Sunday, June 23, 2024
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The U.S. financial market transitioned to a shorter settlement cycle for securities transactions, moving to a T+1 cycle where trades must be settled one business day after the transaction, instead of the previous T+2 cycle. This change, mandated by the U.S. Securities and Exchange Commission (SEC) in February, affects equities, corporate and municipal bonds, and other securities.

Regulators aim to reduce risk and enhance efficiency with this faster settlement cycle, which gained urgency after the 2021 “meme stock” surge involving GameStop highlighted the need for improved capital efficiency and reduced counterparty risk. However, the shift to T+1 could lead to increased trade failures and higher transaction costs due to the reduced time for firms to secure funds, recall shares on loan, or correct transaction errors.

The first major test of this new system will be on Wednesday, as trades from last Friday (under T+2) and Tuesday (under T+1) will be settled. This increased volume could reveal potential issues. Joe Saluzzi, co-head of equity trading at Themis Trading, anticipates some “growing pains and a few hiccups.”

Another significant test will occur on Friday during the quarterly rebalancing of MSCI global indexes, one of the year’s busiest trading events, potentially straining the new system.

Settlement, the process of transferring securities or funds post-trade, is managed by the Depository Trust Company, a subsidiary of the Depository Trust and Clearing Corporation. Failures in this process, where trading obligations are not met by the settlement date, can lead to losses, penalties, and reputational damage.

The U.S. joins countries like India and China, which already have faster settlement cycles. Canada, Mexico, Argentina, and Jamaica adopted T+1 on Monday. RJ Rondini, director of securities operations at the Investment Company Institute, hopes the benefits of reduced risk and collateral requirements will be realized without significant disruption to settlement rates.

Despite extensive preparations and testing by banks, custodians, asset managers, and regulators, a rise in trade failures is expected initially. Jeff Naylor, chief industry operations officer at ICI, noted that all T+1 implementation activities have been completed as planned. BNY Mellon estimates that increased trade failures could result in penalty fees amounting to tens of millions of dollars daily. Research from ValueExchange anticipates the fail rate to rise from 2.9% to 4.1% post-T+1 implementation. However, both Sifma and the SEC expect only a minimal short-term increase.

Ted O’Connor, senior vice president at financial technology firm Arcesium, highlighted that mid-size and smaller managers, who rely more on manual processes, will be closely monitored. Brian Steele, president of clearing and securities services at DTCC, assured that over 90% of the industry has participated in the process since testing began in August 2023, benefiting from the experience of the move to T+2 in 2017.

Trade bodies and regulators believe that shortening the settlement cycle will mitigate systemic risk by reducing counterparty exposure, improving liquidity, and lowering margin and collateral requirements. SEC chair Gary Gensler emphasized that less time equates to less risk. 

However, some market participants worry that the T+1 change could shift risks to other areas of the capital markets, such as foreign exchanges for trade-related funding and securities lending. Foreign investors, holding nearly $27 trillion in U.S. assets, previously had a full day to source dollars for trades. Natsumi Matsuba of Russell Investments noted that her firm tested market liquidity ahead of the implementation by conducting small trades after hours.

The move also poses challenges for exchange-traded funds (ETFs) in managing jurisdictional requirements and capital needs. Gerard Walsh of Northern Trust’s Global Capital Markets Client Solutions group advised managers to be aware of various potential solutions, acknowledging that the full impact of the transition would not be immediately clear.

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