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How T+1 Settlement Impacts Securities Finance Firms

Accelerated securities settlement is coming fast

With the implementation of T+1 in the U.S. and Canada only weeks away, David Turmaine, U.K. Practice Lead at Broadridge, says the challenges created by shorter settlement cycles mean firms globally need to rethink processes and architecture.

The genesis of T+1 may have started with the meme stock phenomenon, shares whose prices exploded based more on social media posts rather than fundamentals, but the impact of accelerated settlement is rapidly spreading around the world. The U.S. changes were driven by the desire to reduce credit risk and the amount of capital tied up in the settlement cycle. Those benefits may come with a cost — a cost that could be multiplied for those that are not properly prepared.

The need to be prepared for T+1 is not something that is limited to the United States. Global financial markets are incredibly interconnected. It did not take long for Canada and Mexico to follow the lead of the U.S. by announcing a reduction in their settlement cycles. By May, all three markets will be operating on a T+1 basis. The U.K. Treasury and EU industry bodies are also evaluating a move to T+1, as are several APAC nations. India, one of the most nimble innovators in financial market infrastructure, jumped ahead of the U.S. by moving to T+1 in May of 2023.

Even for those markets where T+1 is likely to be a long time coming, the extent to which U.S. equities are owned and traded outside of America is a major driver of change. U.S. equities still make up more than 40% of the total global market and a very large proportion are foreign owned. For some international firms, the challenge is going to be even harder than for U.S. firms. Cross-border settlements can be problematic even with the existing settlement cycles. International firms will have very limited time to deal with issues on U.S. equity trades. There will also be the additional challenge of trying to synchronise cash flows from U.S. equity and FX trades when most currency pairs that trade against the dollar will continue to settle on T+2. T+1 will have particular impact in the closely related areas of securities lending, collateral management, custody and, of course, securities settlement.

The need to think holistically

It is easy to take a siloed approach to T+1, but this can lead to a superficial viewpoint without understanding the interconnections across asset classes and the overall trade lifecycle. Take  for example securities finance in the domestic U.S. market. The initial thought may be that securities finance trades already settle on a T+0 or T+1 basis, so there should be no issue with accelerating the settlement cycle for cash trades. The first problem that appears by thinking about the impact holistically, however, is recalls. Securities lending trades are usually booked on an open basis. The lender can recall the stock whenever they choose, which is normally when they have executed a sell trade. A recall, even in the T+2 world, can cause challenges because the borrower (who normally obtained stock to cover either a short sale or a settlement failure) needs to source the appropriate stock to return it to the lender. This means arranging and settling, either a new borrow or making a purchase in the market. This must happen in time for the lender (i.e. the beneficial owner) to settle their sell trade. Both options fit within the current two-day settlement cycle. Things become trickier if there is only one business day to manage this. With only one business day, any errors in processing the transactions triggered by a recall can lead to multiple settlement failures.

Fail to prepare, prepare to fail

This recall scenario, and many others, may only be manageable if processes around trading, custody, inventory, and securities lending happen as smoothly and quickly as possible based on near real-time data. Carrying out any of these activities too late in the day, or based on incorrect data because of a reliance on manual or batch-based processes, is likely to increase the number of fails. High levels of fails can damage client relationships and potentially lead to regulatory action. However, even elevated levels of fails can make it harder to use long securities positions for either securities lending or collateral management purposes. Ironically more fails will also increase the demand to borrow stocks to cover settlement failures.  

Don’t make assumptions

It is important not to make assumptions about the transition to T+1. It is not possible to simply assume a third party such as a custodian will sort things out or counterparties will all perfectly adapt to the change, minimising noise and error in the settlement cycle.

Every firm, whether already involved in trading U.S. securities or in a market planning to make the change will need to take a long hard look at their systems and processes. They will also need to think about how to deal with problems caused by third parties and make sure their exception management processes are well documented and robust.

Counting the cost

Firms with systems that are several decades old, and depend on batch-type legacy processes, will need to implement new technology. This is an expensive process that takes time. A prudent approach might be to implement this new technology alongside legacy systems to gradually reduce dependence on expensive, inefficient infrastructure.

Firms also need to think about the most efficient way of working with their clients, providing them with the tools they need to achieve real time information flow. This may entail investing in client services or automated communications systems to reduce call and email volumes. A comprehensive impact assessment will help inform the best approach for each business.

Whether supplementing existing infrastructure or changing the engagement model with clients, a key tool for assessing potential impact is to look at the data produced by post-trade processes including fails and more general exception management. A pragmatic, data-driven approach can help the right choices to be made when funds and time are limited.

The opportunities from change

Shrinking settlement cycles do not just have be a source of costs and increased operational risks for areas such as settlement, collateral management, custody, and securities finance. Facing up to the challenges in the right way can be a catalyst for more efficient and controlled processes and systems, but you have to ask yourself the right questions.

Do you have the right tools to enable your clients to operate in this time restricted environment? Do they have access to real time information? Do you understand where the pain points are within your front-to-back process flows? Broadridge can help you address these challenges and remain competitive in an evolving securities landscape.

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