Shining the light on the financial trade-offs of Accelerated Settlement

At a glance

• At the end of May 2024, trade settlement will tighten to just 24 hours in the United States. The Securities and Exchange Commission’s final rule requires firms to ensure that securities trades are allocated and affirmed T+1. The rule captures most security transactions excluding government and municipal securities, commercial paper, and some other exempted securities¹. While this rule change only affects firms with direct exposure to the US financial markets, it may pave the way for UK and EU regulators to follow suit.
• The T+1 transformation programme is large and complex. It will require coordination between market participants across the financial services industry globally and implementation of changes across a broad range of functions including front office, risk management, operations, treasury, technology, legal and compliance.
• In addition to a myriad of operational aspects inherent in transforming their existing settlement infrastructure to comply with the new rules, firms need to consider other financial costs arising from capital, liquidity, and failed settlement management. In this blog, we outline a non-exhaustive list of financial implications for firms to consider in their preparation for the transition.
• US firms, together with non-US firms active in US capital markets, will likely have already completed their assessment and now be in the process of implementing changes and testing ahead of the May 2024 cutover.
• The debate about accelerated settlement in Europe is at a much earlier stage. The UK, as part of the Edinburgh Reforms, set up the Accelerated Settlement Taskforce to assess the benefits and costs associated with a transition to T+1. The initial findings are expected by December 2023, with a full report and recommendations by December 2024 but may be accelerated. In the EU, the Association for Financial Markets in Europe (AFME) published a paper discussing the benefits and challenges of T+1 settlement in Europe and set up its own task force in March 2023. No doubt firms and regulators will be watching what happens when the US switches to T+1 very carefully, to inform their attitudes as to whether and how quickly Europe should follow suit.

Liquidity considerations

The US National Securities Clearing Corporation (NSCC) reported clearing of c.$1.95tr per day on average in Q1 2023², of which c.98% is offset by netting³, resulting in a net settlement obligation of 2%, equivalent to $39bn per day. This effectively means that shortening the settlement cycle by one day should result, on average, in c.$39bn reduction in the market value of transactions awaiting settlement, resulting in substantial liquidity benefit for the market. A shorter settlement cycle means that firms’ liquidity is only locked-in for 24 instead of 48 hours, which at times of liquidity stress may contribute to reduced liquidity risk exposure. In addition, tying up assets in collateral generates “allocative inefficiency”, as firms lose out on opportunities to use these assets elsewhere to generate better returns. The shortening of the settlement cycle may result in more efficient allocation of assets, reflecting their actual risk/return profiles instead of collateral usage.

There is also a theoretical discussion about potential reduction in initial margin requirements which could lead to further liquidity benefits for market participants. However, this will depend on the way that CCPs’ internal models will evolve over time to reflect the effect of T+1 settlement coupled with associated behavioural changes in trading patterns and risk taking.

The liquidity implications will also differ based on the product type or structure of the transaction. For example:

• for some open-ended funds (e.g. mutual funds) which already settle at T+1, while their underlying assets settle at T+2, the liquidity risk will reduce;
• for market participants which operate across jurisdictions with different settlement cycles or across multiple currencies (FX markets settle at T+2), the liquidity risk and costs will increase. The participants will need to source the FX liquidity in advance to fund the purchase of a security that has a shorter settlement cycle, or fund the purchase with short-term borrowing;
• for market participants which trade securities that are exchangeable for a foreign security (e.g. ADRs) or baskets which include foreign securities (e.g. ETFs) the liquidity risk and costs will also increase if underlying securities settle at T+2. The participants will need to borrow these securities in advance which is likely to result in wider bid-ask spreads and consequently reduced demand and liquidity for these instruments. The issue may be exacerbated by instances where it is not possible to borrow a security.

In addition, trades settling faster could lead to increased fluctuations in firms’ liquidity needs. Firms must acquire the tools to forecast liquidity and funding requirements efficiently on both an intra-day and end-of-day basis to anticipate changes in their liquidity position. If these capabilities are under-developed, firms will likely need to hold additional capital and liquidity buffers to offset underfunded exposures, especially in the case of unexpected market volatility. This may be a particular constraint for smaller firms which are likely to have less developed liquidity management capabilities. To prepare for T+1 transition, firms should calibrate their liquidity forecasting to be able to adjust to more volatile markets and assess their portfolio for potential settlement mismatches to understand additional funding needs.

