The Securities and Exchange Commission may have just given its official blessing to a shortened trade settlement cycle in the US come September 5, but the Depository Trust & Clearing Corp. (DTCC), its member firms and service providers have already been working long and hard on operational adjustments and industry-wide testing.
All this effort will hopefully translate into a perfectly seamless transition from a three-day schedule, based on what panelists and attendees at a recent T+2 conference hosted by the Securities Industry and Financial Markets Association (SIFMA) in New York tell FinOps Report. No one can afford any glitches because the new settlement timetable has been set in stone. “Now that the commitment has been made there is no turning back,” says John Abel, executive director of product management for DTCC in New York. The DTCC won’t require member firms to certify whether they are ready; so no one will know if a business partner is really prepared unless they take the initiative to check their partner’s readiness.
The SEC’s long-awaited decision to change its rules came more than a year after after trade groups representing the brokerage, mutual fund and other industry sectors had already made up their minds in favor of reducing settlement time from three days to two days. The end game: to reduce market risk. Nothing good ever happens between the time a trade is executed and the time it is settled. Most of Europe switched to a T+2 timetable in October 2014 and Australia did so last year.
Like the US, Canada will also be shifting to T+2 on September 5, the day after the US Labor Day national holiday. September 7 will be a double-settlement day incorporating trades settled under both a two-day and three-day timeframe. The long weekend will give IT and operational workers the last chance to correct any lingering technological glitches before activating the coding changes on the myriad of applications involved.
Firms have little choice but to comply with a T+2 timetable. The SEC says it will allow some leeway in a limited number of cases. However, no one at the SIFMA-hosted event thought any extensions would be given for equity trades. Any exceptions to the T+2 timetable would likely be for firm-commitment underwritings for fixed-income instruments.
Successful industry-wide testing — ad hoc and scripted — is considered one of the final cornerstones for meeting the T+2 settlement cycle. The DTCC, the US umbrella organization for clearance and settlement, is in the fourth of 14 cycles of industry-wide testing with most of its member firms, which have either completed or assessing the changes they still have to make to their internal applications. The DTCC has set up bi-weekly teleconference calls with testing participants during each test cycle which lasts for two weeks, and has created a dedicated webpage in the DTCC Learning Center for firms to find testing partners on their own.
Surprisingly, a good number of member firms have yet to participate in the industry-wide testing which will last through the summer. They are either still testing internal systems or have not set up the IT framework to paraticipate.
Panelists at the SIFMA-hosted event acknowledge they are relying heavily on DTCC’s own T+2 testing documents when it comes to preparing for their internal testing. DTCC has created dozens of possible testing scenarios which include testing for a two-day settlement cycle and for a double T+2 and T+3 settlement cycle on a single day. “The testing document made it easier for us to determine the extent of what we needed to test in terms of the workflow process,” says Frank Tota, global head of securities settlements and Americas trade processing for Goldman Sachs in New York.
Changing internal applications isn’t as easy as switching a line item from T+3 to T+2. Moving to a two-day settlement cycle will likely require revisions to dozens if not hundreds of interrelated front, middle and back-office systems. Just one mistake can have a domino effect.
Speeding up the deadlines for affirming and disaffirming trade details is just one of the mega changes firms need to embrace. Most institutional trades will now have to be affirmed by noon EST on T+1 instead of noon EST on T+2. Prime brokers relying on the Omgeo platform to affirm and disaffirm trades on behalf of their hedge fund clients will have until end of day on T+1 to disaffirm the trades. They can no longer wait until the evening of T+2. Still, the new timetable should be a relief. Omgeo, the post-trade communications subsidiary of DTCC, extended the timetable for disaffirmation to the end of the day on T+1 from the initial plan of the morning of T+1 at the request of prime brokers who complained that the early timeframe was too burdensome to meet.
Financial firms must also ensure that their corporate actions systems, which receive data from information vendors and others, recognize that the ex-date of the corporate action will change to one day before the record date instead of the current two days. Investors must still purchase securities before the ex-date in order to be entitled to the corporate action– either a dividend or income payment or even a compensation in securities. Some exchanges, which set the ex-dates for corporate actions, have agreed that they will not be using either a September 5 or September 7 date to avoid the potential for an influx of claims having to be completed. Financial firms could end up having to file documentation with each other on behalf of their customers asking for the corporate action entitlement to be returned and credited if the trade is in transit “or not settled” between the time they made a purchase and the time the trade is settled.
