The Cross-Border Implications of T+1 Settlement

In this note:

• The U.S. will move to T+1 settlement on May 28, 2024, and Canada and Mexico are moving one day earlier on May 27th. This will present challenges for global investors as North American securities, which represent the largest concentration of global assets, will now settle one day earlier than most of the rest of the world.
• Clients and brokers will need to affirm trades by 9 p.m. ET, which is overnight for most non-North American firms. There are also particular challenges for European funds, many of which settle T+3 or T+4. The variance between U.S. stock and EU fund settlement dates will require increased focus on cash management in the coming years.
• Costs to the industry are expected to increase – between costs associated with fails, information leakage on stock loans, reduced income from stock lending as inventory issues arise, and the commitment of balance sheet for nonstandard settlement. A number of these factors may favor larger participants in the market and could lead to increased concentration on the buy and sell side.
• ADRs where underlying foreign shares settle T+2, non-North American ETFs that hold U.S. securities and any other execution involving FX conversions will face further challenges with the move to T+1.
• Many have asked when the U.K. and EU may move to T+1 to align with the U.S. However, we note that politics, alternative regulatory priorities, and the lack of alignment between the U.K. and EU right now likely mean that T+1 is not truly on the immediate horizon in Europe and these cross-border challenges will remain for some time.

T+1 Settlement Presents Challenges in the U.S. and Europe

While the move to T+1 settlement in U.S. securities on May 28, 2024, will inevitably present challenges in the U.S. – in terms of inventory issues, fails and other hassles – these issues don’t seem to hold a candle to the challenges anticipated by international investors. In particular, European asset managers have raised inherent time zone concerns, the turnaround time to match trades, the need to prefund or short settle currency trades involving North American securities, cash management considerations, and the mismatch between fund settlement and U.S. trade settlement dates will all contribute to a nightmare scenario.

To date, U.S. regulators have resisted any attempts to push the implementation back to align with other jurisdictions. So, while the U.S. plans to move forward with this shortened settlement cycle, the current sense is that non-U.S. investors will bear the brunt of this change. Below we highlight some of the primary challenges on the horizon, the impact these could have on institutional investors and the broader liquidity landscape and possible European regulatory responses to the shortened settlement cycle.

Looking at the Impact of Local Regulations from a Global Perspective

We chose to write this note as a global market structure team, since we have long recognized that changes to local regulations currently have broad-reaching global impacts for investors. We opted to take a cross-border collaborative view, even though regulators may not always follow suit. Perhaps the best example of this was when the SEC moved forward with a May implementation date, even though, as some commissioners pointed out, waiting just a few months for September would have allowed the U.S. and Canada to align the rollout. While the U.S. – the country representing the largest concentration of global assets – forging ahead into T+1 settlement before most other markets may not seem like the best idea, our market structure contribution aims to help clients navigate the coming changes and what they may mean for global investors.

Unique European Challenges

Time Zones

In its simplest form, the biggest challenge to the U.S. moving to T+1 for European investors is time zones. Under the new U.S. regulation, brokers will have to affirm trades by 9 p.m. ET. While this is a big change for APAC-based investors as well, they may have at least a few hours in the morning for local staff to work with brokers to affirm trades. For EMEA investors, however, local staff will need to work through the night to meet the faster turnaround time. This has led some firms to consider adding staff or leveraging existing personnel in the U.S. to help with trade matching on trade date with U.S. brokers.

Time Zone Changes May Have Larger Impact on Smaller Asset Manager

However, it’s important to acknowledge that these are not options available to all firms. They may be more challenging for smaller asset managers. As we discuss throughout this note, this regulation seems to favor the largest players in the market, whether it is brokers providing nonstandard settlement or buyside firms leveraging cross-border internal resources to smooth this transition. While the T+1 rule in the U.S. is not the first regulation to favor larger firms, we already have an increasingly concentrated execution landscape. Some have raised concerns that the move to T+1 could lead to further concentration on both the buy and sell side.

Changes to Order Affirmation

As we approach the T+1 deadline, we have seen some firms change the way they choose to affirm orders. Many firms choose to match completed orders intraday at order level as opposed to matching all trades at firm level when they complete at the end of the trading day. However, it is important to recognize that a growing share of total North American equities volume is traded in the final 15 minutes of the day. So, trading in the U.S. and Canada will naturally involve a heavy workload around the close since that is where volumes and, increasingly, institutional activities tend to be concentrated. (See chart below for the volume profiles of major North American indices.) It would be difficult to accomplish execution goals and address liquidity challenges without continuing trading through the close, which means there will still be a fair number of orders to process after 4 p.m. ET.

