move to T+1 will be a significant undertaking that will require close collaboration across the industry,” she says.

Hillery says that shortening the US securities settlement cycle will impact firms in Europe and Asia, and says work is being done to identify those impacts. “We will identify any tech and operational challenges, as well as issues related to the cross-border impact of a US move to T+1, as part of our work to complete an analysis on the next steps to achieving T+1 by Q3 2021,” she says.