US T+2 Settlement: The Long Journey Officially Begins

What a difference a day makes.

Until September 16, the US financial industry had only been talking about a two-day settlement cycle. Only a preliminary roadmap of the stepping stones to T+2 had been completed, indicating that at least 30 operational workflows will be affected, requiring rule, behavioral and technology changes.

On that day Securities and Exchange Commission Chairman Mary Jo White gave a clear signal last week that the securities market watchdog endorses the US shortening its settlement cycle from three days to two in the third-quarter of 2017. Such regulatory certainty gave buy- and sell-side firms, self-regulatory organizations and market infrastructures the necessary push to solidify and hasten their preparations, say panelists and attendees at the Securities Industry and Financial Market Association’s T+2 event in New York the next day.

In her letter to the Securities Industry and Financial Markets Association (SIFMA) and Investment Company Institute (ICI), White did not specify a day when the US market would shift to T+2 from T+3. However, she urged the securities industry to provide the SEC’s Division of Trading and Markets with a more detailed implementation schedule by December 18, including “milestones and dependencies. “I am committed to considering the regulatory changes necessary for his migration to proceed on a timetable that will permit the industry to complete its essential work no later than the proposed goal of the third quarter of 2017,” wrote White. “I encourage you to use the time at hand to continue to make whatever preparations are necessary.”

Given the multitude of challenges ahead, the third quarter of 2017 isn’t that far off. “The securities industry doesn’t need to wait for the SEC to propose a rule mandating a shorter settlement cycle, but we will be requiring self-regulatory agencies and market infrastructures to come up with their economic analysis and a rulemaking timetable of what needs to be done,” explains Stephen Luparello, director of the Division of Trading and Markets at the SEC. “We will be coordinating our efforts with self-regulatory organizations and DTCC.”

So far, a T+2 Industry Steering Committee (ISC) organized by DTCC and comprised of a cross-section of industry participants including SIFMA and the ICI has led the T+2 charge. The ISC recommended the T+2 timetable in a white paper released in June, with SIFMA and the ICI sending the SEC their recommendations quickly thereafter. In addition to the SEC, all of the exchanges, the Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB) will need to adjust their respective rules to accommodate a T+2 settlement cycle. As DTCC is the umbrella organization for clearing and settling US securities transactions, its preparations will be just as critical to achieving a T+2 settlement cycle and the market infrastructure will also need to come up with changes to its policies that will require SEC approval.

Setting Parameters

Panelists and attendees at the SIFMA-hosted event acknowledged that they will have to uncover all of the intricate interconnected steps necessary to meeting the two-day settlement period as time goes on, but for now it was important to allocate higher technology budgets for 2016 and 2017. In addition, they urged creating T+2 swat teams to coordinate the buy-in of multiple departments. It is expected that the heavy-duty front, middle and back-office alterations will take place in 2016, with industry-wide testing in 2017.

“We already incorporated expenditures for T+2 into our budget using estimated models for 2015, 2016 and 2017,” says Gregory Vitt, managing director of streetside operations in St. Louis at investment advisory firm Wells Fargo Advisors, which is reviewing all of its applications for T+2 readiness. Wells Fargo Advisors, a subsidiary of regional banking giant Wells Fargo, has also put in place an advisory steering committee to analyze the impact of a two-day settlement cycle on products operations, IT and finance with subgroups dedicated to middle and back-office operation as well as testing.

Likewise, Fidelity Investments in Boston formed a governance committee over a year ago to study the changes necessary to be made for the institutional and retail brokerage and asset management units, says Mark Kazelnick, chief operating officer in New York for Fidelity Institutional, the custody and brokerage arm of fund management giant Fidelity Investments. Wall Street powerhouse Goldman Sachs will be relying on a change management team evaluating up to 40 business lines, according to Frank Tota, global head of settlements in New York. Norman Eaker, chief administrative officer for regional brokerage Edward Jones in St. Louis says his firm has formed a “cross-divisional group” studying the ramifications to technology, finance, operations and cash flows.

Surprisingly, it isn’t the multitude of operational and technological changes which must be made to accommodate T+2 that worries US market players the most. Rather it is testing that keeps most of the industry’s C-level executives awake at night. For now, the exact scope and details of the testing have not been determined. A lot more work must be done to devise the best game plan to shore up any weaknesses before the final drop-dead migration date. A two-day and three-day settlement cycle will likely overlap on the same day, as was the case in Europe.