2023 Intraday Volume Curves: U.S. & Canadian Indices

Options to Help with End-of-Day Processes: Auto-Affirming Trades, AI

Clients have been exploring various options to help with these end-of-day processes, including having custodians automatically accept a broker confirmation on behalf of a client. This could get problematic. Auto-affirming larger trades could present risk, and brokers are not always correct with small discrepancies occurring on a regular basis. It feels as though the risks here could outweigh the benefits for many clients and brokers.

We have all also been closely following the advancements in AI, and the impacts AI can have on the asset management and execution industry. One of the earliest places for adoption seems to be in clearing and settlement with AI potentially being able to identify anomalies and reduce the amount of manual intervention. However, it still feels as though we are in the very early days of generative AI adoption in our industry. At least for the near term, we will be reliant on existent technologies and processes come May 28.

Possible Increase in Fails Due to Reduced Processing Time

Given the current environment and the significant reduction in processing time to affirm trades on trade date, we would expect to see an increase in fails and in the costs associated with those fails on both the buy and sell side. In a recent study, DTCC said that only 69% of allocations and confirmations in December 2023 were affirmed by 9 p.m. ET on the trade date (the timeline that will be required under T+1). Granted, this may not represent what will happen on May 28. But if even a portion of that remaining 31% of trades did begin to fail because they missed the tighter allocation/confirmation timeframe, we could expect to see a higher rate of failed trades. If the fail is caused by the client, then brokers could issue a claim for DK interest to recoup the costs assigned to the broker from the clearing firm. Increased traffic at clearing firms following the T+1 change will probably mean clearing firms validate their claims a bit more closely.

The SEC now requires closer oversight of this process as well. Rule 15c6-2 in the T+1 regulation requires brokers to establish policies and procedures to ensure their institutional clients are allocating, confirming and affirming trades in a timely manner by the end of trade date. While there isn’t a provision in the SEC rules for penalties like there is the U.K., repeat fail offenders on the buy side and sell side could expect to see increased costs – not only on the funding side for extended or shortened settlement – but also on the overdraft fees or claims. In the current rate environment, these charges could add up quickly.

T+1 Could Cost the Industry U$30 Billion

A recent Bloomberg article estimated that the move to T+1 could cost the industry an estimated U$30B across funding, fees, a reduction in securities lending, currency costs and various other costs (or lost returns) associated with the change in the U.S. One of the specific costs they cited was that it could get more difficult or costly to borrow securities as firms face pressure on portfolio finance operations. This could make it more difficult to find securities to borrow.

A recent Plato study found that 96% of institutions interviewed said the main reason for settlement failures was inventory issues. Speeding up allocations will not necessarily resolve that. If the move to T+1 instead exacerbates inventory issues, we would expect to see rising costs associated with fails and some supply/demand issues on the securities lending side.

In the same article cited above, Bloomberg estimated that 10% more borrows could fail under T+1, which could cause an increase in fail-funding costs. They also raised concerns from the stock lending community that earlier recalls of stock loans required to meet a T+1 timeline may leak information regarding future stock sales, and they included that leakage as part of their U$30B estimate. Whether you agree with Bloomberg’s estimates or not, it’s clear that there will be some cost associated with this move, and we’ve had a number of clients understandably concerned about who is going to shoulder that cost in the industry.

How will T+1 North American Settlement Work with European Mutual Funds on a T+3 or T+4 Settlement Cycle?

Another potentially costly consideration, specifically for EMEA investors, is that many European mutual funds operate on a T+3 or a T+4 settlement cycle. Contrast this with U.S. funds, many of which already settle T+1, and Canadian mutual funds, which currently settle T+2 and will move to T+1 alongside the change in securities settlement.

Many U.K. and European fund subscriptions and redemptions, on the other hand, are settled T+3 or T+4, which is already misaligned with the T+2 settlement cycle in most global equities markets. The move to T+1 in the U.S, which represents a large share of many managers’ holdings, could exacerbate those challenges. Today, firms can manage the existing mismatch in fund versus security settlement schedules using short-term credit facilities or by holding cash as a buffer for funding gaps. However, in a market that has melted upwards in recent years, holding more cash may not be a competitively advantageous option, could impact performance, and in certain instances may even be capped by regulations or mandates.

