With less than seven months to go before the U.S. and Canada is mandated to shift to a shorter settlement cycle for equities, municipal and corporate bonds next May, the clock is ticking on efforts by US broker-dealers and investment managers to speed up their post-trade processing and matching of institutional trades.
As banks, fund managers, and custodians gear up for what is one of the biggest changes in US market infrastructure to happen in recent times, there are implications for global trading desks and higher costs for operations and technology budgets.
The market reforms will impact the whole industry, which will need to work in tandem to hit T+1, and the number of changes will vary from firm to firm, reported American Banker in “Goldman Sachs, DTCC and rest of Wall Street prep tech for T+1 Settlement,” published in July.
For some firms, the shift to T+1 will raise costs in terms of upgrading post-trade technologies, adding headcount in operations, and it will leave less time for participants to address errors in their transactions.
In February of this year, the Securities and Exchange Commission (SEC) voted to adopt rule changes that will shorten the standard settlement cycle for most broker-dealer transactions in securities from two business days after the trade date (T+2) to one day (T+1) on May 28 of 2024. [Canada will transition to T+1 a day earlier on May 27, 2024.]
Under the change, U.S. brokers and their institutional investment managers will need to agree on confirmations, allocations, and affirmations by 9 pm eastern standard time (EST) on trade day, whereas today they have until 11:30 a.m. on T+1.
“For a typical operations, middle-office and back-office this is really compressing the time frame,” said Brad Bailey, Research Director at Burton Taylor.
The regulatory event is seen as a reaction to the meme-stock trading frenzy of 2021 when concerns about risks to the clearinghouse emerged. Amid heavy trading by retail investors in popular stocks like GameStop and Bed Bath & Beyond, several online brokers had put up more collateral at the clearinghouse to protect against potential losses over a 48-hour settlement window.
Shortening the settlement cycle will put shares into circulation more quickly, lower margin payments, and increase liquidity. “Two of the biggest benefits of T+1 is around reducing counterparty risk and default risk,” said Matt McNamara, Managing Director and Head of Global Portfolio Trading at Raymond James. “If you shorten the cycle, then there there’s less time for defaults,” he said.
The industry has been evolving toward a shorter settlement cycle over the past 30 years – moving from T+5 to T+3 in 1993 and most recently from T+3 to T+2 in 2017However, some experts argue that the transition to T+1 is of a higher magnitude because it leaves only a few hours for brokers, investment managers, and custodians to correct errors and prevent settlement fails.
Unlike the conversion from T+3 to T+2, when the date changes were dependent on hard coded changes in software, that is not necessary this time. “The majority of the changes taking place in T+1 is around the processes, coordination of the processes and behavioral changes,” according to Robert Walley, Principal Financial Services at Deloitte, who moderated the Financial Technologies Forum webinar, “T+1 to T+0 Operations: The Ultimate Endgame,” held on Oct. 12.
With T+2 rules, when the day ends on T+0 (trade day), asset managers have over 19 hours to get affirmations and allocations into their executing brokers, from which Depository Trust and Clearing Corporation (DTCC) or other settlement venues are processing those changes, with errors coming out in the afternoon on T+1,” explained Walley. “Then, on T+2, firms are [still] scrambling and sending emails and calling their counterparties to resolve issues,” said Walley.
“In tomorrow’s world, that all changes,” said Walley. “Firms will move to 7 o’clock on trade day, which is when DTCC requires allocations to be in and the rule is defining 9 o’ clock as the deadline for affirmations,” said Walley. “Fundamentally, the industry is moving from having 19 hours to five hours for the operations process to allocate and affirm trades across all counterparties on the buy and sell side,” said Walley.
In a live poll during the FTF webinar, 39% of attendees said they were very confident they would be ready for T+1 on May 24, 2024, while 57% indicated they were somewhat confident and only 4% said they were not confident.
Large broker-dealers and prime brokers which have invested in straight-through processing technology and automated a lot of their workflows, though there is still work to be done, said Finadium’s Bailey. But smaller and mid-size brokers may not have the resources to overhaul their operations or invest in new technology, he said.
Industry participants maintain that all the technology and processes exist to handle a transition to T+1.
“In terms of matching trades, taking in clients’ allocations, ensuring that trades are allocated to the correct portfolios on both sides, that’s all-in place today,” said McNamara at Raymond James. “The speed with which we address things is going to change.”