“Testing will be a challenge,” acknowledges John Abel, vice president of settlement and asset servicing strategy at DTCC in New York. “There is an industry debate about whether we should create a new test environment. We will targeting to have a test approach at the end of the year, followed by a more detailed plan.”

With testing still a long way off, firms are starting to focus on immediate changes. “Large global fund management, broker-dealer and custodian banks could have an easier time than their regional US-centric brethren because they have already made the migration to a T+2 cycle for European securities,” cautions Gregory McDonald, head of product strategy for securities transaction software provider GBST in New York. Over 30 European countries shifted to a two-day settlement cycle in October 2014, well ahead of the staggered phase-in of the European Central Bank’s pan-European settlement platform Target2 Securities beginning in June 2015.

“There is a long interconnected series of steps which must be reviewed before the exchange of cash for securities takes place on settlement day,” explains McDonald, whose firm was one of the exhibitors at the SIFMA-hosted event. “Some financial firms are still relying on batch legacy systems, while others depend on a multitude of platforms, one built over another which could easily require workarounds or manual intervention for some processes such as asset servicing.”

The ultimate effect: buy and sell-side firms might not know whether they have matched their trades on time, have available securities or cash to make their settlement obligations or handled their corporate action events correctly. They might not even know if the trade failed to settle on time. “When one starts evaluating the lifecycle of a trade after it is executed, it’s clear that real-time processing will be required,” says Louis Rosato, a director in charge of trading operations for fund management giant BlackRock in Philadelphia.

Critical Pain Points

Topping the list of dozens of operational adjustments which need to be made by fund managers, broker-dealers and custodians is speeding up the time it takes to acknowledge or match the terms of the transaction. Instead of such matching — or affirmation of institutional trades– being completed by noon two days after the trade is executed, it would have to be completed by noon on T+1, or the day after the trade is executed.

The ultimate trade affirmation could take place in one of two ways — either through a sequential communications process called localized matching between the fund manager and broker dealer or through the use of a third-party central matching system such as that offered by Omgeo, a post-trade communications service provider owned by DTCC. Omgeo has over 1,000 fund managers, broker-dealers and custodians using its Central Trade Manager (CTM), which requires fund managers, or their custodians, and broker-dealers to simultaneously input trade details with each other for matching to occur. About 94 percent of US institutional trades matched through the CTM are affirmed on the day they are executed, more than double the rate for locally matched trades, estimate DTCC officials.

Yet another matching timetable that must be changed: that of matching between broker-dealers through the National Securities Clearing Corp’s RTTM system which also allows them to track a transaction from trade entry through to clearance and regulatory reporting. Currently, fixed-income securities such as corporate bonds and municipal bonds, which often trade over-the-counter, must be matched in RTTM by 11:30AM on T+3 to be assigned a T+3 settlement date. In a T+2 environment, those trades must be matched by 11:30AM on T+2, requiring the NSCC to file for a rule change with the SEC. The NSCC, a subsidiary of the DTCC is responsible for clearing US equities and fixed-income trades.

Next up: reducing the times to execute and settle a foreign exchange transaction, to recall a security out on loan, and for retail investors to make payments on purchase orders While foreign exchange transactions can be settled in two days to meet a three-day settlement timetable, they will likely need to be settled in one day if not sooner to meet a two day cycle. Securities out on loan will also have to be recalled by fund management firms in one day instead of two days before settlement date.

None of the panelists or attendees at the event indicated just how the forex settlement process could be shortened but emphasize that automation was the key to recalling securities out on loan. Fund management firms lend out securities to earn additional revenues but may need to ask for those securities back in time to meet settlement obligations. If that is the case, they will need to ensure they do so via an email rather than fax or a phone call. Does such automation exist? Not always.

“We currently rely on a phone call or fax to recall securities, but now considering a major revamp of our inventory management system that will include the ability to electronicall recall securities on loan,”  says one operations manager at a fund management shop attending the SIFMA-hosted event. His stance mirrored that of his peers at two US regional brokerages.

Revamping Retail Payments

Although most of the attention at the T+2 gathering was spent understanding the ramifications of a two-day settlement cycle on procedures affecting institutional investors, one critical issue affecting retail investors was touched upon briefly. That is how they would pay for their purchase orders. Institutional investors might rely on wire transfers of funds from their bank accounts, but many retail investors still depend on the old-fashioned check which might not clear in two days for the seller to receive its funds. One alternative floated: investors could prefund their cash accounts at their banks or rely more on an automated payment system such as ACH. Such changes would naturally require substantial client education and even operational alterations to the ACH system.