Some European Funds Considering a T+2 Settlement Cycle

Ahead of the U.S. move to T+1 and discussions about the eventual T+1 move in Europe (more on this below), some funds are considering amending their settlement cycle to T+2. While this keeps the gap between security and fund settlement at to 0-1 days, this is likely not an overnight change for most funds. Different jurisdictions in Europe have varying fund administration oversight, and there may not be a broad appetite for this change in the near term especially as European markets remain on T+2 settlement for the time being. What this likely means is firms that face this challenge are likely going to spend significantly more time on cash management in the coming years.

Extended Settlement a Potential Solution for Spread Between Fund and Security Settlement Date – With Some Caveats

Another solution to the current spread between fund and security settlement date is that some funds will utilize extended settlement. This isn’t exclusive to European fund managers. For a variety of reasons, institutional clients may choose to leverage non-standard settlement across the globe, and some brokers choose to offer it as an option.

Non-Standard Settlement as a Standing Instruction Violates SEC Rules

Going forward, however, extended settlement in the U.S. is not going to be a sweeping solution to the challenges T+1 presents. Brokers offering non-standard settlement as a standing instruction would be in violation of the SEC rules. In fact, brokers always offering non-standard settlements on certain types of trades or baskets could be viewed as offering standing instructions (or at least dancing very close to the edge of standing instructions) and could be subject to regulatory scrutiny.

Reg-T Limits How Long Settlement Can Be Extended

There are also limitations to extended settlements in the U.S. Regulation T limits how long you can extend settlement. The current limitation is T+4. However, when the U.S. moves to T+1, Reg-T limitations will be amended to T+3. Nonstandard settlements could also be viewed as an inducement in the U.K. or EU, creating further compliance complications.

Non-Standard Settlement Requires Funding to Facilitate Off-Cycle Settlements

Beyond the regulatory headwinds, providing non-standard settlement requires funding. Some brokers may not have access to the amount of balance sheet necessary to regularly facilitate off-cycle settlements. Other firms may choose not to tie up a large portion of their balance sheet for equity trading. In a rising interest rate environment, balance sheet is becoming more valuable.

Non-Standard Settlement Facilitation Likely to Be Done on an Ad Hoc Basis

At the same time, we have seen declining margins in trading, and they seem to be getting skinnier each year. The net result is that facilitations of non-standard settlements will most likely be done on a one-off basis for a subset of trades or a subset of clients. The implications of this are far-reaching, especially when you consider that settlement and funding issues may impact where natural contra-side liquidity is concentrated.

Again, this may be a scenario where – both on the buy side and the sell side – the move to T+1 may favor those firms with scale. This obviously isn’t comforting to a broad investor base looking for consistent solutions as these rules are implemented in the coming weeks. We also anticipate that there will be periods of time when there is significantly increased demand for non-standard settlement across the industry:

• Periods when volatility is elevated
• Larger rebalance days (such as Russell in June or the quarterly S&P 500 events)
• Around non-U.S. holidays, where the spread between U.S and non-U.S. settlement dates widens

These time periods will be a challenge to a number of investors which could exacerbate supply/demand issues when it comes to brokers offering non-standard settlement to asset managers.

ADRs Will Settle on T+1, But Foreign Shares Will Settle on T+2

We’ve gone through a litany of challenges here and haven’t even scratched the surface. Another challenge is that ADRs will settle on T+1, whereas, in many cases, underlying foreign shares will settle on T+2. Non-North American ETFs that hold U.S. securities will face a similar mismatch in settlement dates that we see with European mutual funds.

Forex Complicates North American Share Transaction Settlement

As mentioned earlier, one final unique challenge for international investors to highlight will be currency conversions needed to settle North American share transactions. European funds, for example, are often denominated in European currencies like Euros or GBPs. When they buy or sell a U.S. security, there is therefore the extra step of currency conversion.

Most clients’ FX components of trades are done after the asset manager has received a confirm on the underlying trade. With timelines for confirms accelerating, this will impact the FX components as well and is a possible added level of complexity that will disproportionately impact non-U.S. funds.

There are some solutions to this potential problem, all of which have a cost

1. The first is to pre-fund currency transactions and true-up post trade. However, this is hard to do given the unpredictability of future trades. Traders aren’t regularly given advance notice that a PM may wish to establish or amend a position in a North American stock before receiving the execution.
2. The second solution would be to short settle the currency trade which will include a cost built into the currency price.
3. And, finally, the fund could hold cash positions in foreign currencies (perhaps government bonds) for future needs – a strategy that may run in violation to a fund’s mandate and cause performance drag.

