Clearing: Is T+2 Finally Coming to America?

A shorter trading cycle is coming to Europe and is already a way of life in Germany and Asia, but a similar shift in the U.S. faces its own set of concerns.

The U.S. trade settlement and clearing process could be getting shorter soon.

U.S. industry pros are finally coming around to what the European trading markets have already decided is a good operational move: shortening the trade cycle (the time between execution and actual security delivery) by one day.

European regulators, central banks and other firms have mandated that all financial market trades will be settled two days after trade date (T+2) via the CSD Regulation (CSDR) by 2015. They argue that a shorter cycle would reduce risk and increase operational efficiency of the marketplace. Also, by mandating a single universal trade clearing cycle such as T+2, it would help unify the multiple financial trading markets and streamline trading between the European nations, many of which use T+3 or longer cycles. Germany, the regions strongest financial market, already uses T+2.

It appears that U.S. regulators and participants are also beginning to embrace the shorter cycle.

Proponents of T+2 in the U.S., such as the Depository Trust and Clearing Corp. (DTCC) and other large institutions, argue that a move toward shortening settlement cycles for equities, corporate and municipal bonds would help lessen systemic risk by reducing both payment “float” and the potential for an accumulated backlog of unsettled transactions, especially for institutional brokers and custodians.

T+2 is also fast becoming the norm in the Asia-Pac trading markets. The Japanese Financial Services Agency implemented a move to T+2 settlement for the Japanese government bond market in April 2012, with a view to moving to T+1 in the future. China already implements a T+1 trade settlement cycle.

Technology and Cultural Challenges

The challenges of moving to T+2 settlement fall broadly into two categories-those that represent direct operational challenges where technology and process changes will be required, and those that represent cultural and market practice changes, according to consultancy Aite Group.

The biggest outlay for the majority of participants will be in the review and analysis process itself to determine what process changes are required and to test that systems are ready for a move to T+2. An example of this could be within the trade cancellation process, where manual checking of data to determine accordance with market rules could be ruled out due to the compressed time frame.

Bearing these challenges in mind, U.S. regulators have been mum on any regulatory proposal to shorten the cycle, despite some advantages such as shortening the time brokers must commit capital for a trade or be exposed to counterparty risk.

The Securities and Exchange Commission picked up the T+2 baton back in 2004 with a concept release focused on exploring the benefits of same-day affirmation-where the confirmation and affirmation process between client and broker is completed on trade date (T+0)-and the challenges of a move to shortening the settlement cycle from T+3. After a four-month consultation period, the regulator deemed the shortening of the domestic settlement cycle to be too much of a tricky proposition and backed away from mandating the move. It instead recommended various amendments to processes at the National Securities Clearing Corp, a subsidiary of DTCC and the central clearinghouse for U.S. equity and fixed income transactions, to improve the speed, safety and efficiency of the domestic trade settlement process overall.

Then in 2011, the DTCC kicked off a business case analysis of the impact of a move to T+2 or T+1 for the U.S. equities, corporate and municipal bonds, and unit investment trusts markets. The results of the DTCC study, which was published in October 2012, suggest that moving to a T+2 environment would cost the industry approximately $550 million in incremental investments, whereas upgrading systems and processes across the market to support T+1 would require around $1.8 billion.

At a recent SIFMA conference, attendees said that compliance with T+2 would be closer to $1 billion for the industry, with larger broker-dealers privately discussing individual costs between $10 million and $15 million per firm.

I know that the U.S. has been looking at a shorter assessment cycle, said Virginie O’Shea, an analyst at Aite Group. Regulators have made noises, and the DTCC and other clearinghouses want the speedier cycle.

OShea explained that DTCC and other clearers such as Omgeo all have a large infrastructure and plenty of capital required to make the technological and operational changeover to a faster trade cycle. They will see more business come their way as a result, she added, and there is pressure on the U.S. in this global market to accommodate Europe and Asia.

Large brokers and institutional investors also should have less difficulty adapting to a fast trade cycle as their economies of scale make T+2 adoption less difficult, according to Robert Iati, global head of consulting at Tabb Group. Also, those firms that wish to do business with Germany or China are finding themselves increasingly locked out as U.S. trade settlement cycles do not align – causing a loss of business.

Iati explained that the global nature of the financial markets dictates that U.S. firms provide institutional investors with access to global markets, which are moving to a shorter settlement cycle.

We want to do our best to stay globally competitive, so synching up with Europe is good from a business perspective, Iati said. While it might not be absolutely imperative to switch at this moment, theres no denying delays will inhibit business and will ultimately affect the industry. We have the technology to do this and it is worth doing.

Iati said that he thinks adoption of T+2 has a good chance of coming within the next 12 to 18 months, despite some of the logistical and political hurdles to trimming the settlement cycle.

The industry is now in a position to put a lot of money into a T+2 initiative, and many have been chatting this up, he explained. There is just more momentum now.

Smaller Players Money Concerns

However, there are those who are against moving to T+2 here in the U.S. Those would be the small-to-mid-size brokers and firms that are more resource-constrained thanks to lower U.S. trading volume and shrinking commissions. As OShea noted, clearing has for the most part been a very manual process, and the extra time allotted by the current T+3 cycle has been needed to physically deliver securities or files. Moving to a shorter cycle will force many firms to upgrade their technologies at a time when they simply cannot afford it, she added.

Some of the big brokers are in favor, but they too are a little concerned about T+2 as it will cost money to automate middle office processes, just when they dont have the money to do so, OShea said. And for the smaller firms, many of which are still using a fax or other non-standard delivery format such as bulk batch files, which are hard to reconcile, this is a real problem.

And the buyside itself might not be in favor of moving to a shorter T+2 settlement cycle, as it too could be faced with unexpected costs – such as technology and legal – as it must adopt new standards and automate certain processes, such as moving away from fax and e-mail.

From the buysides perspective, they dont see much of a benefit to this, OShea said. And they could wind up pressuring their brokers to deliver more services for less at a time when the brokers are already doing more with less.

OShea said the biggest outlay for the majority of participants will be in the review and analysis process itself to determine what process changes are required and to test that systems are ready for a move to T+2. An example of this could be within the trade cancellation process, where manual checking of data to determine accordance with market rules could be ruled out due to the compressed time frame.

However, Aites OShea and Tabbs Iatiboth noted that despite market concerns and potential costs the fact remains the market has become more global in scope and the trading universe smaller, thus necessitating the need to move to T+2.