Settling Down: How the US Finally Embraced T+2

Nothing good happens between trading day and settlement day. For years, that has been the mantra of the financial services industry. Keeping risk at a minimum while waiting for a security to be cleared has been an operational and technical challenge, but despite this, it has taken two decades for the industry to shorten the settlement cycle.

T+2, or the settlement of a trade two days after execution, is ready to be implemented on September 5, 20 years after the industry last shortened the cycle to three days from five. Canada, Mexico and Peru will also join the US in shortening their settlement cycles on September 5, while Japan has announced that it is also in the throes of moving to a two-day cycle.  

Moving to a shorter cycle was finally prompted in part to harmonize the US with other global markets that have already made the jump. The European Union implemented its T+2 cycle in 2014, in an uneven manner, with some markets remaining for the time being on T+3, such as Spain, which did not move equities settlement to T+2 until 2015. This was still enough to prompt the US financial services industry to form a technical working group to look into moving to T+2 that same year. Headed by the Securities Industry and Financial Markets Association (Sifma) and the Investment Company Institute (ICI), the group gathered custodian banks and buy-side firms to figure out the steps to prepare the industry for a move of its own. 

Tom Price, managing director for operations and technology at Sifma, says discussions around T+1 had been around for a while but it was not until 2014 that plans went full steam ahead. The speed at which the industry worked toward T+2 is proof of its commitment, he says.

“There have been discussions on the shortened settlement cycles. At one time, I think in 1999 or 2000, there were conversations about going to T+1,” Price says. “But in 2014, once the EU harmonized at T+2, it was just a matter of time before we followed. It was lightning speed for this industry—just about three years—for a project of this size.”

Long Journey

Ever since the industry adopted T+3, participants have been talking about further reducing the settlement cycle. Carol Penhale, now managing director for professional services at vendor Broadridge Financial Solutions, remembers being part of an industry group in the late 1990s when she was still with Mackenzie Financial—now Mackenzie Investments—to discuss shorter settlement times, but many felt that it just was not a good moment to move to a more technically challenging process. “I sat on a committee back in 1999 and there was an effort to move to T+1 then. I remember saying that I’m not really worried about Y2K, but this T+1 thing scares the crap out of me,” Penhale says. “The difficulty is that even a kindergarten student can recognize that if you’re trying to do something in one day that used to take five days, it will be tough.”

Penhale points out that after the 2008 financial crisis, the perception of just how much risk was in the system began to change, with the prevailing attitude being that this amount of risk should be reduced—including that in the settlement cycle. But at that point, every financial institution was more concerned about meeting new regulatory requirements than focusing all of their attention on one area of the post-trade lifecycle. 

In the aftermath of the 2008 global financial crisis, the US government introduced a host of new rules around capital requirements and reporting that consumed much of banks’ infrastructure budgets, notes Thomas Giacalone, managing director and head of operations, wealth management for the Americas at UBS, leaving little in the way of resources to tackle T+2.

“If you look across the US, there’s a lot of interconnectivity between players, industry utilities and other participants, so sometimes making changes to it means we’re not as nimble as some other newer or smaller markets,” he says. “There have also been a lot of regulatory items over the last financial crisis that firms have had to deal with that consumed a large portion of their IT investments, which meant they haven’t been delivering as much innovation. Given all of the regulatory projects prioritization, it just took time for the industry to get to this point.”

Giacalone adds that because the US is moving to T+2 within three years, going to T+1 or even T+0 should be much faster. 

Costs

The costs associated with the move to T+2, including those related to critical systems upgrades, meant that the industry had to be convinced that the benefits of moving the cycle outweighed any expense. Pinar Kip, who leads global strategic operations at State Street, says the cost of going down to a one-day cycle is three times more than a two-day process, so the steps for lowering the settlement time even further could well face obstacles. “When the group sat down and looked at what it would take to move to a two-day cycle, we had to consider not only the project cost of making this change but also the technology adjustments with the risks and mitigation costs that come from that—and it is not small,” she says. “To pull the trigger, the benefit of moving versus the risk of not moving had to end up balancing out. So in the spirit of not letting perfect get in the way of good, the group continues to have conversations on what the path will be.”

Illustrating just how large the bill could be, the US Securities and Exchange Commission (SEC) estimated that moving to T+1 would cost around $1.77 billion today compared with $550 million for T+2, in a ruling on May 30, 2017, that paved the way for T+2 to begin in earnest. The SEC did not respond to requests for comments. 

One benefit of the EU being the first mover in the switch to a T+2 cycle has been that the US is able to use lessons learned in that process to guide its own implementation. One such lesson was around the treatment of on-exchange and off-exchange transactions, which drove home the importance of seeking regulatory clarity. This means that there will be no option for certain transactions to remain at three days to settle. Another was to take a closer look at how a shorter cycle might affect derivative structures priced on underlying equities in a basket. 

In the European Central Bank’s (ECB’s) paper, Best Practices of T2S Markets’ Migration to T+2, the ECB states that it is important to have clarification when off-exchange or over-the-counter (OTC) transactions settle. It felt that without any clarity, OTC transactions would default to T+3 and cause confusion, advice the US T+2 working group has heeded. 