T+1 Also Presents Challenges for Canada and Mexico Trade Settlement

Lastly, from a global perspective, we know that all eyes will be on the U.S. start date of May 28, 2024, which is the Tuesday following the Memorial Day holiday weekend. However, it’s important to remember that Canada and Mexico will actually be leading the North American T+1 charge on Monday, May 27, as this date is not a holiday in either of these countries. While these markets may represent a much smaller percentage of asset managers’ portfolios, the same issues with time zones, overnight matching and mismatches between fund settlement date and security settlement date apply to both these markets as well.

CSDR & Politics Likely to Slow T+1 Progress in Europe

The prior discussion naturally raises the question: when will we see a regulatory solution in the U.K. and Europe to some of these challenges? Unfortunately, as James Baugh, TD Cowen’s Head of European market structure, wrote in a recent note, “Central Securities Depositories Regulation in Europe and differing opinions in the U.K. mean that timelines on aligning with the US, who move to T+1 at the end of May, remain uncertain.” He continues, “There could be an even more protracted period when Europe, including the U.K. and Switzerland, will continue to settle T+2.” The U.K., broadly speaking, was coalescing around a Q2 2026 date. However, prioritizing alignment with Europe has delayed announcements of a formal timeline. This is also the position the Swiss have taken.

ESMA’s Consultation Paper on CSDR Penalty Mechanism Will Likely Delay T+1 Discussion in Europe

At the same time, ESMA’s ongoing December 2023 consultation paper on the CSDR penalty mechanism, which seeks to further reduce settlement failure rates in Europe, will likely delay any real progress in discussing T+1 dates in the EU. ESMA imposed a September 30, 2024, deadline for recommendations on any new penalty mechanism. This means the focus will remain on CSDR penalties for the time being.

While settlement fails in structured products like ETFs have been improving, they still remain relatively high. ESMA’s focus on getting existing fail rates down before exacerbating the situation with a move to T+1 is somewhat understandable. Although many argue that a stiffer penalty regime will simply be borne by the investor via wider spreads and potentially less liquidity in ETFs rather than actually improving settlement rates. However, it’s important to acknowledge that the EU has other clearing and settlement priorities “in the queue” as we discuss timelines for T+1.

Indications of a Possible Move to T+1 in Europe, But Not Anytime Soon

That said, a roundtable was held in Brussels earlier this year where the Europeans gave their first indications of a possible move to T+1. These early talks actually may have been partially responsible for the U.K. postponing any formal T+1 timeline as alignment with Europe seems to be a priority for many in the U.K.

The U.K., however, is also not without its own challenges. Some suggest the CREST updates in 2026 will make a Q2 2026 move to T+1 tricky. However, James also mentioned that there may be, “general unease amongst a number of the larger banks in aligning with Europe, preferring the U.K. to move quicker without the additional shackles of 27 member states agreeing to a way forward. Whether this is just political posturing is difficult to tell.”

For the time being, with T+1 not truly on the immediate horizon in the U.K. or Europe, it seems the near-term focus will be on interim solutions like cash management to finance misaligned settlement cycles, rather than on greater efficiency or post-trade automation. As James put it best, “For now, at least, with timelines unknown, this could be a painful and potentially expensive process on this side of the pond that may last for some time.”

Conclusion

While it will be a challenge, we have no doubt that firms will adjust to this new model come May. We’ve received several inquiries from clients over the past year and know that European clients, in particular, have been working on this transition. They have been addressing cash management concerns and further automating clearing and settlement processes in advance of this change.

This note is not to say that the world will end come May 28. We seek to highlight the unique challenges associated with this move, particularly for international investors. The U.S. represents such a large share of many global portfolios and indices. It also happens to be on the least convenient point in the trading daytime zone map to be a leader in the move to shorten settlement cycles.

This all raises the question of what we are trying to accomplish here. While the hope is that a shorter settlement cycle in the U.S. will lead to reduced margin and collateral requirements and therefore encourage more liquidity, there is no denying that this regulation was in direct response to the “meme stock events of 2021”, as Chair Gensler specifically stated in his approval speech for the T+1 regulation. However, we know that what happened during meme stock mania – increased single stock volatility causing DTCC margin calls, which then led brokers to halt trading in single stocks – is not the heart of most settlement issues.

Individual retail activity has significantly declined since the meme stock craze in early 2021, when it hit an estimated peak of 30% of U.S. equity volumes. Despite that, the retail experience remains the primary regulatory focus for the SEC. This is an important point to remember as we move forward. The SEC is still considering other regulations – like Reg Best Ex and a new tick-size regime – which also seem primarily focused on improving the retail investor experience in the U.S. These regulations, like the T+1 change, could have broad implications for global institutional investors.