Fund managers outside the US may need to change the timing of their foreign exchange trades to meet the shorter settlement cycle for US securities that are being introduced in May.
The standard settlement cycle for most US broker-dealer transactions in securities will be reduced from two business days after a trade, T+2, to T+1 on 28 May 2024 in the US and on the previous day in Canada. The US Securities and Exchange Commission said the aim is to reduce latency, lower risk and promote efficiency and greater liquidity but it requires streamlined and efficient operational processes, presenting an opportunity to increase post-trade automation.
The challenges for asset managers outside the US, particularly in Asia Pacific, in meeting the shorter settlement cycle for buying and selling US stocks were discussed in a webinar hosted by financial services group Brown Brothers Harriman, Talking T+1: Solving for FX on 8 March 2024.
RJ Rondini, director at the Investment Company Institute, which represents buy-side firms across the globe, said on the webinar: “We recently ran an industry preparedness survey, and 70% of respondent firms said FX was the number one issue for them in T+1. There are some issues around CLS [Continuous Linked Settlement].”
CLS is the FX settlement infrastructure that was set up to reduce settlement and counterparty risk and currently has 18 eligible currencies. An EFAMA survey of European fund managers in March estimated that 40% of daily FX flows will no longer be able to settle through the CLS platform, which could be between $50 and $70bn, but could rise to hundreds of billions of dollars in volatile markets.
EFAMA said in a statement: “We urge central banks and regulators to take a more pro-active role in requiring mitigating measures such as an extension of the CLS cut-off time, and improved cut-offs and alignment among the custodial community. This urgency is further compounded by the fact that within days of the US go-live, major indices like MSCI World are set to rebalance (31 May 2024).”
Nicole Walsh, head of FX product development at BBH, said on the webinar that the firm created an FX simulator for T+1 to help clients work out what they need to change to be ready for the May deadline. She added: “The end result is usually an update to their execution timing.”
For example, Australian clients trading US shares may not be able to match trades until close to 5 p.m. ET in New York.
“One suggestion has been that these clients add an 8 p.m.ET execution before the Aussie payment deadline, but after the FX dead zone between 5 p.m ET and 6:30 p.m. ET when bid offer spreads are wide,” Walsh added.
She continued that it is clear that the US moving to T+1 requires 24-hour coverage of FX execution, either by having FX desks around the globe or using an outsourced solution.
Gerard Walsh, global head of capital markets client solutions at Northern Trust Capital Markets, told Markets Media that T+1 is a portfolio management issue, as much as a middle and back office issue, due to considerations around the use of cash to fund settlements.
“Trading from anywhere that is not Wall Street becomes very difficult as the end of the working week approaches outside the United States,” he added. “Chief investment officers need to think very carefully about how they fund US dollar trading.”
He continued that Northern Trust has had discussions with clients in Asia Pacific who said they will need to be very careful about trading from Thursday lunchtime onwards, because the risk of being unhedged across the weekend is very uncomfortable.
“We are having multiple conversations with clients in Asia Pacific around supplementing their existing capabilities on desks, with specific help for US dollars,” he added.
Automation
Anthony Arciniaco, principal at Pzena Investment Management, which has mandates ranging from small cap US equities to emerging markets stocks, said on the BBH webinar that the asset manager trades in China, where deals have to settle on trade date or T0, and in India, which moved to T+1 last year. Arciniaco said: “We have run the playbook.”
The firm moved some FX coverage to Dublin in order to meet the settlement deadlines in India and China. Pzena Investment Management initially tested pre-funding by estimating the cost of the equities and buying the currency needed for settlement.
“We found pre-funding was extremely manual, time consuming and very hard to estimate,” Arciniaco added. “Even if you don’t make a mistake, you are always either overfunding or underfunding, so we have moved away from that whenever we can.”
In order to meet the US T+1 deadline, the firm is shifting some US coverage to later hours and also investing in automation. Pzena Investment Management has partnered with DTCC, the US clearing infrastructure, to make its settlement processes more efficient and uses FIX, the industry-driven standard message types, in order to improve operational efficiency.
Arciniaco said all equity deals are executed via FIX with the asset manager’s brokers directly into its order management (OMS), and then sent to DTCC’s Central Trade Matching platform. CTM provides central matching of both cross-border and domestic transactions and automates trade confirmation across multiple asset classes, including equities, fixed income and repos.
In Pzena Investment Management’s legacy system, the asset manager used to batch trades on CTM, pulling back those trades into their OMS and then affirming on another module.
CTM includes direct connectivity via FIX from front office to middle office trade processing, as well as via the SWIFT network to a community of custodian banks for settlement notification. DTCC’s ALERT also allows users to automatically enrich trades with account and standing settlement instructions (SSIs) to ensure that reference data is accurate. DTCC said that in February this year, 74.5% of transactions were affirmed by the cutoff time of 9:00 PM ET on trade date, up from 73% in January.
