Tosin: Hello and welcome to the State of the Street podcast series, where we will be discussing the US Securities and Exchange Commission’s proposal to shorten the equities settlement cycle from two business days (also known as T+2) to one day (T+1). I’m Tosin Salami, head of product strategy for asset servicing at State Street. For context, when stock exchanges started, the settlement period was 14 days. Over time, the required settlement period has reduced. It dropped to seven days in the 1970s, three days in the 1990s and the current two-day requirement was implemented in 2017. This proposal may sound simple, as we are only reducing time, but it has major implications for the global financial system, and the move by the US should be seen in its global context with India and Canada, also shortening the equities settlement cycle to T+1, and with other markets set to follow. I’m joined by Chris Rowland, global head of custody product at State Street to discuss the proposed T+1 requirement, understand what it is, and how it impacts you, our clients.
Chris, thanks for joining me today. The proposed SEC rule to shorten the settlement cycle was released in February 2022. What are the implications of the move to T+1, and why should the audience pay attention to it?
Chris: Thank you for having me. The T+1 proposal is a critical industry development which is expected to impact a broad spectrum of market participants across the globe. Although the proposal is anchored by the shortening of the settlement cycle for securities transactions to one business day after the trade date, it is also accompanied by other measures aimed at enhancing efficiency of the post-trade processes. These additional measures include same-day affirmation of securities transactions, amendments to the recordkeeping obligations for investment advisors, amongst others.
As the industry plans for the implementation of the T+1 proposal, changes to trade matching systems and processes, tighter deadlines for the receipt of client trade instructions and faster resolution of pre-trade problems are some of the considerations that the industry will need to address in its planning efforts. Despite the scale of expected changes, the proposal has an implementation date of March 31, 2024, only two years after the proposed rule was released.
This is more aggressive than the move to T+2, which was being discussed within the industry since 2012, until final implementation in 2017. State Street recommended in our response to the SEC a revised implementation deadline of two years from the publication of a final rule. We made this recommendation because the planning and coordination by market participants, in conjunction with regulators, central securities depositories and other financial market infrastructure systems required to achieve T+1 settlement should not be underestimated.
In addition, the US proposal will likely accelerate the plans of major European, UK and Asian markets to move to T+1. Market participants in Asia will be the most impacted by the US changes due to time zone differences, as it means all post-trade activities in those markets will need to be completed in two hours. Foreign investors may be required to pre-fund cash positions and deposit securities prior to trading. This could result in cash being underinvested, making the delivery of securities more complicated and also riskier, and could make the US markets less attractive to international investors.
Moving to T+1 will not come cheap for the industry. The SEC has estimated that this change will cost the industry between $3.5 billion and $5 billion as one-time expenses, and another $5.5 million per institution for compliance costs.
Tosin: So Chris, while the industry has responded to the proposed T+1 rule, it sounds like there is a lot of industry chatter about moving directly to T+0. Why are we not focusing on T+0 instead?
Chris: Well, to set stage, the audience has to understand that T+0 doesn’t mean zero. Instantaneous settlement is not possible in today’s financial environment. That’s because the settlement of securities trades is a multi-step process that involves coordination and communication among a wide variety of parties. The process must allow sufficient time after a trade is agreed upon for the movement of underlying securities, and the appropriate transfers of funds. Timing can be compressed but it can’t be zero. The main consideration for getting to T+0, however, is that the current post-trade infrastructure doesn’t support same-day settlement. For this to happen, a lot of the current infrastructure supporting clearing, payments and settlement have to fundamentally change, requiring a complete rebuild of the post-trade system. To answer your question more specifically, a move to T+0 might not make sense on a cost benefit basis for some years to come, especially given the lack of widespread adoption of technologies that can facilitate same day settlement, such as distributed ledger technology.
Tosin: Ok Chris, we have said a lot about the costs, the compressed implementation timeline for T+1 and impacts. I’m sure there have to be some benefits, what are they?
Chris: Yes, there are benefits, primarily risk reduction and capital efficiencies. First, by removing one day from the settlement cycle, there is a corresponding reduction in risk. This decline in the length of exposure to trading counterparties lowers margin requirements for clearing members, and a lowering of both market and liquidity risk. The Depository Trust and Clearing Corporation (DTCC) estimates that a move to T+1 could reduce the $13.4 billion held by its members on average in margin each day by 41 percent, resulting in capital efficiencies. Secondly, there is greater funding efficiency as investors benefit from gaining quicker access to their funds. Thirdly, there will be operational efficiencies, as firms adopt industry standards, modify systems and processes to further develop automation and straight-through processing.
Tosin: Thank you, those are great benefits you’ve outlined, but what are some of the hurdles that the industry has to overcome before we can reap these benefits?
