T+1 settlement: The biggest FX shake up in decades

Following the commencement of the testing period for the US shift to T+1 in August, Annabel Smith explores what the foreign exchange-specific implications of the transition might be across achieving best execution, sourcing liquidity, flow netting and trade matching.

The TRADE reported on 14 August that the testing period for the shift to T+1 settlement in the US had officially begun. The critical window – set to run until the planned implementation date at the end of May 2024 – is a crucial opportunity for the industry to iron out any creases, of which there are many, before the transition is completed.

While at face value, shortened settlement cycles suggest greater efficiency and could minimise the risk of default as transactions are completed more quickly, the new requirements are likely set to force many institutions to undergo a major operational overhaul to ensure they adhere to them.

Many of the chief concerns revolve around FX trades which are typically executed after an equity trade has been matched and executed and subsequently will be under increased time pressure. If FX trades cannot be completed in the same time frame there is the potential the market could start to see more settlement fails.

Speaking to The TRADE in August, James Kemp, managing director of GFMA’s Global Foreign Exchange Division, explained: “When analysing the impacts of faster settlement, it is important to consider FX both as an asset class in its own right and also in its role in cross border securities transactions and the corresponding FX-funding transactions and operational processes that need to be completed to support those transactions.”

For example, if trades head into the US close, non-US asset managers could be left with a tiny window to get an equity trade matched and FX trade generated and then executed into the market. 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 but this leaves trading desks subject to increased risk of executing FX trades against unconfirmed or unmatched equity trades.

Some buy-side trading desks are so hyper aware of the regulatory changes that they’ve moved to set up new FX desks in the US to ensure no crucial execution flow slips through the cracks because of operational challenges.

In short, the shift is set to give foreign exchange one of the biggest makeovers it’s seen in decades as firms scramble to redesign their workflows to meet the new requirements. Future FX transaction functions are set to be markedly different, exacerbated by the need to settle closer to execution.

Liquidity patterns

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.

“Is there good (any?) liquidity in the FX markets late in the day NY time? I usually do my FX after the trade has been confirmed and matched,” said one individual responding to a T+1 Industry Issues Forum hosted by The TRADE’s sister publication Global Custodian.

Trading patterns are undoubtedly set to change as many trades will now be forced to trade outside of CLS leading to potentially increased settlement risk. Institutions will also need to have dollars available to settle US securities.

“The biggest issue is around the cash management side of things. Should we trade FX after US close? Will this be a liquidity point? Currently there is no liquidity in the US session. Can CLS extend cut offs?” asked one anonymous responder to Global Custodian’s T+1 forum.

“Will they be able to handle T+0 in CLS? Will FX markets also change to T+1 e.g., EUR-USD and USD-DKK? We also have some system limitations on how fast trades can be booked as they go through post-trade compliance. On large volume days it can take an hour to book trades after US close.”

With fewer breaks in a shortened settlement window, custodians may also be forced to opt for alternative automated payment vs payment (PvP) FX settlement methods in their post-trade processes.

“If the CLS cut off is around 11 pm CET on VD-1, how are we meant to keep netting our FX? Does this just mean that we’re going to have to do everything on a gross basis?” asked another respondent to the T+1 forum.

Traders have flagged that the new timelines provided by custodian banks to ensure FX trades are settled on a PvP/net basis under T+1 are restrictive, and if missed could go some way to reversing the work done in the FX industry to reduce settlement risk by forcing volumes to be settled bilaterally.

The operational changes also pose a challenge to counterparty selection. The new requirements could mean that operational considerations and cut of times will have to be taken into account by the buy-side when selecting a counterparty and this has the potential to hinder best execution.

One solution could be to outsource. Outsourcing operations for around the clock back and middle-office could be one such option but is a costly and arduous process to complete before May – especially for smaller firms. Alternatively, desks have the option to outsource FX all together.

In May, a paper released by the Global Foreign Exchange Division (GFXD) of the Global Financial Markets Association (GFMA) suggested the buy-side should adopt a strategic approach to managing FX risk in the lead up to the T+1 shift, in particular highlighting outsourcing currency management – specifically “to specialists who have trading/operations in the major trading time zones, alternate passive or active currency strategies, and 24-5 market access to wholesale FX pricing and liquidity management to assist with best execution.”

However, many traders in response to the T+1 industry issues forum queried how they could be confident best execution rules were being met if they outsourced.

The changes, when implemented, are set to overhaul the way the FX markets currently operate. They will likely act as a catalyst for massive technological evolution as institutions look for solutions to the workflow challenges that arise. Initially it may only be the most automated corners of the FX market that are able to cope with the changes. Technology will be the deciding factor with who thrives in this new post-trade landscape.