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The big shift to the T+1 Settlement cycle in the United States
In 2021, the Depository Trust & Clearing Corporation (DTCC), the Investment Company Institute (ICI), and the Securities Industry and Financial Markets Association (SIFMA) in the US jointly published a financial report of great significance. It outlined industry findings as well as recommendations for migrating to a T+1 cycle from T+2 for securities settlement.
In fact, the DTCC also did a press release highlighting the steps to achieve T+1 with reference to its report.
The report titled “Accelerating the U.S. Securities Settlement Cycle to T+1” offers firms the protocol for reducing the securities settlement cycle, including the applications of the shift, recommendations, and the implementation plan for the shorter T+1 cycle by the first half of 2024.
In this blog, we have highlighted the current scenario surrounding the T+1 settlement cycle in the US while discussing the benefits and impact going forward.
What is T+1 settlement?
There are two essential components behind the purchase or selling of stock, bond, mutual fund, or an exchange-traded fund: the date of transaction (T) and the date of settlement (T+n). In most cases, settlement dates are abbreviated as T+1, T+2, or T+3 denoting the number of days it takes to settle each transaction since its origin.
What is the current scenario?
In the US, the US Securities and Exchange Commission (SEC), along with the boards of other nations such as Canada, Peru, and Argentina, reduced the security settlement cycle from T+3 to T+2 in September 2017. Leading APAC markets like India, Japan, and Australia had already made the shift to T+2 at that time. In 2022, India successfully became the second country, next to China to move to the T+1 stock settlement cycle. Now, the US is also targeting further expediting its security settlement cycle with T+1.
Leading industry bodies such as the SIFMA and ICI joined forces with financial market infrastructures (FMIs) such as the DTCC and other proponents to push for this change. This was following several disruptive events such as the COVID-19-induced equity market volatility as well as the meme stock trading turmoil.
The endeavor aims to roll out the changes within the first half of 2024. Some industry experts reckon that if the T+1 rollout is successful, this can pave the way toward even faster settlements, also called the T+0 or the atomic settlement.
What are the benefits of T+1 settlement?
Implementation of the T+1 settlement has the potential to foster several comprehensive benefits both for investors as well as the market at large.
There is an inherent risk when trading with a counterparty not fulfilling its obligations within the time it takes for a trade settlement into a client’s account from the time of its execution. The degree of risk is directly proportional to the duration between the two events. This risk is further intensified during stressed market conditions and high market volatility. Such risk can end up severely impacting cash or securities ownership transfer(s) due to unpredictable events such as a firm defaulting.
Risks like these are spread over the two days of the T+2 settlement cycle while reducing the same to T+1 will take an entire day’s worth of risk out. Furthermore, accelerating the settlement cycle will also help reduce broker-to-broker counterparty risk, buy-side counterparty exposure, liquidity needs, operational risk, and systemic risk.
Other than protecting investors, a reduction in the settlement cycle will create greater efficiencies in the market. The T+1 system reduces collateral and margin for broker-dealers while allowing investors access to substantially faster fund access post-trade execution and settlement.
The reduction in overall time increases retail participation and upcoming equity market investments. These benefits add up significantly throughout the millions of transactions that the market will continue to witness.
What is the road ahead?
The settlement cycle involved several complex processes. Halving the entire process duration will ensure that the complexities are also halved, and due diligence is deployed to identify and address the resulting operational and business impact. Overall, the instructions will have to be more accurate the first time as opportunities to make changes will be limited. Enterprises need to be sure of the holistic impact of this shift which will inevitably have far-reaching consequences above and beyond just a reduction in overall turnaround time.
For non-US investors, currency conversion adds a layer of complexity to trade processing, and they may have to pre-fund cash positions and deposit securities even before the actual trading. This may make investing in US markets a less attractive proposition with under-investments as well as complicated and riskier delivery securities.
There are cost implications to consider as well. As per SEC estimates, the cost of implementing the transition will be between $3.5-4.95 billion. Moreover, each institution will need to spend around $5.5 million to be compliant.
As a preliminary step, stakeholders would need to identify and outline the processes, products, and markets that will require modifications to be congruent with the T+1 shift. This will involve financial and segregation requirements, foreign exchange and securities lending, and other processes such as broker processing and post-trade affirmations.
The chief considerations would include the following:
The migration to T+1 opens possibilities to improve capital and operational efficiencies. For instance, this might just present the opportunity to financial institutions (FIs) for shifting their digitization efforts toward the back office and cope with scalability and volume challenges with automation. Now, FIs will need to implement automated tools and systems with in-built operational controls and real-time process support. Why? To eliminate redundant processes, save time and expenses and reduce chances of manual errors.
DTCC margin requirements went up with meme stock trading, leading to the suspension of trading for these volatile stocks. Even though T+1 lowers the capital requirements at these brokers, the volumes would still need to be managed.
With the central banks aiming to implement central bank digital currencies, distributed ledger technology (DLT) and digital assets are becoming more mainstream. The enablement of these new asset types is directed at promoting a T+0 settlement cycle. The question of whether or not T+1 is relevant to this is yet to be answered.
In the end, industry participants will influence how the SEC's proposal for T+ 1 settlement is translated into a final rule. The 2024 timeline gives all the stakeholders ample time and the opportunity to shape their strategies for a seamless implementation.
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