“In CTM we are matching our trades T0, and we are going to be affirming all US trades in that same fell swoop,” added Arciniaco. “We are enriching our SSIs from ALERT to ensure there are no fails.”
DTCC’s TradeSuite ID automates the electronic distribution of trade details between counterparties for post-trade processing. Walsh said a TradeSuite ID will become a necessity to make sure data is processed through all of the flows as quickly as possible. He added: “Northern Trust is encouraging everybody to get a TradeSuite ID.
In CTM the SWIFT message communicates the equity trade to custodians, and also generates the relevant FX order which could be transacted through a platform such as FX Connect, or with BBH’s InfoFX product.
“Our clients in Asia Pacific that are trading US equities need to get the FX done T0,” said Arciniaco. “We plan to expand that InfoFX partnership and keep upping our technology solutions.”
The asset manager is considering adding an 8 p.m ET trading session for Asian clients, and also a clean-up session at 10 p.m ET to ensure the trades are affirmed and settled currently.
Moving staff
Catriona Lawlor, multi-asset trader at Baillie Gifford, said on the BBH webinar that the Scottish investment manager tries to execute its own FX trades when it makes investments on behalf of clients. Baillie Gifford is based in Edinburgh and very active in the US, so flagged the move to T+1 around two years ago.
“Over the past couple of years we’ve been working really closely with other market participants and industry bodies, mainly in Europe, to assess the impact on our operating model which led us to decide that we need boots on the ground,” added Lawlor.
Baillie Gifford previously had a team of four fixed income and currency traders who were all all based in Scotland but Lawlor and a colleague moved to New York at the start of this year, so the team is now split between Europe and US. A member of the settlements team is also based in New York.
Walsh added that BBH plans to increase staff for later in the New York day around T+1.
Pzena Investment Management will also have staff working later during the New York day if required according to Arciniaco. Staff may be able to leave the New York office early and sign back in from home later in the day.
FX liquidity
Lawlor had initially been concerned about how FX liquidity changes over the course of the global day.
“After US market closes at 4 p.m. ET, there has historically been a bit of a dead zone when liquidity is much lower,” said Lawlor. “Liquidity was a concern, pricing was a concern, but also coverage was a key concern with the US time zone being at the end of the global day.”
However, Lawlor said that since she has been in New York the asset manager has not faced any issues in the 4 p.m. ET to 5 p.m ET window, pricing has been very competitive and all the firm’s liquidity providers have people available until at least 5:30 p.m ET.
“We haven’t tested trading after 5 p.m. ET, which gets more complicated as a lot of systems across the industry have some down time,” she added.
Arciniaco highlighted that his firm’s systems go down at 5 p.m. ET and it is challenging to change those schedules, because all client reporting is based on systems closing at the end of day at 5 P.M ET.|”
He said: “We have looked at the data and you have a dead zone of trading FX between roughly 4:45 p.m ET and 6 p.m ET.”
While Arciniaco thinks there will be more liquidity at the close of the day after T+1, he said there is no guarantee and some practical and systemic issues need to be addressed to be able to work FX across 24 hours.
CLS deadlines
Rondini said he was encouraged to hear that Baillie Gifford has been able to get trades late in the day into CLS.
“The issue is that the CLS window closes at 6 p.m ET and custodians sometimes have issues processing trades,” he added. “Firms getting their orders into CLS has been a major concern.”
Lawlor highlighted that custodian banks typically build their own internal cut off from CLS, so at best that may be 5:30 p.m. E.T. However, others have a much longer cut off period and their deadline may be before U.S equity markets close at 4 p.m. ET.
“We don’t want to get to a place where my execution decision has to take into account the CLS cut off at a fund’s custodian bank,” she added. “I want to get the best execution on behalf of my client.”
Rondini said CLS is aware of the issue and has been engaging with the industry. He added: “Following a survey of their 74 member banks, CLS is reviewing the possibility of a 30 or 60 minute extension.”
However, this will not happen before May as CLS is regulated by the Federal Reserve Bank in New York, and each of their 18 operating currencies will have to be reviewed by the respective central bank. In addition, the majority of the foreign exchange is driven by global trade, so finance would have to reach outside the industry to get agreement.
In addition to the CLS deadline, another concern is when there is a valid security settlement date for US dollars, but there is a holiday for the base currency of the fund. Walsh said BBH has built an alert to notify clients three days before a base currency holiday.
Walsh highlighted that the increased costs of FX coverage and funding are a serious drag on portfolio performance, as not investing in the US is unlikely to be an option.
“If you think at the macro level about passive versus active, active managers genuinely don’t want to see their total expense ratios going up,” he said. “it’s hard to tell how much those costs will go up but across the entire industry, those costs are material.”
Some clients are already talking to Northern Trust about overdraft overdraft capabilities.
“This is sensible but those pockets are not unlimited,” Walsh added.
He believes that May 28 is not the final implementation date as issues will flush out over a long period of time.
“The T+1 deadline is not actually a deadline, but is the start,” said Walsh. “I would suggest markets will be shortening their settlement cycles over the next decade.”
