Tension is lingering between non-US traders, custodians and CLS over FX deadlines ahead of the rollout of T+1 settlement for equities in North America next week, with frustration and confusion over cut-offs leading to ongoing worries of increased risk for the buy-side.
The whole debacle was sparked by CLS’s reveal last month that it would not be moving its cut-off due to feedback from its members – a decision which surprised and disappointed some – while pointing out that custodians would still be able to tweak their own internal deadlines. The onus is now on these providers to alleviate any workflow issues that may arise for buy-side firms looking to trade around the time of the cut offs – of which there are many.
The result? The buy-side feels its voice hasn’t been heard when looking for support, custodians feel the attention was shifted to their internal cut-offs at the eleventh hour, and CLS is likely feeling stuck in the middle with its hands tied by its sell-side members.
While fingers of blame are being pointed in each direction, the bottom line is asset managers are now facing operational challenges, the notion of pre-funding trades and balancing settlement security with best execution obligations. The idea that more trades might be settled bilaterally also increases the counterparty risk that regulators have been looking to avoid across the industry.
Central to all of this, CLS, the operator of the market’s largest multi-currency settlement system, also probably harbours an element of frustration itself given that an equities problem sprung on this industry by regulators has spilled over into its FX world. And, that it can’t simply make adjustments without due consideration of its membership and the impact on them.
However, it’s difficult not to appreciate the predicament for the buy-side, who now face a last-minute scramble to adjust their operations and trading to avoid prefunding, bilateral settlement and moving team members to the US.
“[We’re] not surprised but disappointed at the way the buy-side concerns appear to have been trivialised,” Adam Conn, head of trading at Baillie Gifford, tells The TRADE.
“The core concern is that if a spot FX trade cannot be cleared through CLS it will need to be settled bilaterally with the FX bank we trade with thus increasing counterparty and operational risk. At this stage of the cycle, it’s more the operational risk but in times of stress that counterparty risk could be just as important. Settling trades gross operationally carries a higher degree of risk than a payment versus payment netting platform which, in my opinion, is really the whole purpose of CLS.”
Baillie Gifford is one of a handful of firms that have opted to open a new trading desk in New York on the back of the US’ move to T+1.
Background of the decision
When the US Securities and Exchange Commission (SEC) announced that the US would move to T+1 settlement for equities in February 2023, a 15-month countdown for preparation began. However, what the regulator probably failed to account for was the knock-on effect outside of the US, and on adjacent processes – securities lending, corporate actions and FX to name a few.
What CLS made clear from the outset was that it would not change its cut-off ahead of the T+1 implementation on 28 May, however, it had reportedly been open with the industry that it would explore a change in its 00.00 CET (6pm ET) deadline – considering 30-, 60- and 90-minute extensions – and promised an update around the end of Q1 2024.
When that update came – with a refusal to budge – the US shift to T+1 was just seven weeks away. CLS concluded that the development to accommodate a move in CLS’s initial pay-in schedule – with a deadline of 00.00 CET – would take “considerable time to implement”.
Global Custodian and The TRADE understand that for some of the larger members, those system developments, and related approvals, could theoretically take between nine and 12 months to roll out.
Either way, in its internal survey, over 40% of CLS settlement members – representing around 50% of CLS Settlement’s $6.5 trillion average daily value (ADV) – declared that system development may be needed, the infrastructure provider said.
For reference, CLS has 76 settlement members, as of December 2023, with 60 of those based outside of the US, Canada or Mexico.
Why it took 14 months to conclude the survey and come to the decision has become a bugbear for custodians and the buy-side. Of the handful of large US asset servicers we spoke to, many of them stopped short of saying CLS threw them under the bus, however they did feel “the ball was put in our court” – as one source put it.
“CLS essentially implied that custodians could absorb the credit risk of confirming settlement through CLS without being able to appropriately check source of funding,” said another.
Baillie Gifford’s Conn added: “If they set about doing this when T+1 was first announced they would have had time, but they chose not to. The SEC chair has publicly spoken about how T+1 will push infrastructure providers to enhance their service. I’m not seeing it yet. One of the big benefits of T+1 was the argument that it will reduce risk but what we feel is happening is a transfer of risk from proprietary trading strategies and retail brokers to asset managers and their clients. That cannot be seen to be a positive outcome.”
Attention turns to the custodians
Following the reveal of the CLS member survey results, attention has turned to custodian deadlines which fall before the CLS cut-off. It appears a portion of asset managers were unaware these were two different things, given their interaction was with the broker-dealers who were the members of CLS, as opposed to them being direct members themselves.
