By Dan Miller, Senior Managing Director, Outsourced Middle Office Services at IQ-EQ
With the US adopting a single-day settlement trading framework at the end of May, many managers are scrambling to ensure their trading architecture can handle a one-day settlement process. But why is it so difficult?
It’s been seven years since the US shortened its settlement cycle to two days, but US asset managers are still struggling with the idea that by the end of this month, they will be required to settle trades in a single day.
The shift to T+1 has been in the works for quite some time. Historically, we’ve seen a variety of settlement times, from T+2 and T+3 all the way to T+5, to settle securities transactions. However, a single-day settlement requires a variety of operational changes that make this new timeline uniquely challenging for many asset managers.
In February 2023, the Securities and Exchange Commission announced the deadline to shorten the US settlement cycle to one business day after the trade date, which would go into effect on May 28, 2024. This gave asset managers and financial institutions a little over a year to reconsider their internal infrastructure and technology to allow for single-day securities settlement, a much more complex ask than it may seem.
The operational hurdles
To understand why the shift to T+1 requires managers to reconsider their tech stacks, it’s important to recognize exactly how a trade is settled and what it entails.
When you buy a security, such as a stock or bond, the brokerage firm inputs the order on the market and the trade is executed. Under a single-day cycle, that order is settled the next day. Even in a T+1 world, trades are not settled instantaneously. By the time the trade is fulfilled, stock prices may differ from the purchase price. In a volatile market, these prices may fluctuate significantly, leading to massive amounts of capital hanging in settlement limbo. The move to T+1 cuts that current limbo-time in half.
However, this condensed settlement cycle also brings with it a variety of challenges for managers to meet the new regulatory requirements.
One significant barrier is the global workings of the market. For managers trading US securities, they may be required to hold US operational hours in order to support settlements on a T+1 scale, whether that’s hiring in-house employees who hold conventional US hours, or outsourcing to a provider in the US that operates on local US hours.
A regulatory shift like this brings with it a headache of operational changes. The complexity of the T+1 cycle also differs based on the manager, as well as their specifics when it comes to how often they trade, who they are trading with, and how they’re trading. Those with more partners, such as multiple prime brokers or custodians, will have more infrastructure changes needed to support the condensed trading timeline.
In recent years, the shift toward buying tech stacks from vendors has increased as allocators pressure to lower fees continues to impact margins and firms are no longer comfortable with significant investments in back-office technology that will inevitably need to be amended to meet future operational changes. Whether shops decide to buy or build, the thought process around designing trading infrastructure should be similar to buying kids clothes, you buy a size up and the kids grow into them. That’s how managers need to be planning for the T+1 adoption. While it’s currently a single-day settlement we’re preparing for, real-time trading is a very real possibility on the horizon.
How Europe can learn from the US
As Europe is potentially a full 18 months (or more) behind the US when it comes to T+1, there are quite a few managers across the pond who will be able to learn from US-based managers once the May 28 implementation deadline occurs. However, there are also key differences between the US and European markets that will create additional barriers for European managers.
The US has a relatively consolidated exchange landscape compared to Europe. The fragmented nature of various jurisdictions and clearing houses in Europe means there is a much wider gap when it comes to consolidating for a single-day settlement cycle.
The cost of compliance
Increased regulation, while imperative to a functioning economy, also brings with it added costs, along with the benefits of transparency for investors. The shift to single-day settlement has a host of costs, including the technology and infrastructure to support the necessary reporting and trade execution. However, the importance of settling a trade within one day is not only important for the funds to meet their regulatory requirements, but also in the best interest of the limited partners (LPs) who are providing the capital for the funds, because at the end of the day it’s their money that’s being traded on the market. In many cases, expenses associated with T+1 trading will be allocated to the fund vehicle for the LP to ultimately pick up the cost, instead of the investment manager taking the full brunt of the expense.
What next?
Only after the T+1 trading settlement cycle goes into effect will we see if managers have properly prepared themselves to handle a single-day settlement timeline. This is, in some way, a test run for the future of instantaneous, real-time trading, or T+0. While back in 2017 amid the shift to T+2, real-
time settlement felt like a far-off alternate reality, it’s clear that the market and technology have advanced enough to make real-time settlement no longer a dream, but a feasible option in the near future. And something that occurs in the Digital Asset space, every day.