What firms worry about is detecting small errors and discrepancies in a high-volume market with compressed time frames.
“In the back-office, the automation and speed which we need to get trades matched and settled is going to increase and the period of time we have to complete that is going to decrease,” said McNamara. For example, there could be a discrepancy in a commission rate or an execution price, that needs to be fixed.
In the front-office, global organizations may need to increase their technology budgets to automate areas that are not already automated, adds McNamara. Shifting to T+1 could also pave the way for higher costs if firms need to hire more staff to handle operations issues, he said.
“It’s a natural progression and a sign of blockchain optionality,” said David Cannizzo, Managing Director and Head of Electronic Trading at Raymond James. He suggested there could be a plan to move to real-time settlement or T+0 on the blockchain in the future, making it easier for regulators to surveil all financial instruments. “If you can make it faster why not,” said Cannizzo. “But first,” he added, “relevant conversations need to be had about the impact of T+1 on program trading and electronic trading.”
Global program trading desks and global exchange traded funds (ETFs) that execute baskets with US stocks and foreign names will encounter a misalignment of settlement cycles with Europe and Asia remaining on T+2. “The reason why costs will increase is due to the mismatch in funding for global basket trades and global exchange traded funds (ETFs),” said McNamara. A mismatch between settlement time periods for US equities and foreign exchange trades will add friction to the process. [See Part II: T+1’s Impact on Global Program Trading and FX].
Securities Lending and Corporate Actions
In a faster settlement cycle, traders will need to manage functions such as securities lending and corporate actions add additional complexity to the trading process.
“If a prime broker lends stock for a hedge fund to short it, knowing one’s inventory will be crucial,” said Bailey. “Some firms have built more frequent reporting tools so they can have clarity into inventory, said Bailey.
“It really comes down to process,” said Bailey, adding that firms will need more frequent reports on liquidity and have a better view of their inventory. Potential changes in recalls and buy-ins could alter securities financing especially for hedge funds who are most actively shorting equities.”
“A lot of the sell side [will] want to shield their buy-side clients from these operational complexities,” said Bailey. Mid-size firms on the buy side are counting on their partners, administrators, primes, and sell-side relationships to really help them,” he said.
Brokers will also need to be proactive with corporate actions. McNamara said, “When providing shortened settlement to align funding, brokers will need to be aware of any securities going through a corporate action, such as a cash dividend, stock dividend or stock split, to ensure that by changing the settlement cycle, they haven’t inadvertently caused a dividend to be misallocated or the wrong amount of stock to be executed. This is something looked at today, but the frequency of these events will increase in the new environment.”
The Holy Grail: Same-Day Affirmation Rates
Moving to T+1 is also a heavy lift for the buy-side.
Commenting on the buy side, Grant Johnsey, Head of Client Solutions, Americas for Northern Trust Capital Markets, said: “The largest challenge will be communication within the tighter deadlines, specifically, the provision of allocations to brokers and subsequent communication of completed trade details to the custodian(s).”
“To accommodate the tighter timeline to communicate trade details and affirm/pre-match pending trades, some asset managers may need to add or change staffing hours to ensure allocations are sent to the broker in a timely fashion on trade date,” said Johnsey. “Asset managers based outside of North America that trade U.S. or Canadian stocks face special considerations given time zone differences and added settlement urgency,” he added.
Sell-side firms will be looking for the buy side’s settlement instructions and allocations notifications to be in by 7 o’clock on trade day and affirmations to be made by 9 o clock so they can be processed overnight [via DTCC’s batch processing cycle,] said Deloitte’s Walley.
Johnsey said that Northern Trust has a fully automated process that will work well in the T+1 environment. “We are spending time with both asset managers and asset owners a like to assess their readiness and provide support through our middle-and back-office teams,” said Johnsey.
Most asset managers use DTCC’s Central Trade Manager (CTM) to match and confirm trade details between the brokers and investment manager clients and affirm the allocation instructions – how the shares are going to be allocated to the investment manager’s account at their custodian.
In addition, the DTCC provides an automated workflow called Match-to-Instruct (M2i) which appends the standing settlement instructions (SSIs) from its existing Alert database to provide automatic trade affirmation. This quickens the process by delivering pre-matched information to the custodian. They also use messaging protocols (FIX and SWIFT) to automate the communication of allocations.
