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Accelerating Settlement

T+1 Today, T+0 Tomorrow

SUMMARY: Starting May 28, 2024, the U.S. market will shift to a one-day settlement cycle (“T+1”), enhancing efficiency by reducing risks and increasing liquidity. This transition impacts various securities and requires faster fund availability and securities delivery. While beneficial, the move poses challenges, particularly for smaller firms and those using legacy systems. The future may see a push toward instant settlement (“T+0”), which would necessitate significant technological and regulatory advancements.

Understanding Settlement

When you buy or sell securities, “settlement” refers to the official transfer of securities to the buyer’s account and the cash to the seller’s account. Since 2017, the standard settlement cycle for most securities transactions has been two business days, known as “T+2”. The settlement process involves several steps, including the verification of trade details, confirmation of fund availability and the actual transfer of securities and money between accounts.

The Shift from T+2 to T+1

Effective May 28, 2024, the U.S. financial market will transition from a T+2 to a T+1 settlement cycle. This change means that most securities transactions will now settle within one business day of the transaction date. This adjustment aims to streamline the settlement process and enhance market efficiency.

The shift to T+1 comes as a response to advancements in technology and increasing demands for quicker transaction completions. Under the new system, investors who hold physical securities certificates must deliver them to their broker-dealers earlier. Conversely, investors using electronic holdings will see their broker-dealers handle the delivery process one day sooner. Similarly, buyers need to ensure funds are available a day earlier than before.

This transition will impact a wide range of securities, including stocks, bonds, exchange-traded funds (ETFs), certain mutual funds, municipal securities and limited partnerships that trade on exchanges. The goal is to reduce the time and risk associated with the settlement process.

A Step Forward for the Market

The primary benefit of moving to a T+1 settlement cycle is the reduction of counterparty risk. By shortening the time frame within which the buyer and seller are exposed to the risk of the other party defaulting, the overall stability of the financial system is enhanced. Another significant advantage is the increase in liquidity. With quicker settlement, investors can reinvest their funds sooner, potentially increasing market liquidity and allowing for more efficient capital allocation. Furthermore, the move to T+1 encourages the adoption of modern technology and streamlined processes, reducing the reliance on manual interventions and thereby decreasing operational risks and costs.

Yet, despite its benefits, the T+1 settlement cycle presents operational challenges. The compressed timeline may strain existing operational workflows, requiring significant upgrades in technology and processes. Smaller firms or those using legacy systems might face difficulties adapting to the new cycle. Additionally, the increased pressure on back-office operations means functions such as trade verification, fund transfers, and securities delivery need to be executed more quickly, which could increase the likelihood of errors if not managed properly. With less time to address issues that arise during the settlement process, there is a higher risk of failed trades, especially for complex transactions or those involving multiple parties across different time zones.

Market Dynamics and the T+1 Transition

The transition to T+1 will necessitate changes in how financial institutions manage their settlement processes. Firms will need to enhance their automation capabilities to handle the increased speed of transactions. Moreover, investors will need to be more vigilant about their cash and securities positions, ensuring they can meet settlement obligations promptly.

For institutional investors, the change may influence trading strategies, particularly around quarter-end and year-end periods when transaction volumes are typically higher. For retail investors, the impact may be less pronounced, but it will still require adjustments in how they manage their accounts and execute trades.

The Vision for T+0

Achieving a T+0 settlement cycle, where transactions are settled instantly on the trade date, presents a compelling vision for the future. However, the path to T+0 faces challenges. The operational complexity of moving to a T+0 settlement cycle would require real-time processing of transactions, a significant leap from the current infrastructure. All parties involved in a transaction, including brokers, clearinghouses and custodians, would need to process trades instantly. This instantaneous processing increases risk, as any error in trade execution or settlement instructions could result in immediate failures.

A major obstacle to T+0 is the challenge of liquidity management. Investors, particularly retail investors, would need to have funds pre-deposited and available for immediate settlement, reducing their flexibility in managing cash flows. Technological and regulatory barriers also pose significant hurdles. Implementing T+0 would require substantial upgrades to the current technological infrastructure and changes in regulatory frameworks. This could be a costly and time-consuming process, particularly for smaller firms and those operating in multiple jurisdictions.

The impact on securities lending and margin trading is another concern. The securities lending process, which relies on a certain time frame for borrowing and returning securities, would need to be overhauled. Margin trading would also face challenges, as the timeline for posting collateral and meeting margin requirements would be compressed. Cross-border transactions would be particularly challenging for T+0 settlement, involving different time zones, currencies and regulatory environments. Coordinating these elements for immediate settlement would require significant changes in how international trades are conducted. Finally, implementing T+0 would necessitate a complete overhaul of existing operational processes, including trade verification, reconciliation and reporting, a daunting and expensive task for many firms.

Despite these challenges, the potential benefits of T+0 are substantial. The elimination of settlement risk, as transactions are settled instantly, could significantly enhance the stability of the financial system. Immediate settlement would lead to more efficient markets, as funds and securities would be transferred without delay, enabling quicker reinvestment and more dynamic trading strategies. Enhanced investor confidence is another potential benefit, as knowing that trades are settled instantly could boost investor confidence by eliminating the waiting period during which transactions could potentially fail. Moreover, achieving T+0 settlement would likely drive innovation in financial services, encouraging the development of new technologies and processes to support real-time trading and settlement.

The Future of Settlement Cycles

As the financial industry adapts to the T+1 settlement cycle, the push for even shorter settlement times will likely continue. While T+0 offers compelling benefits in terms of risk reduction and market efficiency, the significant operational, technological and regulatory challenges cannot be overlooked. The future of settlement cycles will depend on the industry’s ability to innovate and collaborate on solutions that balance efficiency with risk management.

Nonetheless, the move to T+1 is a significant step forward, reflecting the industry’s ongoing commitment to improving market infrastructure and investor protection. As we look ahead, the evolution of settlement cycles will continue to shape the financial landscape, driving advancements in technology and operational practices. The journey toward T+0, while challenging, represents the next frontier in the quest for a more efficient and resilient financial system.

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