Not all custodians felt frustration with CLS however, as one source said “what were CLS supposed to do? There are times you could move to which could be totally redundant because there isn’t any liquidity in the market. If liquidity starts to emerge you could move it, but you can’t put the cart before the horse.”
Global Custodian understands from multiple sources that a handful of custodians are moving their deadlines, with those close to the matter referencing ‘positive moves’ on that front. BNY Mellon, for example, has confirmed publicly that it is adding an extra hour for clients to get their CLS-eligible trade instructions to the bank to increase the chances of those trades making the CLS deadline.
In addition, it is also allowing extra time for FX trade instructions it is executing on behalf of clients to come in for same-day settlement, on trades denominated in the Australian dollar, New Zealand dollar, Hong Kong dollar, Singapore dollar and Japanese yen.
Ryan Cuthbertson, global head of custody services, BNY Mellon, told Global Custodian: “BNY Mellon has been advocating for clients to assess their operating models from execution, through to settlement, this includes FX and funding, since the announcement of T+1.
“We are not surprised by the timing of these issues coming to light, instead we see this as the market reacting to final considerations relative to T+1 that participants of financial markets may have to date believed would be ‘swept up’ in custodians processing. We are actually seeing a spike in interest with regards to FX and funding solutions from clients as they come to the realisation that usage of custodians’ balance sheet in the form of end of day credit is not free and is not guaranteed.”
Many other custodians are tweaking their own deadlines as well but have been less public. Global Custodian knows of one custodian moving its cut-off to 5.45pm ET and one to 5.30pm ET. This is also a confusing process however, with some clients allegedly receiving preferential treatment. Long term this could become a contributing factor to further consolidation of smaller buy-side players across the street, emboldening a trend already seen in recent years.
“Custodians are very good at is picking clients off one by one,” says one source speaking on the condition of anonymity. “At the end of the day, it’s a massive spectrum. So, you can already ensure that if BlackRock reaches out to their custodian they would say ‘right, okay, you want it 30 seconds before the settlement cut off – yeah, we’ll live with that’. It’s not been a unilateral broadcast – they will speak to clients one-by-one-by-one and see how they can divide and conquer.”
In truth, it’s probably easier for the asset management clients of custodians to direct their frustration towards CLS – an infrastructure they don’t deal directly with – but CLS has invested in reaching out on an educational front where possible throughout the past 15 months. Its processes, functions and benefits are arguably clearer to the market than ever, while some custodians feel they are closer to the organisation following the lengthy stretch of change.
When asked why not all custodians had moved, one source put it down to “complex funding constraints, high levels of non-standard instructions, or a combination of both”. However, in the past few weeks, the phrase being thrown around plenty is that there are “positive movements” being made by a number of providers. Ultimately, the move could end up reshaping the competitive landscape, as buy-side firms look to interact more with those that have accommodated them during the shift and less with those that haven’t.
Conn explains: “Our goal is to get everything in CLS before that cut-off. Some of the custodian banks that our clients contract with have been very obliging and some others less so in terms of moving their own cut offs before the CLS deadline. I’m certain that a banks’ ability to be operationally sound will definitely have an impact on where we choose to trade going forward.
“What we and others will be speaking to custodian banks about is their ability to move their own cut off as close to – the CLS cut-off at 6:00 PM ET. The best practise we’ve seen from custodian banks has been to move their cut off time to 5:45 PM ET. It might be too simplistic but if some custodians can do it, I struggle to understand why others cannot.”
Ultimately, this keeps coming back to increased costs, risk and operational complexities for the buy-side. One of the biggest talking points for asset managers and their custodians is liquidity.
Moving the deadlines is one thing, but they have to coincide with where the liquidity is, otherwise moving the cut-off is a moot point. Moving to 4pm ET isn’t going to make much difference, but every minute counts the nearer you move to 6pm ET.
Buy-side pressure
Many desks are now left with a decision – rush to get everything done within the CLS window or execute outside of it and chance taking on undue risk. If trades head into the US close, asset managers could be left with a tiny window to get an FX trade generated and executed. With additional demand caused by time pressure, there is also the potential for traders to face wider spreads on larger size FX risk at the end of the day.
Once such solution to said problem could be simultaneous execution of equity and currency trades – which are usually done after the fact – to alleviate time pressure.
“We used to trade FX a little bit later and wait until equity trades were confirmed but now we’re speeding it up to do our FX trading at the time of execution which is going to be very helpful for us so we can get those trades funded ahead of the cut off,” Blair Connelly, director, cash and FX management at T. Rowe Price, tells The TRADE. “That’s really what we’ve been focused on, just being proactive and trying to create our own solution internally instead of relying on third parties.”
