T+1 to Impact Global Program Trading and FX

November 19, 2023 | By: Ivy Schmerken

As the US transitions to shortened settlement cycle next May, a major concern is how the tighter time frame will impact overseas fund managers trading U.S. equities given the time zone differences, particularly when a foreign exchange transaction is involved.  

The Securities and Exchange Commission (SEC) is decreasing the settlement time for U.S. stocks, municipal and corporate bonds, exchange traded funds (ETFs), and other securities from two days to one day or T+1, effective May 28 of 2024. 

Time zone differences will make it tougher for institutions in Europe and Asia Pacific, which may need to change their work hours or hire additional operations staff to work a night shift. 

When US equity markets close at 4pm ET, it will already be 9:00 pm in the UK or 10:00 pm in Europe. Under the reforms, firms must allocate, confirm, and affirm trades by 9 pm Eastern Standard Time (EST), when it is 1 am or 2 am in Europe. Currently, these firms have until 5 pm EST the day after a trade.  

“Not only is the settlement time going to become more compressed in the U.S., but it’s going to decrease more rapidly for non-US investment managers in Europe or Asia that are 5 hours or 12 or 14 hours ahead of U.S. markets,” said Matt McNamara, Managing Director and Head of Global Portfolio Trading at Raymond James. “That creates some ambiguity around the matching and settlement process for equity trading,” said McNamara. 

McNamara cites the example of a fund manager with a global mandate who is executing baskets with US securities, European securities, and Asian securities. “If they are buying US securities and selling European and Asian securities to fund the purchase in the US, they’re not going to have the cash on T+1 because all the non-US equities settle on T+2,” explained McNamara.  

To meet the imminent T+1 rule, fund managers in Europe are relocating staff or hiring in the US, reported Ignites Europe, a title owned by the FT Group. For example, Baillie Gifford is reportedly moving across three staff members from its trading and settlement teams. 

Robeco told Ignites Europe that it had a trading desk in New York and outsourced its middle office offices to a provider that used a “follow-the-sun” model.  

Based on speaking with buy-side counterparts in the US and Europe, McNamara agrees that firms are going to either add to headcount or move employees from Europe or Asia to their US offices.   Alternatively, firms in Europe and Asia could staff operations roles later at night to be prepared to perform these tasks at 9, 10 or 11 pm EST on trade day.   

More likely, non-US fund managers will need to execute an FX trade to convert their base currency (e.g., in pounds, euros or yen) into dollars to fund the US equity position on T+1, observed McNamara. Overseas managers may need to execute FX later in the day, potentially during Asian market hours, when liquidity has decreased and spreads have widened, resulting in poorer execution quality. 

The Mismatch Between US Equities and FX Settlement 

Halving the settlement cycle is complex because it will put U.S. stocks out-of-sync with the $7.5-trillion-dollar-a-day global foreign exchange market, which settles on T+2.   

On an industry webinar “T+1 to T+0 Operations – The Ultimate Endgame,” Chris Ekonomidis, Director, Transformation at BNY Mellon, said: “The mismatch between securities settlement in North America and the standard FX spot settlement is something that’s a major concern for firms.” 

During a live poll on the Oct. 12 webinar sponsored by Financial Technologies Forum (FTF), one third or 33% of attendees cited FX as the weakest link in reaching T+1 or T+0 settlement, followed by dependencies on counterparties at 27% and securities lending at 17%, with internal IT and operations garnering 14% of the vote. 

Ekonomidis said: “I think it’s up to each firm to understand their own business and understand what the risk appetite is and essentially act accordingly – whether it is to build relationships or open offices in other locations. He added that “international players are probably a bit more disadvantaged than they were in previous changes. There are several ways to tackle this change,” said Ekonomidis. 

“Broadly, the big challenges of T+1 are anything to do with cross-border trades and how the funding will work across borders,” said Brad Bailey, Research Director at Burton-Taylor International Consulting. “It gets tricky with smaller asset managers in Asia trading in the US with a custodian (in Asia).  That [issue] has certainly come up,” said Bailey. Another issue involves global exchange traded ETFs that contain US stocks with T+1 settlement but have components in the basket that settle on T+2, noted Bailey. 

