T+1 settlement in the US - An Asia-Pacific perspective

• Structural changes: Shortened US settlement period likely to drive further automation in the global FX market, leading to significant structural changes.
• Investor options: Larger investment firms may pass operational responsibilities to in-house colleagues, while others can use standing allocation instructions to alleviate concerns.
• Operational challenges: Asia-Pacific investors face operational testing under the new US settlement regime, requiring enhanced technology and control measures.

Participants in the US equity market operating from the Asia-Pacific region are the most significantly disadvantaged by the difference in time zones: the major Asian financial centres—Tokyo, Hong Kong and Singapore—are 13 or 14 hours ahead of New York, depending on seasonal daylight-saving times. 

For Australia and New Zealand, the time difference is greater still—the financial centres of Sydney and Auckland are 16-18 hours in advance of US Eastern time.

The impact of the shorter US equity settlement cycle is a result of physical constraints, such as these time differences, but also due to the way trades are processed in individual Asia-Pacific markets.

At present, under the existing T+2 settlement cycle, Asia-Pacific firms transacting in the US equity market already ‘lose’ a day because of these time zone differences. 

However, in general they can meet the various settlement cut-off times (see the table below, middle column). That’s because, under T+2, Asia-Pacific investors still have most of the business day following the US equity trade to finalise their settlement instructions. 

Japan, due to its unique market structure, is already more heavily impacted. Typically, Japanese asset managers must first send the trade information to the trust bank that represents the end-client (say, an asset owner or fund). The trust bank then deals with the custodian. This adds an extra leg to the settlement process and may cause delays.

Although it is possible, in some circumstances, for Japanese asset managers to send settlement instructions directly to the custodian bank (which then passes the information back to the trust bank), this is not the norm.

Source: FTSE Russell, January 2024. Past performance is no guarantee of future results. Please see the end 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 Asia-Pacific investors operating in US equities will be significantly greater. 

Let’s consider a hypothetical Singaporean investor (Singapore is relatively central within the array of Asia-Pacific time zones). 

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 an 8am cut-off for trade allocation, Singapore time, next morning and a 10am cut-off for trade affirmation. 

Now consider that the Singaporean investor needs to receive the trade execution details and complete any preparatory operational tasks even earlier than this. 

For example, the investor will probably need to calculate the size of the currency conversion required to fund the US equity trade. And other counterparties, such as the Singapore investor’s custodian, may set their own cut-off times, which will be earlier than the official allocation and affirmation deadlines, typically between 30-60 minutes earlier.

Although investors can opt out of the affirmation process, removing the most pressing constraint, this is not possible if the counterparty is 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.

It should also be noted that US equity trades undertaken on a Friday would pose an even bigger challenge for Asia-Pacific investors, since most settlement tasks would need to be completed on Saturday morning, rather than Monday.

As mentioned above, the other critical trade component for an Asia-Pacific 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 Singaporean investor, an additional complexity arises from the FX “value date” change that occurs at 5pm Eastern time (6am next day in Singapore), 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 all major Asia-Pacific currencies.

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/Singaporean dollar 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 Singaporean investor needs dollars the day after purchasing US equities to settle that trade.

Suddenly, the FX conversion needed to fund the US equity purchase (let’s say, a sale of Singapore dollars for US dollars) has become a T+0 transaction: 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.

In fact, the shortened US securities settlement period may well lead to significant structural changes within the global FX market—in particular, there is likely to be a drive for further automation of FX processes.

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 Asia-Pacific 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. 

One aspect of trade processing that may act in the favour of the Asia-Pacific investor is that most trade counterparties are already familiar with very strict settlement processing deadlines. Penalties can be severe in the Asia-Pacific region if cut-offs are not met. 

Consequently, market participants tend to have potential settlement failures at the front of mind and take the actions necessary to ensure trades are processed without problems.   

However, the challenge for Asia Pacific 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.