T+1 settlement in the US - A European perspective

The US equity market’s impending move to a shorter settlement cycle will have significant repercussions for European investors. In this FTSE Russell Insight, we throw light on some of the operational challenges caused by this change.

• Increased Settlement Risks: With FX trades failing to meet the CLS deadline, there's a rise in bilateral settlements, raising the risk of adverse consequences, as seen in the Herstatt case.
• European Asset Managers' Exposure: Under the new T+1 regime, European asset managers may see 40% of their daily FX trades settling outside CLS, representing significant volumes and potential risks.
• Regulatory Challenges: CSDR imposes penalties for settlement failures, and UCITS regulations restrict borrowing, posing challenges for managing liquidity under T+1 settlement.

Participants in the US equity market operating from Europe are considerably disadvantaged by the difference in time zones. The major European equity markets—Germany, France, and the United Kingdom—are 4-6 hours ahead of New York, depending on seasonal daylight-saving times. 

The impact of the shorter US equity settlement cycle is a result of physical constraints, such as these time differences, but also reflects the regulations for UCITS , the most popular legal structure for European mutual funds.

At present, under the existing T+2 settlement cycle, European firms transacting in the US equity market tend to ‘lose’ a day because of time zone differences, unless they significantly extend their working day into the late evening to accommodate the US equity market’s close. 

US equity settlement may involve several procedures, from trade allocation and affirmation to securities loan recalls, FX conversion, ETF creation/redemption (where appropriate) and ex/record dates for corporate actions. These tasks must be completed by 14.5-24 hours after the market close on the trade date.

Under the T+2 regime, these settlement tasks can usually be completed in the morning, European time, on the day after the US equity trade has taken place (see Table 1, middle column). Trade allocation and affirmation, which involve the matching of trades between counterparties, are usually handled by the broker representing the European investor.

Table 1: New time pressure under T+1

Source: FTSE Russell, January 2024. Past performance is no guarantee of future results. Please see the disclaimer for important legal disclosures.

Now let’s fast forward to May 28, when the US market moves to the shortened, T+1 settlement cycle. From this date, the challenges for European investors operating in US equities will be significantly greater. 

Let’s consider a hypothetical Irish investor (Ireland usually has a five-hour time difference to New York, like the UK, and has a substantial asset management industry). 

The new deadlines in the US equity market (allocation of trades to be complete by 7pm Eastern time on the trade date, with the deadline for trade affirmation at 9pm Eastern) equate to a midnight cut-off for trade allocation, Irish time, and a 2am cut-off for trade affirmation. This forces an Irish investor (or its representative) to complete its processing late in the evening on the trade date, as there is no option to handle it the next morning.

Between 9pm Eastern time (when the US market closes) and midnight, the transacting firm also needs to complete other settlement-based tasks, including the calculation of the size of the currency conversion required to fund the US equity trade. 

Although investors can opt out of the affirmation process, removing the most pressing constraint, this is not possible if the Irish fund has used a US broker-dealer, for whom trade affirmations are mandatory. Also, the cost of processing and the likelihood of a failed trade are increased if one chooses to get rid of affirmations. Failed trades lead to a rapid rise in operational risks and likely fines from regulators.

As mentioned above, a critical trade component for a European investor is likely to be a foreign exchange (FX) transaction. If the investor is buying US shares, he/she needs to convert the base currency of the portfolio to US dollars. If the investor is selling US shares, he/she will be selling dollars for another currency. 

For our Irish investor, an additional complexity arises from the FX “value date” change that occurs at 5pm Eastern time (10pm in Ireland), shortly after the US equity market’s close.

In the FX market, value date is the day on which a foreign currency transaction is settled. By convention, for almost all currency pairs, the most common FX transaction, called a “spot” trade, has a value date that’s two days after the trade date. This is the case for the euro, British pound and all other European currencies when traded against the US dollar.

But another FX market convention is that a trade submitted for execution after the 5pm Eastern time cut-off point will be time-stamped for the next working day. And its value date (settlement date) will also be pushed forward by a day. 

[So, for example, a spot US dollar/euro trade handed to a New York FX dealer at 4.55pm on a Monday will have its value date on a Wednesday. But the same trade handed to the dealer at 5.05pm will have its value date a day later, on Thursday.]

