Wall Street braces for faster trade settlement
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[May 23, 2024] By
Laura Matthews and Carolina Mandl
NEW YORK (Reuters) - U.S. trading moves to a shorter settlement on
Tuesday, which regulators hope will reduce risk and improve efficiency
in the world's largest markets, but is expected to temporarily increase
transaction failure for investors.
To comply with a rule change the U.S. Securities and Exchange Commission
(SEC) adopted last February, investors in U.S. equities, corporate and
municipal bonds and other securities must settle their transactions one
business day after the trade instead of two as of May 28. Canada, Mexico
and Argentina will speed up their market transactions a day earlier, on
Monday. The UK is expected to follow in 2027, and Europe is considering
the change.
Regulators sought the new standard, commonly called T+1, after the 2021
trading frenzy around the "meme stock" GameStop highlighted the need to
reduce counterparty risk and improve capital efficiency and liquidity in
securities transactions.
"Shortening the settlement cycle... will help the markets because time
is money and time is risk," said SEC chair Gary Gensler in a statement,
adding it will make the market infrastructure more resilient.
However, it comes with risk since firms have less time to line up
dollars to buy stocks, recall shares out on loan, or fix transaction
errors, which could heighten the risk of settlement failures and raise
transaction costs.
Trades fail when a buyer or seller does not meet their trading
obligation by the settlement date, which could result in losses, penalty
fees and hurt reputations.
"Hopefully, we'll start to see the benefit that we expect to see which
is the reduction in risk, a reduction in margin or collateral, and we're
hoping that this happens without serious impact to settlement rates,"
said RJ Rondini, director of securities operations at the Investment
Company Institute.
Settlement is the process of transferring securities or funds from one
party to another after a trade has been agreed. It takes place after
clearing and is handled by the Depository Trust Company (DTC), a
subsidiary of the Depository Trust and Clearing Corporation.
The U.S. will be following India and China, where faster settlement is
already in place.
WEEKEND CALLS
Market participants, such as banks, custodians, asset managers and
regulators will be working over the coming weekend to ensure a smooth
switch. A virtual command center has been created with over 1,000
participants who will join calls to discuss the transition, the
Securities Industry and Financial Markets Association (Sifma) said.
On Monday, which is a U.S. holiday, all eyes will be on Canada, Mexico
and Argentina. Any hiccups there could impact the U.S., said Christos
Ekonomidis, T+1 program director at BNY Mellon.
On Wednesday, there will be another big test for the market as trades
executed both on Friday, when T+2 was still in place, and on Tuesday,
the first day of T+1, will be settled, leading to an expected rise in
volume.
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Traders work on the trading floor at the New York Stock Exchange
(NYSE) in New York City, U.S., April 5, 2024. REUTERS/Andrew
Kelly/File Photo
More trade failures are expected initially, even though DTCC and
market participants have been conducting a series of tests for
months. A rise in failure was observed in 2017, when the U.S. moved
the settlement period to two from three days.
"It's perfectly normal that we'll see some sort of small change in
settlement rates... but we expect that settlement rates will quickly
return to normal," said Rondini.
On average, market participants expect the fail rate to increase to
4.1% after T+1 implementation from 2.9% currently, a survey by
research firm ValueExchange showed. Sifma expects the fail rate
increase to be minimal and the SEC said there may be a short-term
uptick in it.
Brian Steele, president of clearing and securities services at DTCC,
said more than 90% of the industry has been participating in the
process since testing started in August 2023. There is still "a deep
level of muscle memory" from the industry's move to T+2 in 2017, he
said.
RISK/REWARD
Trade bodies say the shift will mitigate systemic risk because it
reduces counterparty exposure, improves liquidity and decreases
margin and collateral requirements.
Still, some market participants are concerned that the change could
transfer risks to other parts of the capital markets such as
trade-related foreign exchanges to fund transactions and securities
lending.
Foreign investors, who hold nearly $27 trillion in U.S. stocks and
bonds, must buy dollars to trade these assets. They previously had a
whole day to source the currency.
Natsumi Matsuba, head of FX trading and portfolio management at
Russell Investments, said the firm was using small trades weeks
ahead of implementation to test market liquidity after hours during
times it is known to be sparse to see how many bank counterparties
were extending weekend trading hours.
Market participants may have to rely on overnight funding markets to
bridge liquidity gaps caused by different asset settlement timings,
which could be costly given that short-term financing rates exceed
5%.
Gerard Walsh, who leads Northern Trust's Global Capital Markets
Client Solutions group, said managers need to be aware of the
potential range of solutions available.
"I don't think any of that fleshes itself out on week one," Walsh
said.
(Reporting by Laura Matthews and Carolina Mandl; additional
reporting by Davide Barbuscia; editing by Megan Davies and Deepa
Babington)
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