On May 28th, 2024, the US is moving to T+1 settlement, shortening the standard settlement cycle from T+2. Canada will move one day earlier, on May 27th 2024, to T+1 to stay aligned with its larger neighbour.
In this article, we first explore the practicalities, such as which asset classes the change applies to and why the change is happening. We then focus on practical concerns for investment managers from an operational risk perspective and how investment workflows will change.
The History of Shorter and Shorter Settlement Cycles
The lag from trade date to settlement date has its roots in the times when stock certificates were physical. Originally, payment for bought securities (settlement) was due five business days after the trade (T+5).
The standard settlement cycle has since shortened gradually. About 20 years ago, in 2004, it was reduced to 3 days (T+3). 13 years later, T+3 was replaced with T+2. Another step will soon be taken, replacing T+2 with T+1 settlement in the US and Canada.
Some markets, such as India, already operate on T+1. There are differences, most notably the US and Canada time zones being later in the global 24-hour day, which causes additional complications. The US treasury market is another example of transactions that settle on the next business day. With these examples in mind, we know that it’s certainly possible to make the change for more asset classes in the US and Canada.
Transactions in Scope for Settlement T+1 in the United States (US)
- Corporate bonds
- Unit investment trusts (UITs)
For a more comprehensive list of instrument types that will change in the US, see this list from DTCC.
Rationale for T+1 Trade Settlement
The main reason to shorten settlement of securities trading is to reduce risks in the financial markets. Below are two concrete examples of such risk reductions:
1. T plus 1 Settlement Reduces Counterparty Risks
From the time of trade until settlement, there is a risk that the buyer will not be able to pay the seller, i.e. default on its obligation. Some transactions between market participants, such as broker-to-broker transactions, require margin to be posted, which mitigates the counterparty risks.
Moving from two days counterparty risk to one day will reduce the system’s overall risks and allow for lower margin requirements.
A recent event that has accelerated the move to T+1 is the “meme stock frenzy”, where retail investors got together and pushed prices of highly shorted stocks up by buying. This price push caused a short squeeze when shorters had to liquidate positions quickly. For market participants like Robinhood, the amount of trades resulted in exploding margin requirements that almost took the company down.
Regulators look to reduce the implications of similar events in the future by bringing down the time window during which trades remain unsettled.
2. Align Holdings with Mutual Funds Settlement at T+1
A matching settlement cycle will help mutual fund managers keep a smaller cash reserve, benefiting investors over time. When more capital is invested, it reduces cash drag and generates returns for investors.
Possible Complications From the T+2 to T+1 Settlement Change
There are many implications, including corporate action ex-date handling. We’ve identified the three main complications we believe will be visible for fund managers when the one-day settlement cycle arrives. There are certainly more than just these three.
Increased Operational Risk with US T+1 Settlement
A move from two days to a one-day settlement sounds like half of the time allowed for payment. However, it can be as much as reducing 12 business hours to 2 for some APAC market participants. With such a short time window, operational risks increase. Allocation confirmation and affirmation are due 9 pm ET on the trade date to try and minimise operational risks.
The SEC points out that when moving from T+3 to T+2, there wasn’t an increase in settlement fails. This shift is a different order of magnitude; cutting time allowed for the settlement process by up to 83%.
Securities Lending Risks
With T+1 Settlement, it means less time for lenders to recall securities. In the worst case, the T+1 shift can lead to failure to return borrowed assets in time.
Not lending isn’t a good alternative because of the reduction in operational alpha. Real-time transparency in connectivity to custody is critical to monitor the state of securities lending.
Cash and FX Planning, Complications Globally in the UK with T+1 Settlement
An important consideration when T+1 comes is how much cash to hold. As we already discussed, there is potential for mutual fund managers to keep less cash since the settlement cycle of their funds and holdings will align.
However, other capital markets, such as European equities, aren’t moving to T+1. The mismatch creates a new cash management problem. For example, a European EUR-denominated fund that wants to buy a US stock can do a T+1 FX trade to cover the required USD settlement cash, which comes as a funding cost and will cause a drag on performance if done often. The issue becomes more complex if deposits and more orders are involved simultaneously, which is often the case.
An alternative approach is to pre-fund orders, i.e. to make an ordinary T+2 FX trade for example on the day before placing the order on the security. A complication with this approach, when moving exposure from USD to EUR, is that you will sit one day with cash, which if it’s a large enough value risk causing a compliance breach.
The settle date mismatch era across markets we’re entering raises the need for better position and cash management capabilities in the front office. More specifically, the ability to see the cash ladder, including all confirmed and preliminary cash-effecting transactions in real time.