Peter Snasdell, senior vice president at Devexperts takes a look at the real obstacles being faced by market participants when settlement times are reduced and what should be front of mind.
In May of last year, the US, Mexico, and Canada moved from T+2 to T+1 settlement, meaning that securities transactions are now settled on the following business day.
In some ways, settlement times are a throwback to the era when securities certificates had to be manually ferried back and forth between parties. But, as we’ll see below, market participants face real obstacles when settlement times are reduced.
A reason for cutting settlement times down is that delays in completing transactions increase the possibility that the price of a security will be drastically different by the time settlement occurs. Shortening the settlement cycle is desirable as it reduces the counterparty risk that these delays entail and makes markets more efficient.
To this end, the US has been incrementally reducing its settlement times. In the past, settlement took place in T+5. This was reduced to T+2 in 2017, and then down to T+1 on May 28, 2024.
What’s stopping regulators from effecting instantaneous settlement across the board? We live in the digital age, after all, do we not? It has a lot to do with the plumbing of the financial system, which has painstakingly evolved over many decades from its analogue roots and still bears their influence.
Swift points out that going from T+2 to T+1 doesn’t just cut post-trade processing time in half as it may seem. Banks and brokers actually have 80% less time to conduct cross-border settlements, especially when you factor in time-zones and necessary foreign exchange transactions.
So, even though moving to T+1 does aid in the reduction of counterparty risk, it introduces a host of new challenges, particularly for overseas investors and those that have yet to modernise their systems.
As mentioned above, the international nature of markets introduces the added complication of managing foreign exchange transactions, but the reduction in settlement times also impacts lending, with participants having far less time to call back securities that are currently on loan.
In the case of US markets, investors from the Asia-Pacific region are most impacted by the reduction in settlement times, owing to the great difference in time zones. These participants must execute their required FX transactions ahead of time or even negotiate some form of pre-funding.
We tend to think of Western markets as the most developed due to the long history of stock exchanges in places like Europe and the United States, but when it comes to settlement times it’s actually the other way around. It has been easier for relatively younger markets
that haven’t had to contend with legacy systems and outmoded methods to cut settlement times down.
China, South Korea, Taiwan, and India, all offer T+0 settlement, whereas Europe still operates under T+2 and is aiming to knock this down to T+1 by the end of 2027.
It’s important to recognise that, unlike retail traders, who must pre-fund their trading accounts, institutional participants conduct business differently, often making payments to clearing houses the following day.
The shortening of settlement cycles throws many of these established ways of doing business out and requires new systems to confirm, reconcile, and report trading activity. Add to this the need for near instantaneous cross-border transfers which are not the way things work in a world that still relies on intermediaries for a simple currency transfer to be completed.
India’s phased move to T+0 is actually an interesting case in point. When the Securities and Exchange Board of India (SEBI) reduced settlement times from T+2 to T+1 in 2023, it was overseas participants that were the most outspoken opponents of the move. These investors were forced to allocate capital in advance of executing trades, exposing themselves to currency risk in the process.
The emergence and establishment of crypto as a new asset class, rather than overturning the global financial order as initial proponents hoped, has merely highlighted some of its technological insufficiencies and perhaps even spurred it on to evolving. Crypto instruments effectively act as bearer assets with instant settlement and close to zero counterparty risk.
Though distributed ledger technology (DLT), the mathematical magic behind bitcoin and other crypto assets, is a prime candidate for this evolution, at this stage it’s hard to imagine a “blockchain all the things” approach to the digitisation and settlement of securities.
What’s closer to becoming a reality is the phased introduction of CBDCs (central bank digital currencies) and other similar digital currencies that can knock down currency transfer times, allowing international investors to enjoy the same access to markets as locals.
What’s certain is that increased automation and digitisation will be vital if the trend toward compressed settlements continues. This will require infrastructure upgrades, new risk management processes, and some degree of protocol standardisation across geographies.