“Every facet of market structure stands to be reshaped” by compressed settlement, Bloomberg Intelligence says.
The biggest cost contributors include financing fees, information leakage, increased FX costs and settlement failures, according to new data from Bloomberg Intelligence – while block trades could complicate things even further, with “a substantial portion” of trades likely to fail. We speak to authors Larry Tabb and Nicholas Phillips to learn more.
A new study from Bloomberg Intelligence (BI) has estimated that the upcoming US transition to T+1 settlement could cost the industry over US$31bn a year, with the move reflecting “profound implications” for both the US and global markets. “Every facet of market structure stands to be reshaped by this evolution,” said the report.
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Securities lending and bank borrowing
According to BI calculations, based on 2023 US trading data from primary sources including DTCC and the SEC, the biggest impact is likely to come from changes to securities lending, including financing fees, market impact and lost opportunities, which could cost the industry US$24bn.
“Quickening settlement will pressure short sellers and portfolio finance operations. It will make it harder to find securities to borrow and increase fails, as the time window for reclaiming lent securities tightens,” said BI.
Speeding up the recall process for lent securities is likely to cost US$17bn a year in information leakage, by not only informing custodians that investors are preparing to sell, but also giving notice to the borrowers, who are already short the issue.
“Investors who short are typically the most sophisticated, and leaking information to them will only raise selling pressure and likely have an adverse impact on stock prices,” warned the report. “Even if this lowers selling proceeds by a modest 10 bps, the effect will be significant.”
Cutting the time between trading and settlement is also likely to cause around 10% more securities finance transactions to fail, estimates BI, which could leave investors on the hook for a further US$4.1bn. And with bank borrowing likely to rise (BI estimates that around 30% of securities finance transactions could switch to this method to reduce market impact and leakage) this would add a further US$2.7bn in financing charges. “Some of this will be picked up by brokers, but it would also show up as some other fee/cost such as adverse execution quality,” said BI.
FX impact
FX currently settles on a T+2 basis via the Continuous Linked Settlement (CLS) payment system, an intermediary between two trading parties to deliver currency. The move to T+1 will halve the FX settlement cycle, giving traders just two hours to submit FX trade details after US markets close – which could amount to US$6.2bn a year in additional FX costs, based on current interest rates. And that’s not taking into account the additional (but almost inevitable) extra HR cost, with foreign buyers of US equities almost certainly needing late night/early morning staff to support the shortened cycle.
What it does include is the cost of borrowing and the cost of pre-funding – currently 20% of total FX needs per day. “The FX cost is a big deal because it seems like lot of traders haven’t really thought about how they’re going to manage it – and if you’re based in Asia, for example, then you’ve got no overlap at all,” said Nicholas Phillips, market structure research analyst at Bloomberg Intelligence. “They can basically pass it on, they can pre-fund, or they can take the failure hit. It also depends on how big you are as a firm. The big guys can probably afford to accommodate this, or they’ve got bigger overdraft facilities and more flexibility, but the smaller buy-side players that are already squeezed are really going to struggle if they don’t have a plan in place.”
ETF issues
Notably, exchange-traded funds and notes (ETFs and ETNs) are one of the asset classes most at risk from the shift to accelerated settlement. Each day, US$1.3bn in the value of ETFs and ETNs remains unsettled, representing 60% of the average daily failed value of US securities (US$2.2bn). Accelerated settlement is expected to exacerbate this failure rate, which could translate to US$381m a year in interest costs for investors, based on current rates.
Bloomberg is expecting a “significant” six-fold surge in ETF failures, to US$6.7bn from US$1.3bn, with non-US ETF issuers encountering mounting obstacles in settlement processes.
In parallel, failures in US equities are projected to triple, from US$879m to US$2.6bn, culminating in a total increase of US$7.1bn in failures from the current US$2.2bn – a 223% increase.
READ MORE: T-100 – Countdown to T+1 in the US
Institutional trade fears
One of the biggest impacts is likely to be on US institutional trades, with the report warning that a “substantial portion” of these will fail after 28 May.
According to Larry Tabb, director of market structure research at Bloomberg Intelligence, block trades (among other institutional activity) are likely to complicate the push to next-day settlement.
“The challenge is that only 69% of allocations/confirmations were finalized before the new DTCC cut-off,” he explained to BEST EXECUTION. “Meaning, a good chance that 31% fail. That is a lot of trades. Now that isn’t just blocks, it’s pretty much a large percentage of institutional buy-side orders. Now the confirm rate will improve, but it will have to improve a lot or it will be very impactful. Sellers won’t get paid on time, buyers won’t get their securities, which could then jeopardize other transactions.”
The problem is that the institutional equity-execution process in the US is operationally intensive, explained BI. Portfolio managers send orders to traders, who bundle by stock and send for broker execution. Most executions are small, as the average US equity fill is about 150 shares. Once executed, smaller fills are bundled, the prices of the trades are averaged and, once completed, all fills for the day are cancelled and corrected to reflect the appropriate fund owner and average price of the small executions. An average is used so that all investors get the same price, independent of execution time.
“Without migrating to central matching, accelerating this process, or turning to bank financing, a substantial portion of institutional trades will fail, complicating settlement operations and costing investors dearly,” warned the report.