On the foreign exchange side, firms have talked about “prefunding” the position, meaning the buy side would do the FX transaction on trade day, said Bailey.  

Currently, managers prefer to wait until the equity trade details are “match agreed” before they undertake the FX trade, noted McNamara. Currency transactions funding securities transactions currently settle in two days. 

To address the misalignment, McNamara said it’s possible that fund managers will try to move up the FX settlement to T+1 and ask their brokers to carry the FX position for one day on their books. Brokers are expected to charge for that premium, said McNamara, adding: “There is a carrying cost and a variance as rates move.” 

David Cannizzo, Managing Director- Head of Electronic Trading at Raymond James, expects there to be more requests for special settlements in the short term while the industry adjusts.  

McNamara suggests that if managers “won’t have cash on hand to cover T+1 transactions in the US, they may need to lean more heavily on the sell side to provide capital. In a higher for longer interest rate environment, combined with internal operational expenses, the cost of capital will increase.” 

On a “large global program trade, where a client needs to use capital,” a broker will assess their costs to finance that trade, said McNamara, adding that he expects the sell side to evaluate where it makes sense for them to deploy capital to fund trades for buy-side clients.  

“The point is that everything gets more expensive – whether that is investing in technology, investing in human capital, or using balance sheet. It all gets more expensive,” said McNamara.   

At the same time, this is an opportunity for the sell side to service their clients. Brokers offer financing as a facility to their clients, though some may become more selective in which clients they offer it to. 

FX brokers may need to staff desks later in the night to accommodate transactions that international investor managers need to execute for their US securities. “It could cause a shift in the way the FX world works, more so than in the equity world,” said McNamara. 

While the SEC is mandating T+1 to take risk out of the markets, there could be pain points in the short term with FX settlements.  

“The overarching benefit to shortening the settlement cycle is margin compression and that traders and investors get their money back to settle quickly,” said Bailey. “What takes away from that are the operational challenges, such as if you had to pre-fund FX to have the funds available to settle in that more accelerated pattern,” said Bailey. 

However, Bailey recalled, the last time the US shortened the settlement cycle for equities was in 2017 when it transitioned from T+3 to T+2, while Europe adopted T+2 in October of 2014. “There was a three-year period when Europe was on T+2 and the US was T+3, so you had the asymmetry in settlements [in equities], but you didn’t have that issue with the funding,” said Bailey. 

Grant Johnsey, Head of Client Solutions, Americas, for Northern Trust Captial Markets, said: “This situation has been prevalent in the past. “In fact, varying settlement dates across the globe has been the norm until recent years,” he said. “Yes, it is a concern, but one that can be managed at the outset of trading,” said Johnsey. “Settlement dates can often be adjusted, and financing methods are available to support a global program trade across T+1 and T+2,” he explained.  

“The primary consideration is the increasing cost of financing as global interest rates are higher than they have been,” he cautioned. “Some investors may have to weigh whether being out of the market for a day or irregular settlement makes the most sense to them. Developed markets around the globe have added pressure to match the T+1 time frame, but it will likely be a few years before it is implemented elsewhere,” said Johnsey. 

During the FTN webinar, panelists noted that changes are also being considered in the FX market.  

On Sept. 26, Reuters reported that CLS, the largest multicurrency settlement system for FX, is exploring delaying settlement instructions for foreign exchange trades. Foreign asset managers who use currency trades to fund their US securities transactions requested the change. According to Reuters, investors face the prospect of more FX settlement failures on May 28, 2024, when they must begin to settle equity transactions on T+1. “Investors may have to change their methods on the FX side to ensure their FX trades are not left out of CLS. Parties to FX trades may have to settle bilaterally if their trades are not included in CLS,” reported the news agency.  

However, when May 28 arrives, fund managers will need to juggle different settlement regimes in FX and US equities, unless the FX settlement authorities tweak the rules by then. 

“People need to be aware that those spot trades for payment [for US securities] need to be made for T+1 and work within those windows,” said Bob Walley, Principal, Financial Services at Deloitte, who moderated the webinar. “It is a topic we are working on at industry levels,” said Walley, noting that conversations are going on with CLS about potentially changing some of those windows.”