“Big players on the buy side, depending on their custodial relationships, have to make sure the affirming and allocation process takes place in an automated way,” said Bailey of Burton Taylor.
In September, DTCC announced that 350 investment managers are now leveraging CTM’s automated trade affirmation capabilities to accelerate the post-trade lifecycle.
According to DTCC, investment managers that use the CTM together with M2i workflow have a 98.39 % same-day affirmation rate by 9 pm EST, vs. a 46.67% same-day affirmation rate for investment firms not on CTM that are affirmed by the custodian.
Meanwhile, brokers will rely on their third-party order management system (OMS) vendors or clearing firms to provide seamless connectivity into the DTCC’s matching systems.
For example, FlexTrade Systems is in the process of interfacing its global enterprise sell-side OMS, FlexOMS, with the DTCC’s M2i automated workflow which automatically affirms broker allocations trades. It’s currently making changes to its middle office (Mosaic) to integrate with M2i.
However, there are different ways to submit trades to DTCC and not every firm is automated. In fact, some firms could be sending a fax or uploading spreadsheets. “The submissions vary,” said Bailey.
Speaking on the webinar, Tim Kelly, Director of Operations at Chicago-based Driehaus Capital Management, said his firm affirms each one of its US and Canadian trades between 3:00 and 3:30 Chicago time (4:30 EST), adding that so nothing will change for the firmDriehaus, which invests $15 billion in assets internationally, handles from 55,000 to 85,000 trades a year, said Kelly.
On the buy side, Kelly emphasized the need for communicating with counterparties. “We need to understand on the buy side that all the heavy lifting is being put on the brokers and the custodians because their time is really being cut short,” said Kelly. The operations executive advised buy-side firms to do their matching in the most efficient way
“If the market closes at 3pm (CT), you start using CTM, Alert and your different tools, to get those trades matched as soon as possible,” advised Kelly.
Instead of waiting for the market to close, Deloitte’s Walley suggested that investment firms send in their allocations earlier in the day. “There is no reason that firms should be waiting until markets close at 4pm. Even though the amount of volume and transactions at 4pm is high, it doesn’t mean that everything that happens during the day needs to wait,” said Walley.
“Affirming trades and getting into CTM and other platforms is on behalf of the entire ecosystem to make this work. It’s not one side or the other.” Walley urged buy-and-sell-side firms to recognize the dependencies between both parties and to change their behaviors now, rather than wait until May 28.
Walley noted that the SEC’s rules require brokers to monitor their clients for allocation times and affirmation rates. “In essence, the SEC and FINRA will be looking at the behavior of the operations of the entire ecosystem and really they’re driving towards 100% affirmations,” said Walley.
With over 200 days remaining until the T+1 transition, Deloitte’s Walley said every firm should be testing their systems with the DTCC, which opened its testing framework on Aug. 15, which runs until the end of May. Brokers and banks can test their workflows into DTCC’s platforms with Nasdaq, CBOE, and the Options Clearing Corp. (OCC)However, brokers and institutional clients will need to test separately on their own.
It remains to be seen if the industry will be ready on time and whether the SEC will need to push the deadline. Some industry observers are skeptical, pointing out the number of settlement issues that firms still have today on T+2.
“There will be growing pains early on,” predicted Cannizzo. “I don’t know how quickly all facets of the equity market are going to bring automation where it’s still lacking years later in T+2,” he said. “There are still issues with settlements where there is a lot of human capital involved today not just on the sell side, but with the clearing agents and the buy side,” said Cannizzo. “The solution is not throwing more humans at the problem. We are fans of automation,” said Cannizzo.
According to Johnsey of Northern Trust Capital Markets, “Readiness for T+1 is very much case-by-case.” “Most asset managers based in North America have confirmed they are ready or will be ready by the spring,” commented Johnsey. “Managers based outside of the region seem somewhat less prepared,” he said. “Generally speaking, if the asset manager is sending allocations manually and/or faxing trade communication to their custodian(s), they will not be as ready as those who have straight-through processing or automated methods.”
Meanwhile, Walley said the industry needs to have “all-hands-on deck,” during the transition. “It’s going to take two-to-four months to adapt to these timings,” he said. “We may see upticks in settlement fails, and people need to be prepared for how to handle that and have funding on hand.”