When it comes to securities lending deals, the SEC rule-change announcement appears to suggest that the recall period will remain at three days. Not so, counter panelists at the SIFMA-hosted event who urge attendees to seek clarifications from the US regulatory agency. Once T+2 goes into effect, lenders of securities will likely have to recall — or ask back — the securities on T+2. That is because the new recall period needs to align with the new trade settlement timeframe. If the recall period is changed to T+2, the borrower must return the securities no later than T+4 which represents one day before the closeout date under SEC Rule 204, explains Jeffrey Stern, executive director and head of infrastructure compliance for the Americas at Morgan Stanley in New York.
Panelists at the SIFMA-hosted event whose firms have completed their internal changes, praised the DTCC’s industry-wide testing as progressing relatively well, with the exception of a few minor snafus. “When we started industry-wide testing with DTCC we found out DTCC had not set up our files which resulted in a one week delay,” says John Geer, vice president of technology for Raymond James. “Since the issue was resolved our testing has gone well with the exception of three small defects.” One of the three related to the firm’s market-maker not sending a file to DTCC. The other two related to the internal environment setup.
DTCC’s Abel acknowledges that DTCC did have a few minor hiccups during the initial round of industry-wide testing related to the test environment. By far, the biggest challenge was creating a test-set up with participants. Case in point: testing the delivery and receipt of ISO 20022 messages related to corporate actions could take up to four weeks to set up.
Tota says that Goldman Sachs will join DTCC’s testing program in the fifth testing cycle and complete all the testing by the eleventh cycle. “We want to be finished early with the months of July and August as a buffer,” he says, noting that the firm wanted to first complete internal testing its front-to-back-office systems first. Goldman Sachs will also be testing separately with third-party providers for its stock lending and mutual fund activities.
Broadridge Financial, a mega provider of middle and back-office operations outsourcing, already made changes to 35 of its applications and completed internal testing by October 2016. It began testing with customers in November and has participated in all of the DTCC’s industry-wide testing to date. Broadridge’s most difficult challenge: setting up the testing environment with customers. ‘We thought we had nailed everything but then discovered that our clients didn’t have the correct file setup for testing,” says Charles Lichter, vice president of product management at the New York-based firm. “We had a lot of work to do from ground zero but it eventually all worked out.”
As if financial firms didn’t have enough challenges adjusting their internal applications and conducting industry-wide testing, they must also explain the shorter settlement cycle to their customers. Christopher Haines, head of regulatory operations at brokerage Edward Jones in St. Louis, says that brokerage account and advisory account agreements will need to be reviewed to change any reference from T+3 to T+2 before September. Edward Jones is also evaluating all of its documentation, internal and external websites, training materials, statement inserts and branch flyers to ensure they reflect the new T+2 timetable.
Perhaps the most difficult aspect of explaining T+2 to customers is the change in funding requirements, particularly for retail investors. “We have a vast number of retail customers who already have money in their accounts on trade date, so meeting a two-day timetable won’t be a problem,” says Haines. “Not so with a few customers who are still relying on checks to clear before payment is due.” One solution: other panelists from other brokerage firms say they will be asking or even requiring customers to keep funds on hand with their brokers. No one wants to deal with a potential mountain of requests from customers for extensions on the time to pay.
The most surprising aspect of the progress of T+2 preparedness revealed at the SIFMA-hosted event was the lack of widespread testing on the part of banks, broker-dealers and even some service providers with customers. Apparently, either firms are overly confident their customers have their acts together or customers are taking a lackadaisical approach, stances questioned by some attendees. “Our clients are counting on us to be ready, but they have not asked to test with us,” says Becky Lenz, a product manager with Thomson Reuters in New York. Says Goldman Sachs’ Tota, “We have had plenty of communications with clients, many of which have already been through a T+2 settlement cycle in Europe and Asia, so we aren’t worried.”
Another potential surprise particularly for DTCC participants: their widely-expected reduction in margin requirements for trades cleared by DTCC’s equities clearinghouse National Securities Clearing Corp. under a T+2 cycle won’t be immediate. In fact, participants will experience and intermediate short-term increase in their margin requirement. The uptick will start when NSCC speeds up the time it imposes its trade guarantee laster this month from the current time of midnight on T+1.
“Initially, the margin requirement could go up by an additional 15 percent at the time the accelerated trade guarantee (ATG) takes place on April 21, because NSCC will be stepping in to serve as the middleman immediately after the trade is validated by an exchange,” says Timothy Cuddihy, managing director at DTCC in charge of risk management for the Fixed Income Clearing Corp (FICC). “The margin increase will be offset or wiped out in September when T+2 takes effect.” The rationale: NSCC will be assuming counterparty risk for a longer period of time — between T and T+3 — when it imposes the ATG. When the settlement cycle changes to T+2, NSCC will assume counterparty risk between T and T+2.