Another year is over, and now is a good time to take a look into the future and see what it might hold.
In the autumn of 2022, the Association for Financial Markets in Europe (“AFME”) published a report analysing the option of moving securities trading to a T+1 settlement cycle and calling for open dialogue on this topic between the participants in European securities markets. The AFME also proposed establishing a task force to conduct a detailed assessment of the benefits, costs, and challenges of T+1 adoption.
The report published by the AFME comes after several countries, including the US, have announced plans to move from their previous T+2 cycle to the faster T+1 cycle. An example of earlier calls for a transition to a faster cycle is a white paper called “Advancing together: Leading the industry to accelerated settlement”, which was published by the US Depository Trust & Clearing Corporation (“DTCC”) in the spring of 2021. In this white paper, the DTCC proposed that the default settlement cycle should be replaced with T+1.
Currently, the move to the T+1 settlement cycle is expected to occur in the US at some point in 2024. Similar discussion is to be expected in Europe. What is the expected outcome of this discussion? What are the benefits and challenges of adopting the T+1 cycle? Read on for a more detailed discussion of these topics.
The basics: what is a settlement cycle?
The settlement cycle is when the actual change of ownership takes place in securities trading. On average, when one is trading in securities, the trade is matched immediately after the buy and sell orders align. This day is referred to as the trade date (T).
The matching engine connects a seller with a buyer to complete the trade on the agreed terms and price, but the securities and cash will still need to be transferred. The buyer is not entitled to dividends or any other rights or obligations that the securities confer before they are transferred.
The settlement process is required for the change of ownership to take place. Settlement currently takes place, on average, on the second day after the trade has matched. That day is referred to as T+2 to demonstrate the delay between the trade and the settlement.
Settlement is primarily simply a process for exchanging information, which is done to ensure that the securities and cash are delivered to the right recipients. This is process is mostly automated but does sometimes require manual intervention, which is done in the back office of a bank or a broker. This manual process takes time and, like any manual process, is prone to errors if done incorrectly or in haste.
The history of the T+2 settlement cycle
European markets moved to the current settlement cycle, i.e. T+2, in 2014 when the central securities depository regulation (CSDR) entered into force. The purpose of the regulation was to safeguard the financial markets and give market participants confidence that securities transactions are executed properly and in a timely manner, including during periods of extreme stress.
One of the key aspects of the CSDR was its Article 5, which set the intended settlement date to “no later than on the second business day after the trading takes place”. The regulation also introduced measures to maintain settlement discipline by preventing settlement fails and establishing penalty procedures for settlement failures.
The European Commission recently conducted a review of the CSDR and published its final report (COM(2021) 348 final) in 2021. In the report, the European Commission came to the conclusion that the feedback it has received does not point to a need to make any fundamental changes to the most core requirements of the CSDR.
The benefits of moving to a T+1 settlement cycle
Since the current regulation has served its purpose just fine so far, why would a faster settlement cycle be needed? The most obvious answer is synergies. If the rest of the world adopts a faster settlement cycle, Europe does not want to be sidelined. In finance, the money flows where access is easy. Immediate money transfers are already reality in most parts of the world, and it is probable that securities trading will follow this trend.
Secondly, a settlement delay equals to counterparty risk, and risk always comes with a price. By reducing the time required for settlement, counterparty risk is also reduced, which in turn will reduce the price of the mitigative actions required to prevent settlement failures.
The CSDR already comes equipped with counteractive measures, such as central counterparties (CCP) that function as intermediaries in between parties to a transaction. This system is designed to prevent settlement failures, but all these measures are costly. By reducing the actual risk, it should be possible to similarly reduce mitigative costs.
Accelerating the settlement cycle should lead to reduced systemic risk and to fewer liquidity needs as well as to a reduction of margin and collateral requirements – assuming the change is done properly and without an increase in settlement failures.
While it seems clear that the world is striving towards instant settlement, we are not there quite yet. The benefits of a faster settlement cycle will cease to exist if the reliability of trading is compromised due to failures in settlement. Besides, it is already possible to settle a trade immediately on the same day it occurs (which is referred to as T+0 settlement) but not at the quantity or scale that would be required if all trades were to be settled instantly.
Also, while trading is international and cash moves are fairly simple, manual settlement is tied to certain hours before and after trading. Different time zones are not really a major issue currently – but even moving to T+1 trading will reduce the time available for settlement to only a few hours. This would already mean that any manual part of the settlement process would need to be as minimal as possible if the T+1 settlement cycle is adopted.
As for legislation, the CSDR does not prevent faster settlement. While certain legislative actions will be required to move all trading to a faster settlement cycle to prevent discrepancy between the European markets, the framework for the move is already in place. However, caution is required due to the more fragmented nature of European markets in comparison to US markets, including multiple currencies and legal frameworks.
It might not be currently fully possible to grasp all the challenges that moving to a T+1 settlement cycle would entail, which is why further industry-wide dialogue is required before Europe is ready to move forward. The benefits of a faster settlement cycle are clear but will require concentrated efforts to be implemented without friction.
Since the possibility of settlement failures is the main factor that speaks against the adoption of a shorter settlement cycle, it should be ensured that Europe is ready for the change. Faster settlement will also mean that cash and securities will need to be available one day earlier. If not, settlement failures will follow.
More minor but still relevant details to consider are changes that this move would introduce to the schedule of dividend payments and to other corporate actions. Corporate actions, on the other hand, have a direct impact on general meeting notices and other disclosures required from publicly listed companies.
If you have any questions about the subject or would like to discuss the matter in more detail, please contact the undersigned or your regular Borenius contact.