The global shortening of the settlement cycle: The future direction of travel

There are less than six months to go before the North American markets make the move to shorten their settlement cycles from trade date plus two days (T+2) to T+1 and many firms are still grappling with the required operational changes, especially those in international markets. Moreover, when one major region moves, others are bound to follow and the European Securities and Markets Authority (ESMA) kicked off its own consultation on shortening the settlement cycle across the 27 member states under its regulatory purview in October 2023. The United Kingdom and Australia are also in the midst of a similar review process to determine the timing and details of their own potential moves.

ESMA's consultation on T+1 and even the consideration of a potential move to T+0 is due to be completed in December 2023, after which it will produce recommendations to the European Commission based on the received industry feedback, likely a year later. The move could be especially impactful for firms active in the European markets because of the continued high level of settlement failures in the region combined with the Settlement Discipline Regime (SDR). According to ESMA estimates from earlier in 2023 (see the chart below), settlement failures have gradually decreased for equities but increased for both government and corporate bonds since 2022. This means that settlement penalties for bonds are likely to be higher than normal and equities failure rates will likely increase as the settlement cycle is reduced.

A panel at the recent Posttrade360 conference in Copenhagen noted that dealing with the complexity of moving multiple central securities depositories (CSDs) regulated by multiple regulators, using multiple currencies, and with differing market practices is a significant undertaking. The feedback to ESMA from the industry will, no doubt, highlight the magnitude of this challenge and caution a considered and potentially phased approach to T+1. There is little doubt, however, that once the North American markets have moved, Europe and much of Asia will do the same within the next two to five years.

The pain of handling multiple settlement cycles, especially for a single asset that is listed on both American and European exchanges or for a basket of assets underlying an exchange-traded fund (ETF), will hasten the move. Capital markets remain global and this necessitates some degree of harmonization across markets to reduce operational complexity for cross-border investment. However, as shown by the chart below, the majority of attendee respondents to a poll at Posttrade360 feel that Europe will implement it in 2027 or later. The pain of misalignment between settlement cycles will therefore be persistent for some time to come and place pressure on firms' operational processes.

In the US market, the Securities and Exchange Commission (SEC) has identified broker preparedness for T+1 as an examination priority in 2024[1]. This means that the regulator will be actively assessing domestic broker preparations ahead of the May implementation deadline with a view to compelling more automation and new market practice adoption. This tactic could also prove popular within the wider regulatory community as other markets move and national regulators seek to ensure a smooth transition from T+2 to T+1. More regulatory scrutiny means more pressure to prove investments have been made in key areas at a time when spending on people has reduced. The first three quarters of 2023 have been dominated by stories of layoffs and downsizing, which has placed teams across the business under pressure. As a cost center, operations teams are often front of the line when it comes to downsizing, which means a huge operational change in the move to T+1 is being implemented with bare-bones teams.

The "great resignation" that followed the global pandemic has also depleted staff numbers within the operations space. The manual and repetitive nature of a lot of the tasks within the middle and back office has meant attrition has been particularly acute within these functions overall. There have also been recent stories of staff being moved from another continent to the US or Canada to deal with processes on T+0 in that time zone, but manual processes will be put under significant pressure and this will increase operational risk overall. Automating as much as possible could reduce this risk significantly.

The management of liquidity and FX are two areas that are top of mind for global firms, as highlighted by the audience voting at Posttrade360 (see below), but there are a catalog of changes required as part of the move to T+1. The move will place a huge manual process burden on firms in a real-time context, which will increase operational risk if firms fail to automate their middle and back office processes accordingly.

The five industry concerns about T+1

• Foreign Exchange timing for funding
• Liquidity
• Settlement timings
• Affirmation and confirmation timing
• Margin payment timings and clarity

Though every market participant will be impacted by the shortening of the settlement cycle, not every firm will be impacted equally. Global custodians, for example, have a business priority to address asset servicing deficiencies to understand where holdings are within the market. One of the big changes will be the move of ex-date to the same day as record date. During an active corporate action event or when an expiration date is upcoming, these firms will therefore be placed under increased pressure to capture all of the holdings that are entitled to participate in the event in question. These firms will need to assess their shareholder review process beyond just settled trades and focus on how to better deal with late instructions, as well as automating as much of the process as possible overall.

The direction of travel beyond T+1 is also a concern for firms (as highlighted by the chart below), especially for those firms active in Europe and facing existing cross-border complexities related to inconsistent tax and securities market practices. There is no doubt that the settlement cycles across the globe will shorten further and firms need to start thinking now about the next steps to get them to T+0.

For shorthanded and time-pressed teams, there is the option of working with managed services providers to reduce the burden of directly maintaining technology and operational expertise. The benefits of such a service include:

• Increased predictability of costs: The vendor has a service level agreement to meet and therefore is accountable to clients for its continued performance. This essentially means the vendor has a huge incentive to keep everything running smoothly at a predefined cost.
• Expertise: Vendors operating in this space need to have the requisite expertise to ensure they keep their clients happy and everything running as expected. Firms therefore don't need to keep excessive numbers of experts in-house (though some should be retained for oversight purposes).
• Keeping pace with industry changes is the vendor's responsibility: Upgrades and new functionality are researched and provided by the vendor, while clients can focus on other areas of revenue-generating importance.
• There is support to lean on for massive market changes: Firms aren't left struggling to manage industry changes such as the move to T+1 on their own. The managed services provider is there to help shoulder the burden and guide their clients in transitioning from one market practice to another.
• The power of community: By joining a community of financial institutions on one platform, firms can benefit from the expertise and continuous feedback into the system from their peers.

[1]2024 Examination Priorities, SEC Division of Examinations, October 2023.

S&P Global provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.