Nellie Dagdag considers the implications of a move to T+1 settlement cycle for equities in Asia Pacific, and the benefits it will bring.
There is a saying that time to settlement equates to risk. The longer it takes to settle a trade after it is executed, the greater the likelihood of a trading party failing to meet its obligations. Thanks to technology advancement, most financial markets today have converged at T+2.
Building upon this, in an ongoing quest to create market efficiencies, the US is preparing to accelerate its settlement cycle for equities, corporates, municipals and unit investment trust (UIT) transactions even further to T+1, with the Securities and Exchange Commission (SEC) recently voting unanimously to shorten the settlement cycle.
Here in APAC, India has successfully forged ahead and gone live with a gradual rollout of T+1 that began in February of this year, starting with the bottom least traded 100 stocks by average daily capitalisation. From March 2022, the next lowest 500 stocks were added on the last Friday of each month, with the final batch of stocks moving to T+1 settlement by January 27, 2023. Now, questions remain as to whether other markets in the region may also consider an acceleration of their settlement cycle.
The reasons for such a move are numerous. Despite the innate intricacies and complications of this significant endeavor, shrinking the time between trade execution and settlement by one business day can yield greater market efficiencies and lower capital requirements – key essentials to further improve the resiliency and robustness of capital markets.
On a macro level, reducing settlement timeframes will lower the overall risk in the financial system, with decreased margin requirements and a reduction in pro-cyclical margin and liquidity challenges. Market participants will also enjoy significant benefits, including reduced exposure to credit, counterparty and operational risks and faster settlement of transactions.
After all, the longer it takes to execute and settle a trade, the greater the risk exposure.
Converging on T+1
With Canada also planning to move to T+1 for securities settlement to align with the US, what is next for APAC? While the Chinese equity market is already functioning on a T+0/T+1 settlement cycle, most markets in the region are still on T+2. Should the rest of APAC consider a move to T+1?
Because of the interconnectedness of global financial markets, further harmonisation of settlement cycles globally will likely happen at some point, but markets will move at their own pace as they did in the move to T+2. The potential benefit of further harmonisation is highlighted in today’s unpredictable environment where the transmission of extreme market shocks and volatility can spread overnight on a global scale.
That said, any move to T+1 should focus on regulatory and market readiness, particularly the level of technological and operational sophistication required to achieve such a move by market participants (investment managers, brokers, and custodians) and market infrastructure providers (central counterparties, central securities depositories, and payment systems).
Given that countries are at different stages in their adoption of automation and vary in market maturity, a shift to an accelerated settlement cycle may be more challenging for markets that are still relying on manual processes.
As a first step, it is important for market participants to understand what a shift might mean on their operations including existing processes, underlying technology, and funding. And as with any market reform, the behavioral changes cannot be underestimated as even the best systems will not succeed without the buy-in of affected stakeholders.
Funding of cross-border trades occurs after trade details have been matched and agreed. In a T+2 environment, there is a full day to conduct this process. However, the funding window will be squeezed in a T+1 settlement cycle, which is made even more challenging in many APAC markets that do not permit overdrafts.
In the absence of bridge funding from local agents for overdrawn amounts, and depending on local FX market operating hours, it may be impossible, using current processes, to fund transactions based on matched trade details – putting foreign investors in costly pre-funding situations based on estimates instead of confirmed trades on T+0.
One solution is to implement a low touch, automated trade confirmation process, enabling trade details to be matched as close to the trade execution time as possible. The industry could also explore ways to enhance post-trade FX flows. In addition, access to the liquid FX market within the prescribed market cut-offs is crucial, especially for markets where the local settlement currency is not actively traded in other time zones
A deliberate shift in market practice and mindset will be required to achieve a compressed timeframe and ensure trades continue to settle efficiently. Firms will need to review pre-settlement activities, post-trade processes such as matching, allocation and the enrichment of standing settlement instructions, and, for foreign trades, FX funding, to ensure that accurate trade data flows downstream to avoid potential increases in failed trades.
Technology has long been viewed as a key enabler to moving to a tighter settlement timeframe. Increasing automation, standardisation and straight-through processing in the trade lifecycle will enable a more seamless post-trade process with minimum breaks – which is critical to tackling the operational complexities of a move to a shorter settlement window for cross-border trades. The goal should be to move toward no-touch post-trade processing.
A move to T+1 should also include an industry-level methodical review of the operational impact across the trade lifecycle. Industry consultations should include a wide group of stakeholders, including local and regional brokers, global and local custodians, investor groups, trade associations, government bodies, market infrastructure providers, and the various system vendors and outsourcers servicing the industry.
The group should focus on gathering insights, conducting impact analysis, identifying dependencies and potential bottlenecks, and developing an industry roadmap toward T+1. It is also important for local firms to obtain feedback and engage their clients/principals throughout the journey to ensure the transition can be supported by appropriate trading strategies to cover market and liquidity risks in a T+1 environment.
Time zone considerations for cross-border trades and addressing unplanned public holidays, which usually cause market confusion, should also be reviewed.
It is a significant effort to accelerate the settlement cycle, and many markets in APAC may adopt a wait-and-see posture. In addition to extensive and meticulous planning and industry-wide engagement to support such a move, firms must consider the impact on their operations.
Adopting higher levels of straight-through processing and automation in post-trade operations would help ensure a seamless, orchestrated, and responsible implementation in the move to T+1. By bringing together shared expertise, experiences, and capabilities across borders, the industry could successfully assess the impact of such a move to facilitate a favorable change in the financial marketplace – for the benefit of the industry and investors.
To prepare APAC for local moves to T+1 in the foreseeable future, discussions should begin now.
By Nellie Dagdag, Managing Director, Marketing and Communications, APAC, DTCC