However, this could leave trading desks subject to increased risk of executing FX trades against unconfirmed or unmatched equity trades.
Among the most central challenges for the foreign exchange market caused by the shift to T+1 is its impact on liquidity and the potential for a shortened settlement window to make the market less attractive to source FX.
Thanks to the UK/EU and US time difference, the shortened settlement timeframe has been flagged by traders as likely to create a “golden hour” of liquidity at 5 pm Eastern Time – otherwise known as midnight in the UK. The result of this, if no other solution emerges, means that for many the prospect of moving FX desks to the US will become a reality.
The prospect of divergence is also still very much on everyone’s minds. While the US shift is imminent, the UK and Europe have opted for a more “wait and see what happens” methodology, leaving trading desks to juggle differing regimes.
With the European market as complex as it currently is, it’s likely the road to implementing T+1 will be a long one. If the EU and the UK don’t follow suit, markets could see a variety of nuances to navigate including in some areas such as ETFs and paper share certificates staying on T+2.
A not insignificant 1%
Pressure ramped up even further on CLS last month when the European Fund and Asset Management Association (EFAMA) released a report estimating that roughly 40% of daily FX flows – representing between $50-70 billion – will no longer be able to settle through the CLS platform, resulting in increased risks.
While this headline stat caught a lot of attention, digging deeper into the report showed that it was actually the inability to meet internal custodian deadlines – based on their trading patterns and relationships – that will mean that 40% of daily FX flows will no longer be able to settle through the CLS platform.
CLS has said its own research aligned with that of EFAMA’s but stressed that the 40% figure only related to the 1% of CLSSettlement ADV which it believes could be impacted by the move to T+1 and could settle outside of CLS.
So taking holistic view, the impact seems minimal, but if you’re caught up in that not-insignificant percentage which still accounts for tens of billions of dollars, the whole saga has been a point of frustration.
“If they’d [CLS] have put the figure in dollar value it might have been slightly more headline worthy,” says Conn. “In the EFAMA report, US$65 billion upwards a day could potentially settle outside of CLS. That’s a lot of money sitting outside of a payment versus payment network.”
“One percent might not sound like a lot but in notional value it’s probably pretty significant,” adds Connelly. “Depending on somebody’s flow there could be some very big and impactful days, but I think from a market level they’re probably right it’s probably not that impactful. It’s going to have an impact on certain people on certain days.
“I don’t feel a backlash from our perspective. We understand that the members are the ones that drive the agenda for CLS. They’re the ones that are going to have to make the technology change and the ones who are going to have to spend. They’re valued trading partners of ours so I can certainly understand that there probably is a backlash but from our perspective, I don’t feel that backlash. We’re understanding of it.
“In 6-12 months, there will be a lot of telling to see who’s right who’s wrong. In terms of the people that think CLS are wrong, when the data comes through that’ll be interesting and I think it’ll be rehashed.”
While the deadline remains firm, CLS has said it will monitor the impact of the shift to T+1 and make assessments on the impact in both June and September, in what it calls more of a “wait and see” approach through “temperature checks”, Lisa Danino-Lewis, chief growth officer at CLS told Global Custodian at the time of the member survey announcement.
“It’s difficult to ascertain exactly what might be related to T+1, because we don’t have that level of detail, but we can look around certain parameters. If we found that volumes and values stay exactly the same, then we can safely assume that the impact has been negligible. Obviously, if impacted volumes are much higher than expected we’ll reassess it sooner.”
The path forward
In lieu of a change at this point, CLS is reminding members that they can still submit their trades to CLSSettlement up until 06:30 CET for settlement that day. It’s a message they will be reminding the market of for a long time.
“We can’t move if our members can’t move, but there’s nothing that precludes them entering those trades. Within CLSSettlement, members can submit trade instructions up to 6.30am CET on the day of value. It’s really down to each individual member to agree with their clients.”
In addition, CLS highlights that “for same-day instructions that cannot settle within CLS due to custodian cut-off times CLSNet, CLS’s automated and standardised bilateral netting calculation service, can help to reduce funding obligations and the number of payments required by calculating net payment obligations that facilitate payment netting”.
Regardless of who is to blame an equities problem has spilt over into the FX world. Somehow custodians and CLS have ended up between a rock and a hard place, which is fine – unless you’re a matter of days away from one of the largest structural changes in the history of the financial markets.