Now remember that our hypothetical Irish investor needs dollars the day after purchasing US equities to settle that trade. Suddenly, if they are unable to calculate the currency amount needed, and then execute the FX transaction (let’s say, a sale of euro for US dollars) within an hour of the US market close, the FX conversion needed to fund the US equity purchase will become a T+0 transaction: i.e., it needs to settle on the same day.

Neither of the obvious options to deal with this problem is particularly attractive:

• The investor can undertake a same-day value FX transaction. While this is theoretically possible for US dollar transactions, same-day value trades are not available in all currencies, and they may create a significant settlement risk.
• Or the investor can pre-fund the FX transaction (it can execute the FX before the equity trade is completed). This option has inherent inaccuracies since the investor doesn’t know exactly how much foreign currency to buy or sell. And it leads to the investor being exposed to additional market risks: the investor may have to sell out of another market ahead of time, for example, to fund the FX traded, or he/she may be exposed to another currency that is inconsistent with the desired portfolio exposures.

Given these time pressures, many market participants were hoping that the CLS Group, which operates the largest global currency settlement and multilateral trade netting system, would change its cut-off time for payment instructions for foreign exchange trades. 

However, despite pressure from the European investment community, CLS confirmed on 9 April 2024 that it would not delay the current deadline. In extremis, FX trades that cannot meet the CLS deadline will in future have to be settled on a bilateral basis, raising the risk of adverse consequences from an FX settlement failure (in 1974, the collapse of a German bank called Herstatt caused a major chain reaction across the world after the bank failed to settle large dollar/deutschemark FX trades with its US counterparties).

In a recent survey, the European Fund and Asset Management Association (EFMA), whose member firms manage more than US$30 trillion in assets, found that under the new US T+1 regime, 40% of European asset managers' daily FX trades would have to settle outside the safety of the CLS multi-currency platform. EFAMA estimated that this would represent US$50-70 billion in FX trades on a typical day, with higher volumes when markets are more volatile.

Given that the focus of the European Union’s Central Securities Depositary Regulation (“CSDR”) is on reducing the incidence of failed trades, European investment portfolios that hold US equities may suffer from an increase in their settlement failure rate. CSDR imposes penalties ranging from 0.5-1 basis point for each settlement failure, payable by the party responsible for the failure.

Under T+1, the reduced post-trade processing time for US equities will mean the cash amount required for settlement will have to be found more quickly. Funds with a substantial portion of their investments in US equities will need to find much larger cash sums, putting added pressure on liquidity. According to the EFAMA Fact Book for 2023, the share of US stocks in the asset allocation of UCITS equity funds was around 42%. For global index funds the exposure will be larger. The prolonged bull market in US stocks means that they now represent a substantial part of global equity indices: in March 2024, 62% of the FTSE All-World index was allocated to US stocks.

However, UCITS funds are prohibited from borrowing more than 10 per cent of their net asset value, for example to meet temporary settlement needs. Should settlement failures occur, the managers of UCITS funds will need to monitor their borrowing attentively to ensure that the borrowing limit is not breached.

So, what are the options for investors concerned about the impending change in the US equity market’s settlement cycle?

Undoubtedly, some of the larger global investment managers, brokers and custodians based in the European region will be able to pass their new operational responsibilities to in-house colleagues located in other time zones. 

However, many asset management firms or other large investors (such as corporate pension funds, industry/community-based investors, or sovereign wealth funds) may not have this option. 

The use of standing allocation instructions (given to the executing broker) could speed things up and alleviate some concerns. But this flexibility will depend on the relationship between the investor and broker and the technology available to both. 

The challenges and increased failure risks for European investors should not be underestimated. These firms’ operational teams will be tested under the new US settlement regime. Any solution is likely to be heavily dependent on applying more technology and on putting appropriate controls and working practices in place.

More broadly, this single example shows just how many knock-on effects the shortening of the US equity settlement cycle may have on other financial market participants around the world. 

Among those affected could be index fund managers: the replicability of regional or global benchmarks may be tested if the new settlement cut-off times are unattainable for the index-tracking portfolio.