Capital considerations

Some of the capital benefits of T+1 are easier to assess then others. The most obvious capital benefit is the potential reduction in counterparty credit risk due to overall reduction in exposure duration to a counterparty and lower probability of default (PD) which reduces in line with exposure maturity resulting in lower counterparty risk capital charges.

From a market risk perspective, the risk across the market should decline from the overall reduction in unsettled transactions. In addition, market participants that experience counterparty default and enter into a new transaction under a T+1 settlement cycle are exposed to less market risk than would be the case under T+2. On the other hand, market participants that deal in multiple currencies will need to account for an extra day of currency risk or extra cost of hedging it in the derivatives market.

Assessment of operational risk is more complicated. While initial operational changes required for the implementation of T+1 settlement are undoubtedly a heavy lift, in the future, the need for faster settlement will drive modernisation of settlement infrastructure and automation of manual processes throughout the trade processing lifecycle, including industry adoption of Straight-Through Processing (STP). Reduction of manual intervention should significantly reduce operational risk and consequently operational risk capital charges. On the other hand, the shorter settlement cycle also increases operational complexity for market participants which must manage and settle trades faster, communicate with each other more efficiently and have very limited room for error due to compressed timelines. The increased complexity could result in a higher frequency of operational errors and shorter time to resolve them, leading to an increase in operational risk, particularly in the shorter term, while systems are being calibrated.

To mitigate possible increases in the operational risk, firms could accelerate their actions for the transition, design robust testing plan and define stringent operational risk metrics during the testing phase to ensure minimal operational risk exposure when systems go live for T+1 settlement. The US Depository Trust and Clearing Corporation (DTCC) has already started testing and will be running 21 two-week test cycles for its members, until May 2024, to iron out operational complexities⁴.

Costs associated with failed settlement

A shorter settlement cycle is likely to result, at least temporarily, in more settlement fails and potentially higher costs as a result. For example, in the case of a clearing member’s default, the CCP will need to liquidate assets from its default fund to cover its obligations. The requirement to settle the transaction at T+1 will make liquidating a defaulting member’s position more costly due to a shorter time horizon, particularly for less liquid assets. There may also be higher costs associated with buy-ins for trades that are not settled on time. Buy-ins occur when an investor has to re-purchase a security that was not delivered by the counterparty by the settlement date, which, due to the price volatility, could lead to higher (or lower) cost.

If T+1 settlement is eventually introduced in the EU, firms may also be affected by higher mandatory buy-in costs, which occur when the original seller fails to deliver the security and the buyer purchases it from a third party. A compensation payment is then made from the original seller to the buyer if the value of the security has increased since the trade date. Under the EU’s Central Security Depository Regulation (CSDR), mandatory buy-in rules have been postponed from February 2022 to November 2025⁵, due to concerns about impacts on market liquidity, the cost of the regime for market participants and the readiness of CSDs. The cost of the failed settlement in the EU also includes financial penalties for the late matching or failed settlement of trades involving all securities traded on an EEA trading venue or cleared by an EEA CCP. The UK Government announced that the UK will not be implementing the EU CSDR Settlement Discipline Regime but will assess its approach to settlement discipline to ensure it is appropriate for the UK market⁶. However, the rules will still apply to the UK and US counterparties clearing via an EEA CCP.

Conclusion

Whilst awaiting further developments in the UK and EU, firms should consider the implications of T+1 move in the US through the lens of their business models, cross-border and foreign currency exposure, operating model set up, change maturity and asset/liability management capabilities. A robust testing plan with clearly defined operational risk metrics, monitoring of operational effectiveness during the testing phase and calibration of liquidity forecasting should help to reduce operational and liquidity risk and mitigate the potentially higher cost of settlement failures.

¹ Commercial bills, bankers’ acceptances and security-based swaps are also exempt.

² CPMI-IOSCO-Quantitative-Disclosure-Results-2023-Q1.pdf (dtcc.com)

³ DTCC-Accelerated-Settle-WP-2021.pdf

⁴ UST1-Detailed-Test-Document (dtcc.com)

⁵ Under CSDR – mandatory buy-in would not occur just at t+2. Instead, it occurs at t+2 + another set number of days (4 for liquid shares, 7 for illiquid shares and other instruments, 15 for SME markets).

⁶ Central securities depositories | FCA