Corporate actions will also be affected by the shorter settlement timetable with the ex-date and cover-protect provisions of corporate actions needing change. “Currently, the regular ex-date is two business days before the record date, and the investor would need to purchase securities before the ex-date to be entitled to any dividend payment,” explains Steven Dapcic, director of corporate actions for correspondent clearing firm Pershing in Jersey City. “That timetable must be changed to one business day before record date under a T+2 environment.” Because the exchange on which a security trades sets the record date, all of the US exchanges would need to change their rules.

As if changes to the ex-date weren’t enough, there will also need to be changes to the cover/protect or guaranteed delivery timetable for some voluntary corporate actions such as exchange offers and rights subscriptions. The premise of the cover/protect or guaranteed delivery is to allow an investor to participate in a voluntary corporate actions even if it doesn’t hold securities in its account at the time the offer expires because of trades pending settlement, failed trades or even securities out on loan. The investor would then be allowed to protect the securities on or before the expiration date of the voluntary corporate action. The move to T+2 will require the cover/protect period to be calculated as two days after the expiration date or the date when the investor must make a decision about the offer.

“Extending the timetable by which an individual or institution can make a decision on a voluntary corporate action is dependent entirely on the issuer of the security who establishes the terms of the corporate action in the offering document,” explains Dapcic, whose firm is a subsidiary of mega custodian BNY Mellon. “Not all voluntary corporate actions will offer the privilege which gives investors the ability to trade the security on the expiration date of the offer.”

Any change in the ex-date of a security or change to the timetable for making a decision on the corporate action will likely need to be reflected in the fund manager, custodian bank or broker-dealer’s corporate actions system which typically downloads information from information vendors who have incorporated the timetables into its data feed. An additional step must be taken in the case of cover/protects falling under a T+2 timetable: altering the language of the agreement between the financial intermediary and the client allowing for the change.

The obvious efficiencies that can be gained from T+2 are also capturing the attention of investors who imagine they solve another bothersome problem. That is the question of how quickly investors can transfer their securities accounts from one financial intermediary to another. The DTCC’s ACATS system now requires five days — with the clock ticking from the time the investor makes the request to the new or receiving bank or broker-dealer which must then file the paperwork through the ACATS system with the old or delivering bank or broker-dealer. “Customers are saying that if we can reduce the settlement cycle why can’t we cut back the time it will take to transfer their accounts,” says Phillip Smith, head of customer account transfers at SEI Private Trust Company, the institutional and personal wealth management operations arm of custody and fund administration firm SEI.

Sigh of Relief

If the thought of moving to a two day settlement cycle sounds onerous enough, there are two saving graces. At the very least financial firms will become more operationally efficient and cost-effective by doing a rehauling of their workflows and technology to ensure best practices. “[T+2] will give us the ability to eliminate friction from the post-trade process, but we must be selective about any changes made so that we can justify the additional expense,” says Goldman Sachs’ Tota.

Once T+2 is established in the US, market players will also avoid the punitive fines currently being imposed by European depositories for their bank and brokerage member firms who don’t settle their trades on time in Europe. Several attendees at the SIFMA-hosted event tell FinOps that they have been reassured by DTCC that they will not be charged any fines if they don’t settle their trades on T+2.

However, broker-dealers may still need to change their policies for cleaning up “fails.” Regulation T, Regulation SHO and SEC Rule 15c3-3 (m) require broker-dealers to cancel or close out transactions if settlement or margin obligations have not been satisfied within a certain period of time after the settlement date. The timeframes under these rules are measured from settlement date rather than trade date and, while no changes to the rules are planned so far, it is likely the timetable to cancel or close out transactions would likely need to be shortened, say conference attendees. It is unclear just who would make that decision and what the new timetable would be.

Will all the preparations for T+2 eventually lead to T+1? Not exactly. Although it sounds like a great idea, that’s all it is for now. Granted, some of the work for T+2 can be leveraged, but there is still too much left to consider, say panelists and attendees at the SIFMA-hosted event. “What exactly will we do with international investors, such as a pension plan all the way in Japan,” asks Graeme McEvoy, managing director at brokerage Morgan Stanley in New York. “The chance of a trade settling on time diminishes if there are any glitches along the way.” Says Edward Jones’ Eacker, “I’m squarely in the camp of folks who believe T+1 simply isn’t cost-effective.”