In moving to shorten the U.S. securities settlement cycle by one day to T+1, the Securities and Exchange Commission appears to have hit on something upon which virtually everyone can agree. Judging by the comments to the SEC's T+1 proposal, everyone from State Street to the Cornell Securities Law Clinic agrees that moving to T+1 is both desirable and beneficial to risk management in the long run. That said, despite this rare moment of accord between the regulator and the regulated, according to some commenters, some parts of the proposed implementation need attention, fine-tuning, or reconsideration.
This moment of agreement is not unexpected, however, because the industry has been mulling the T+1 idea over for some time and even mapped out the transition. The industry supporters of the move concur that a compressed settlement cycle will help reduce settlement, counterparty, and operational risks and will make suddenly erratic market conditions more manageable.[1] The Commission's proposal has considered much of the work securities industry groups have already done. The request for comment was an open-ended invitation for the industry to sound off on anything the Commission might have overlooked. Summarized below are some of the major areas of concern.
Implementation Timeframe
The most common criticism among T+1 commenters was the proposed effective date of March 31, 2024.[2] The Investment Company Institute, the Managed Fund Association, the Canadian Capital Markets Association, and others suggested that, depending on the adoption date of the final rules, the Commission should set the compliance date for T+1 transition to no earlier than September 3, 2024, immediately after the three-day Labor Day weekend the U.S. and Canada. This date would allow for a three-day weekend to effect last minute systems changes, as well as avoiding the end of a fiscal quarter.
Securities Lending in a Compressed Settlement Environment
RMA and State Street provided extensive input on the effect that T+1 and T+0 settlement could have on securities lending. According to RMA, absent some technological solution, a compressed settlement cycle is particularly unsuitable in the context of agency securities lending because of the time required for information and instructions to work through intermediary processes.
"The length of the standard settlement cycle becomes an issue in the context of securities lending when a Lender sells a security that is on loan. At that time, the Lender must notify the Lending Agent of the sale so that the Lending Agent can either reallocate the loan to another lender or recall the loaned securities from the Borrower for delivery to the Lender in time to settle the sale. When the Borrower receives a recall notice from the Lending Agent, it will seek to source replacement securities to satisfy the delivery requirement. If the Borrower is unable to borrow the securities, it will be required to buy them in the market. All of this takes time, even in the most automated world . . ."
State Street echoed the RMA's concerns and described how a move to further shorten the settlement cycle to T+0 is untenable with current systems and would require significant outlays for cutting-edge technologies to make securities lending work in a real-time settlement environment.
"The systems which currently support the securities lending business in the US market are not designed to accommodate same-day settlement. As such, the advent of T+0 settlement would require the development of costly new systems using emerging solutions, such as DLT, that enable the real-time movement of securities across market participants and platforms."
They also point out that a compressed settlement cycle could have the unintended consequence of constricting securities lending as lenders reduce their exposure by limiting their lending.
"Faced with increased risk, agent lenders may seek to manage their exposure by reducing the number of shares they make available to lend, further limiting the supply of inventory and compounding liquidity constraints. This includes greater restrictions on the availability of 'hard to borrow' securities which are generally sourced at the end of the business-day when liquidity is often already challenged."
Given the difficulties that securities lending would experience in a T+1 or T+0 environment, RMA asks for more time to develop, test, and implement the distributed ledger technologies, API connections, and smart contracts that would be necessary to comply with the compressed settlement cycle.[3]
"Though RMA is supportive of moving to a T+1 standard settlement cycle, we want to highlight that, if implemented today, the technology and processes used by securities lending market participants would not be ready to successfully implement this new standard. A target of late 2024 is more realistic but will still be challenging given other competing demands for resources such as Proposed Rule 10c-1, should that be finalized and implemented."
ETFs and Mutual Funds
ICI and State Street described the difficulties T+1 would impose on mutual funds and ETFs with foreign securities and ADRs. The misalignment of settlement between a U.S. market on a T+1 cycle and foreign markets on longer cycles could create NAV calculation difficulties that could only be remedied by exempting these funds from T+1 or using emerging technologies. According to State Street:
"From a broader perspective, in a T+0 environment essentially all of the major systems and processes that support the day-to-day operations of mutual funds would have to be reinvented using emerging solutions, such as distributed ledger technology (“DLT”), that eliminate friction in the flow of information between market participants, greatly reduce the need for reconciliations and permit the real-time or near-real-time movement of both assets and cash."
Conclusion
The industry zeitgeist on T+1 is generally postitive. By tapping into that sentiment and following the industry's lead, the SEC seems to have come up with a proposal that, though not perfect, offends few and delights many. In finalizing the path to T+0, the Commission must listen closely to what the practitioners are saying while keeping an eye on how they are innovating and employing technologies to gear up for the future.
[1] SIFMA, DTCC, ICI, Deloitte, "Accelerating the US Securities Settlement Cycle to T+1," December 2021.
[2] ICI also astutely observed that the proposed March 31, 2024 compliance date falls on the Easter holiday.
[3] Indeed, in the industry's 2021 roadmap for T+1, the authors anticipate the need for and recommend “the widespread adoption and utilization of tools to streamline the recall, contract compare, corporate action, buy-ins, and rebate interest collection processes."
Accelerating the U.S. Securities Settlement Cycle to T+1.” DTCC, 1 December 2021, p.6 https://www.dtcc.com/-/media/Files/PDFs/T2/Accelerating-the-US-Securities-Settlement-Cycle-to-T1-December-1-2021.pdf. Accessed 5 December 2022.