Regulatory bodies and market participants across the globe appears to be positive in shortening the settlement cycle, which is likely to reduce the inherent risk in a longer cycle and increase operational efficiency. However, there is resistance from the smaller participants as the cost of implementing T+2 requires heavy upfront investment.
Current Settlement Cycle – Global Scenario
Discussions on reducing the cycle to T+1 commenced in 2000, five years after the US moved to T+3 from T+5. That year the Security Industry Association (SIA) calculated the upfront cost at US$8bn with an annual saving of US$2.7bn, arising from the day of implementation (expected year 2004). The estimated cost was judged to be too low by industry players. The SIA therefore decided to drop the idea of shortening the cycle and focus on straight through processing.
The 2008 financial crisis forced regulators to revise risk management practices among the market participants, thereby bringing back the idea of shortening the cycle in the US. In Europe the CSDR has mandated all countries to move to T+2 ahead of its common cycle and to harmonise settlement through the Target2Securities (T2-S) settlement engine by 2015. Trade allocation, confirmation and affirmation are performed on T+1 in case of T+3. However, to move to T+2, these processes have to be completed on the trade date.
Shortening settlement of the cycle could lead to an increase in settlement failures in the short term, due to the transition from old processes to new and an increase in trade volume. This trend was evident when Germany and Norway shortened their cycle. The settlement failure percentage in Norway rose from 5.4% in 2009 to 11.31% in 2012; however the change will help increase trade efficiency and reduce costs in the long run.
Markets such as Chile, Israel and Saudi Arabia operate under T+0, whereas China operates on T+1. There are countries such as Germany, India and Bulgaria, which operate on T+2. Others have a relatively longer cycle. Eleven European countries are mandated to shorten their cycle to T+2 by the end of 2014.
Table 1: Global Picture – Settlement Cycle (Cash Equities Trade):
As per data gathered by regulators in the US and Europe, settlement failures as a percentage of total volume for the US is low compared to European countries. For example, in March 2012 the US settlement failure rate was 0.02% compared to 0.47% in Belgium. The following chart highlights the settlement failure percentage for major players during the month of March 2012.
Need for Shortening the Settlement Cycle
Risk management has been a major focus area in the financial industry since the 2008 financial crisis. Developed markets are in favor of shortening their cycle from T+3 to T+2, or T+1, to reduce risk and improve post-trade efficiency based on the premise that the time is risk and risk is directly proportional to settlement time.
There are many inherent risks present in T+3. Some of them are:
- Systematic risk, which an investor faces as the potential losses due to fluctuations in security prices. Shortening the cycle helps to mitigate this risk.
- Risk on transactions carried out on the client side between brokers and buy side firms, as these transactions are unsecured or uncollateralised. This risk is a function of time and volatility; hence the shorter the cycle, the less the risk.
- Trades executed on an exchange between broker and dealers are guaranteed by the National Securities Clearing Corporation (NSCC) by making clearing fund deposits as collaterals, but clearing fund deposits used for maintaining margin on a mark-to-market (MTM) basis. A longer cycle means larger clearing fund requirements.
T+2 not T+1 or T+0
After analysing the benefits of moving to T+1, US and Europe regulators decided to move to T+2. According to them, T+2 is a more realistic target because of wider scope of changes required before moving to T+1. The European Commission’s (EC) taskforce expressed the view that T+1 is too short as there might be a mismatch with the foreign exchange (FX) market, which works on T+2.
Possible reasons for sticking to T+2 and not moving to T+1 or T+0 include:
- Cost of technology upgrades are expected to be significantly higher. Small and mid-tier brokers may not find it financially feasible.
- Forex market may need to shorten their cycle from existing T+2 to T+1 to operate in sync.
- Wider agreement among different countries to accept common standards, such as the Financial Information exchange (FIX) protocol and SWIFT protocol.
- Real time processing of back office operations which is difficult to achieve currently as there are other regulatory requirements to implement.
- Clients need to fund their traded securities two days sooner.
Transition to T+2 – Potential Implementation Challenges
One of the major challenges the market participants face today is prioritisation in responding to daunting regulatory requirements. As market intermediaries are loaded with complex regulatory compliance, changing their current infrastructure for T+2 implementation might not be top of their list. Currently some of the ongoing regulatory changes impact the same core systems, which need to be changed as a part of T+2. This may lead to conflicts in prioritising which project to ‘green light’. All these may lead to additional overheads.
Retail and institutional brokers feel that the cost of moving to T+2 may exceed the DTCC’s budget by 15-20%. Retail brokers who do not do self-clearing will have minimal impact, while retail and institutional brokers who do self-clearing are likely to face huge expenses in upgrading the systems. The cost in T+2 implementation estimated by the DTCC is shown in table 2 below.
Table 2: DTCC’s Estimate Cost of moving to T+2:
The biggest challenge confronting the industry is to streamline the post trade processes and introduce efficiency to the system. This initiative will not only bring down the cost per transaction but also increase trade volumes. There will be more liquidity in the market coupled with effective risk management practices. Regulatory bodies and industry associations should come up with a realistic timeframe for the implementation of T+2.
As per leading analyst estimates, the cost to upgrade the required business processes and technology stack in moving to T+1 stands at US$1.8bn and US$550m for T+2. This is obviously a huge investment for the capital market firms, when regulatory changes are already formidable. Nonetheless, the benefits of this initiative are equally compelling for an upgrade to align settlement across geographies and fortify risk management practices by reducing exposure between market participants and protect investors’ interests through a faster and efficient settlement cycle.
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