Outreach Blog

Thursday, October 6, 2022

Is T+1 Something We Can All Agree On?

The Industry Reacts to a Compressed Settlement Plan


Author: David Schwartz J.D. CPA

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.

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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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