understanding the historical trends in trade settlement can provide important context to help firms prepare for this massive shift.
By Kaisha Schnoll, AVP, STP Investment Services
Imagine hopping aboard a ship to sail from Amsterdam to London, with a stock certificate in hand. In 14 days, the stock trade you’re facilitating will be settled and the trading parties’ work is complete.
This is almost unfathomable in our world today. Rapid communication and advancing technology are accelerating the way we operate in the markets today.
We can see the impact of this acceleration through the historically decreasing trade settlement cycle. And in just a few months, we’ll see another decrease that will have lasting implications.
In February 2023, the SEC announced a move to a T+1 trade settlement cycle expected in May 2024. This means that securities transactions must settle one business day after the trade date. Up until this point, the trade settlement cycle has been two business days (T+2). While halving the time to settlement may seem like an aggressive jump, the goal is to make markets more efficient for investors and to reduce risk. But that doesn’t mean there won’t be challenges.
Additionally, the move to T+1 has many speculating whether T+0 is on the horizon. While that’s likely not something to be concerned about any time soon, understanding the historical trends in trade settlement can provide important context to help firms prepare for this massive shift.
The History of Trade Settlement
European stock exchanges in the 1700s required two week settlement periods to allow for travel and delivery of the stock certificate. When the U.S. stock exchanges opened in the early 1800s, they followed the same settlement period standards.
With the development of rapid travel means and improving technology, the 14-day cycle became unnecessary. In the 1970s, the U.S. first shortened the trade settlement cycle from 14 days to 7 days. Over the next 20 years, the settlement cycle dropped from 5 days to 3 days, and in 2017, T+2 became the standard. As we sit on the precipice of yet another drop, it helps to look back in history to acknowledge the significance of each cycle change¹.
The Benefits of T+1
The benefits of T+1 are extensive and positively impact investors, market participants, and financial entities globally. Some of the strongest positives include:
- Reduced Counterparty Risk: In theory, the shorter the settlement cycle, the less risk involved in the trade, and vice versa. This is because a shorter trade settlement cycle reduces the exposure of counterparty risk—or the risk associated with one party’s inability to fulfill its financial obligations related to a trade. Less time for the trade to settle means there’s less time for engaged parties to default on their contractual obligations.
- Enhanced Market Integrity & Efficiency: Market integrity refers to the degree of fairness, honesty and transparency in the financial markets and is critical for maintaining a seamlessly functioning system. Market efficiency refers to how smoothly the market operates.
Improving both are valid reasons for changing regulation and market processes. The goal in enhancing market integrity and efficiency is to establish more transparent and reliable trading environments, improve confidence in the markets and encourage participation.
- Liquidity Efficiency: Liquidity efficiency plays an important role in market efficiency. When trades are settled faster, market participants can more quickly access funds from their trades and pursue other opportunities. When liquidity is improved, transaction costs are lower, making it easier for investors to confidently participate in the markets.
- Operational Efficiency: The less time spent on settlement, the more efficiency gained for the firms participating in the trade, leading to saving costs for market participants and enabling operational teams to handle trades faster.
- Global Agreement on Settlement Standards: Financial markets across the world agree on the benefits of T+1 and shorter settlement cycles overall. As the global financial system becomes more intertwined, standardizing settlement cycles will contribute to creating a more uniform experience for market participants.
While T+1 will be beneficial to the markets, the transition will pose challenges to financial institutions and key market players who are preparing for the May implementation date.
The Challenges of T+1
Beyond the concerns many financial institutions have about the timeline to T+1, the chief challenge for institutions is the overall cost involved with decreasing settlement cycles.
The SEC itself has estimated the move to T+1 will cost the industry anywhere from $3.5 billion to $4.95 billion2 to implement, excluding additional compliance costs. This includes costs for technology enhancements and training for staff involved in trade settlements. Preparing for these expenses in a short window has been an additional financial burden.
While new compliance needs may lead to incurring higher costs, T+1 may also require compliance departments to adjust their operational procedures given the shorter settlement cycle. This also applies to operational teams involved in overseeing trade settlements and responsible for all steps in the process—including trade execution, clearance, confirmation, and payment. As processes change, so may the technology needed to execute faster trade processing.
Faster trade settlement could also mean overlooking potential risks. One fewer day for risk management activities, like conducting counterparty risk assessments, credit rating reviews, and confirming proper documentation, minimizes firms’ ability to thoroughly confirm acceptable levels of risk.
Finally, while global markets are aligned on the value of T+1, not all markets are working toward faster settlement standards at the same pace. Until global financial systems are fully aligned, coordination across borders will add complexity to trading globally.
Preparing for T+1
Minimizing disruptions to day-to-day workflows is a top consideration for all firms navigating the transition to T+1.
Communication and staff and client education will play an important role in not only preparing for T+1, but in ensuring all parties are equipped to handle the new requirements. Communication regarding new timelines and operational changes should be seamless, rapid, and frequent.
Understanding that T+1 will inevitably lead to an increased reliance on technology will help firms get ahead of the curve by implementing new systems proactively.
Buy-side firms must be prepared to handle faster execution and settlement of trades, which may require the implementation of new technology and systems. This will require firms to adjust their procedural operations and day-to-day standards to accommodate T+1. Additionally, firms should ensure they always have enough funds to settle trades more rapidly, requiring closer monitoring of liquidity.
The preparations above will likely lead to more staff and technology, incurring additional costs. However, leveraging an outsourced partner to manage a firm’s trade settlements can decrease burdens related to T+1, so firms can enjoy the opportunities.
Why Firms Should Consider Outsourcing Trade Settlement
Leveraging a specialized service provider to outsource trade settlement activities can not only alleviate the burden of T+1 preparations, but also help firms gain operational efficiencies, which, come May, could give them a helpful competitive advantage. The benefits of outsourcing investment operations—especially trade settlement—are broad:
- Gain scale & efficiency: Outsourcing trade settlement will allow firms to focus on what they do best, while their service provider manages the nuances involved with T+1, providing firms with operational efficiencies and allowing them to scale their growth.
- Leverage proven technology: Top service providers often provide proprietary technology that has been proven to support a firm’s specific needs, including fingertip access to relevant data and information.
- Save on associated costs: Leveraging an outsourced partner with the necessary technology and infrastructure in place can help firms save on costs while gaining expertise.
Preparing for T+1 is imminent and necessary step to ensure PE firms, hedge funds, and institutional asset managers can easily navigate these challenges, and one with which specialized outsourced providers are poised to assist. The move to T+1 undoubtedly will have implications for years to come as firms navigate the many opportunities the transition.
Sources:
¹ https://www.investopedia.com/terms/s/settlement_period
2 https://www.statestreet.com/web/insights/articles/documents/state-street-importance-of-getting-T-1-right-may-2022.pdf
About the author:
Kaisha Schnoll is the AVP of trade settlements and T3 at STP Investment Services. Kaisha oversees STP’s trade settlement process, which she developed and integrated into the firm’s offering. She joined STP in 2019 and has over nine years of industry experience in various investment operations roles. Prior to joining STP, Kaisha performed several roles at Barclays, SEI Investments, and Aviva Investors which have helped her attain a holistic view of the global trading process, back-office operations, and investment management.
Kaisha graduated from Villanova University with a B.A. in Political Science.