Consensus Taking

Along with the Depository Trust and Clearing Corp. (DTCC), Sifma and the ICI began reaching out in 2014 to market participants to seek consensus that a program to move to a shorter settlement cycle was important. Most acknowledge that gathering industry-wide consensus was the hardest part of the journey, including Graeme McEvoy, managing director at Morgan Stanley. “I think the biggest challenge was making sure the industry was moving in the same direction at the same time,” McEvoy says. “There are a lot of different constituents within the industry, and they all have to agree that T+2 is a good thing, and we’re going to do it on a certain time and date.” 

The other important step to a shorter cycle lay in regulatory support. Sifma’s Price says it was important to get the SEC to change the regulations surrounding settlement so that the entire industry had a ruling to follow. The SEC amended Rule 15c6-1—lowering the settlement cycle to two days or fewer—in around six months, something of a minor miracle in the often-glacial environment of regulatory change.

To mitigate the risk of potential settlement failures, testing has been undertaken to familiarize market participants with the shorter cycle. The DTCC set up 14 two-week testing runs beginning in February and lasting until a few weeks before September 5. John Abel, vice president for product management, settlement and asset services for the DTCC, says the testing is entirely voluntary. “Our commitment was to build out an environment that will allow members to test whatever transaction they thought they needed to test,” Abel says. “The industry testing group agreed that we wouldn’t mandate testing. We’re processing almost a million transactions per test cycle so we’re getting very robust participation in the testing environment and I can report that there have been no systemic issues.” 

Abel says that the last few testing cycles have seen fewer transactions as the implementation date nears, possibly signaling market participants’ growing confidence in their settlement processes. 

September 5 was chosen specifically for the T+2 implementation date because it sits right after the Labor Day public holiday in the US, so securities-market volumes will not be as high as they might otherwise be in early September. The Thursday after is considered a double settlement day because it happens to be at the end of a three-day cycle for securities traded the Friday before the holiday. This means that the DTCC will settle both T+3 and T+2 trades. Nevertheless, the industry is confident that September 5 and the subsequent settlement day of September 7 will pass without much trouble. However, just in case, Sifma, ICI and the DTCC have set up a hotline that companies can reach in case of a potential break. “We’ll have a command center that we will be monitoring. It will provide resources starting Friday night through the weekend and into Thursday the next week where members can get information and support,” Price says. 

With many custodian banks having experienced moving to a shorter cycle in other markets, it is mostly the smaller firms that are vulnerable to any potential issues. Kip says smaller firms may need to have additional people on hand who must work faster to ensure that all the processes are met within the shorter timeframe. Corporate actions will probably be difficult to navigate during the first few days of T+2, because as Morgan Stanley’s McEvoy explains, discretion dates related to buying stocks and getting voting rights are built around settlement dates. 

T+1 in the Near Future?

But now that the US capital markets are on the cusp of T+2, is an even shorter cycle next? Many in the industry say that T+1 discussions have already started, though it may be harder to move to one day from a two-day cycle. The technology transformation needed for a two-day cycle, Morgan Stanley’s McEvoy notes, was already a compromise between the three-day cycle and the more expensive systems overhaul required for one-day settlement. “To go from five to three days decades ago was a major lift; to go from three to two given the efficiencies that exist within the process today is a modest lift,” McEvoy says. “But to go from three to one would require substantial changes in many adjacent markets, like the foreign-exchange (FX) market and the stock-loan markets, and there is a lot of other fundamental work that would need to happen.” 

Going even further down the rabbit hole may not just require technology and infrastructure upgrades, but also an overhaul of established processes. Right now, trades are processed in batches, usually kicking off at the end of the trading day, although a shorter timeframe might mean that some trades may need to be processed immediately. 

Giacalone of UBS says the technology lift around T+2 mostly involved changing configurations—for example, there may be tables within a bank’s system for calculating settlements that required updating, or codes where the dates needed to be changed. He adds that UBS also needed to adjust reports containing settlement language. These changes are relatively simple when compared to those that would be required for a shift to a T+1 environment. 

“Moving to a shorter settlement cycle means a lot of things have to happen in a more real-time fashion,” Giacalone says. “You need quicker sharing of information and real-time reconciliation. With T+2, the industry was ready to go because no fundamental processes had to change. The next step is to get more efficiencies with real-time reconciliation and interfaces.” 

In all likelihood, the industry will inevitably get to that point sooner or later. The SEC tasked its staff—along with help from the industry and other stakeholders—with submitting a report “no later than three years from the compliance date of Rule 15c6-1(a).” 

The report will include the impact of T+2 on market participants, potential impacts of an even shorter settlement cycle, the identification of technological and operational improvements that can be used to move to T+1 or T+0, and cross-market impacts. And there may even come a day when trades settle almost immediately, according to McEvoy. “Eventually, I imagine you could get to the point where you even settle the trades before you know you’ve executed them,” he says.