Chris: We expect a number of challenges as we work through the T+1 implementation. I will focus on key post-trade processes that need to be compressed in order to speed up the settlement cycle. First, let’s discuss the Allocations, Affirmations and Confirmations process. Under current (T+2) rules, the affirmation can be completed by 11.30am ET the day after the trade date, giving the institutional investor time to complete their allocations process and get all relevant data to their custodian, and giving the custodian time to match the affirmation to the client’s trade instruction. But under T+1, trades will have to be affirmed by 9pm on the day of the trade, meaning the trading entity must get affirmations to the custodian in time for it to conduct its matching process, and resend to DTCC. State Street’s analysis of its own DTCC data for June (the most recent available) shows that nearly 15% of trades were delivered the day after the trade date, meaning these trades would have failed under the T+1 regime. It is important to note that the confirmation and affirmation process can only occur once allocations have been completed.
A second hurdle is the identification and elimination of problems that lead to changes in instructions, such as mismatches in the affirmation process that I just explained as early in the process as possible. This will be key to minimizing trade failures caused by such problems, which push trades beyond trade date. Examples include mismatched trade dates, settlement date, executing broker and clearing broker details, place of settlement, or net amount and breakdowns of relevant commission information.
Tosin: Wow, the new deadline for affirmations is a major change! It is expected to shave more than 12 hours from the cycle. How will institutional investors accomplish this major shift?
Chris: That’s a good question. This change can be accommodated using an automated affirmation tool such as the DTCC’s Central Trade Manager (CTM). This tool can make the process more or less instantaneous as they deliver pre-matched information to the custodian. DTCC’s Match to Instruct (M2I) product is also another automated tool aimed at identifying or pre-empting these issues. We recommend these solutions or equivalent ones. Along with technology changes, both US and non-US institutional investors will need to adopt process and behavioral changes to meet this new cut-off time. There are recommendations from industry groups that allocations are made as soon as practicable after an order is executed, to ensure members have sufficient time for affirmation processing.
Tosin: That is very helpful information for our listeners, how can the non-US investors – especially the Asian investors we spoke about earlier in the podcast – meet the very compressed T+1 timeframes resulting from time zone differences? Also, how should investors think about corporate actions and income distributions?
Chris: The timeframes laid out by DTCC for T+1 are US East Coast timeframes, thus overseas investors need to factor time zones into account when enacting their instructions and processes, and giving their custodian time to do the same. It is recommended that overseas clients use prefunded trade settlements in this case. If the investor’s domestic currency to USD conversion is a consideration, State Street provides our clients automated FX capabilities to achieve prefunding and avoid overdrafts.
Another hurdle to watch out for are Corporate Actions and Distributions. Clients should be aware of the ex-dividend date that typically occurs before the record date of the event, and in a T+2 settlement cycle, the ex-date is two days before the record date. This now moves to one day before the record date. This process will require a quicker and more efficient distribution process, and exploring technology solutions in this area is recommended.
Tosin: Chris, there is obviously a lot to unpack for our clients to ensure they are prepared for these changes. We have touched on the allocations, affirmations and confirmation process. You also enlightened us on how non-US investors can prepare. Are there other post-trade process considerations or hurdles that our clients should start thinking about?
Chris: Of course. T+1 is a big undertaking that touches every corner of post-trade process. I’ll address two key activities that will also be impacted by the T+1 implementation: securities lending and ETF activity. Where stocks are on loan from the trading organization, an additional element of complexity is added to the trading process. The loan recall time must be factored into the cycle, along with the time taken to return any collateral held against the lending transaction. A number of factors can affect recall times, such as any timescales stipulated in the original lending agreement, and the liquidity of the loaned security.
The reduced T+1 trade cycle means future securities lending deals should take these factors into account. It is recommended that behavioral changes be adopted such that custodians and other trading service providers are given more advanced information about trades involving loaned securities, wherever possible. From the ETF perspective, shares in ETFs typically take longer to settle than most equities and other liquid securities because they involve the transfer of the underlying securities that make up the index that the fund’s portfolio tracks. In some cases, these securities can be listed across different time zones and jurisdictions, generating similar added complexities to those we discussed about non-US investor trading times, which require prefunding trade settlements a day earlier. The DTCC is changing their systems to support ETF trades, including transforming its ETF application from a batch to real-time processing system. They will be making functional changes to their Universal Trade Capture process, and the primary and secondary ETF creation and redemption process.
Tosin: Thanks Chris, this is a lot of good information for our clients to prepare them for the impending changes. My last question, how can State Street help with the move to T+1?
Chris: Although the industry has responded to the SEC’s proposal and we are awaiting the final rule, there will be continued engagement with industry groups such as the DTCC, the Securities Industry and Financial Markets Association (SIFMA), and the Investment Company Institute (ICI). State Street will provide timely information to clients based on these interactions.
Also, State Street’s various asset servicing solutions and capabilities are available to make the implementation of T+1 easier and enable our clients navigate the various potential challenges we have discussed.
Tosin: Chris, thanks for joining me in this episode. For those listening, I hope this helped you learn more about how the Journey to T+1, its benefits, costs and challenges. You can reach out to your relationship manager to learn more about how State Street can help on this journey to T+1.
