T+0? More Risk, Fewer Benefits

As part of our work to shorten the settlement cycle from T+2 to T+1, we investigated whether the industry could shorten the cycle even further, to T+0 or ‘end of day’, as some have suggested.  After a great deal of analysis by a broad cross section of industry participants, we concluded that moving to T+0 or end of day would require fundamental and costly changes in market operations affecting institutional and retail customers and actually increase risk.

The Securities Industry and Financial Markets Association (SIFMA), the Investment Company Institute (ICI), and The Depository Trust & Clearing Corporation (DTCC) are taking steps to accelerate the U.S. securities settlement cycle from trade date plus 2 days (T+2) to trade date plus one day (T+1).  Five years ago, this same industry group led the effort that shortened the settlement cycle from T+3 to T+2.  That effort paved the way for shortening the settlement cycle to one day, which will improve market resiliency by further reducing risk that exists while a trade is being finalized, benefit investors by shortening the execution time frame between buying or selling their securities, and reduce the level of margin market participants must post to offset the settlement risk.

As part of our work, we investigated whether the industry could shorten the cycle even further, to T+0 or ‘end of day’, as some have suggested.  After a great deal of analysis by a broad cross section of industry participants, we concluded that moving to T+0 or end of day would require fundamental and costly changes in market operations affecting institutional and retail customers and actually increase risk.

The settlement cycle is the time between the trade date, when an order is executed in the market, and the settlement date, when participants exchange cash for securities and a trade is considered final.  In December 2021, SIFMA, ICI, and DTCC issued a report, Accelerating the U.S. Securities Settlement Cycle to T+1, which provides firms with a roadmap for shortening the settlement cycle, including considerations, recommendations, and next steps for moving to T+1 in the first half of 2024.  This timing will allow firms to assess the changes they need to undertake, the industry to conduct comprehensive testing, and regulators to make the necessary regulatory changes.

Moving to a T+1 settlement cycle is a complex undertaking and will require significant planning, execution, and testing.  Moreover, it will require substantial changes in market operations.  Knowing changes are necessary, some have asked why not just go to T+0, or “T end of day,” rather than T+1.  It’s a fair question and one that our group considered.  The answer comes down to one fundamentally important consideration: will the benefits outweigh the risk?  Our research found the answer to be no.

Why Not T+0?

The settlement system is complex and contains many interdependencies which benefit investors, and the U.S. capital markets alike.  As we look at accelerating settlement, the basic assumption is reducing the time between trade date and settlement reduces risk.  We believe going from two days to one day will provide optimal benefits to investors and market operations, including risk mitigation.  In the case of T+0, our group found that the law of diminishing returns applies:  shortening the settlement cycle beyond one day embeds more risk without creating additional benefits available for widespread adoption across the industry.

A T+0 settlement cycle isn’t easily achieved by all industry participants due in part to their reliance on current business, infrastructure, and operational processes.  A T+0 framework no doubt would impact the competitive landscape in a way that disadvantages market participants who are unable to make the investment or lack the scale to compete in such an environment, creating winners and losers across the industry and impacting competition.  Smaller participants with limited resources would be at a competitive disadvantage to make the necessary investments.  But it’s not just about firm size—the competitive landscape would shift in terms of cross-border issues, institutional versus retail, and fixed income versus equities, with each firm’s operations being put under extreme stress to entirely change their processes for settling trades in a long list of markets, including but not limited to equities.  Perhaps even more important, retail investors, many of whom don’t have pre-funded accounts or still use checks, would be required to alter their behavior.

Additionally, T+0 would likely result in more failed trades in the system.  Fails are caused by incorrect settlement instructions, trade details, or other human errors and occur when settlement errors are not corrected in a timely manner before settlement date.  Compressing the settlement time to T+0 would expand the number of fails, as it takes time to repair fails.  In a T+0 environment there would be little or no time to make those repairs and more trades would fail.  This likely would be substantially exacerbated in a period of high volume and volatility.

Similarly, T+0 would impact firms’ regular compliance efforts to identify and root out cybercrime or fraud.  As securities and cash are exchanged, firms undertake standard validations and controls and the risk of doing so on a compressed timeframe won’t allow for proper vetting and safeguards.

The industry working group has identified many other critical areas which would be significantly impacted and become exponentially more challenging to manage during high volume, high volatility market periods in a T+0 environment, including:

  • Reengineered securities processing: T+0 settlement would require the redesign of many securities processing functions, including ETF processing, options and margin investing, and securities lending.
  • Securities netting: Significant changes to NSCC securities netting may be required in order to maintain the benefits that the process provides and may require large volumes of securities and cash to move throughout the trading day, which will likely increase the risk of trade errors and subsequent settlement fails.
  • Funding requirements: Funding trades would require foundational changes, such as requiring the Federal Reserve’s payment systems to maintain services for longer periods of time throughout the day to determine funding requirements between counterparties, particularly in order to post funding to clearinghouses to facilitate services. Further, we know from experience that market utilities, including the Fedwire, are not immune from outages, and an overly compressed settlement cycle would not allow for addressing such situations.
  • Impact on retail investors: Many retail investors submit payment after placing orders, and in fact some market participants report as many as 20% still make payment by paper check.  In a T+0 environment, retail investors would be required to deposit funds in trading accounts in advance of trading (pre-fund) given the time required to process ACH actions and wire transfers from consumer banks to securities accounts, potentially leaving cash in low-yielding investments.
  • Securities lending: The securities lending process, which supports useful investment alternatives and generates additional assets for shareholders in investment funds, would not be able to operate in a T+0 environment as it does today and would require an extensive overhaul, possibly resulting in less benefit to investors and shareholders.
  • Prime brokerage: Current prime brokerage processes are not set up to capture allocations, calculate margin requirements, and ensure margin accuracy prior to Fedwire deadlines on trade date, and facilitate trade reporting and disaffirmations given sequential dependencies between counterparties.
  • Global settlement: Like retail investors, foreign investors may be required to pre-fund cash positions and deposit securities prior to trading.  This could result in cash being underinvested, make the delivery securities more complicated and also riskier, and could make the U.S. markets less attractive to international investors.
  • Primary offerings, derivatives markets, and corporate actions: Ancillary securities processing activity related to secondary market trading will require reengineering to execute contracts and allocations across asset classes under compressed timeframes. Often, these processes span multiple trading days given their nuances and the legal and contractual obligations may not, and in the case of primary offerings cannot, be satisfied within the trading day window for end of day settlement.
  • Mutual funds: A move to T+0 would dislocate the settlement between the mutual fund’s portfolio securities transactions and the mutual fund’s shares transactions.  Since the mutual fund shares settle on a T+1 basis, a move to T+0 for the portfolio securities could result in cash from portfolio redemptions needing overnight investment while waiting to fund the proceeds of mutual fund share redemptions.  This can harm shareholders, as the cash is likely to receive very little earnings as compared to remaining fully invested in the market until the following day.  In a purchase scenario, the fund may need a source of funding for a day to complete settlement of portfolio security purchases while waiting for the cash from mutual fund share purchases the next day.  This funding requirement also may negatively impact the fund shareholders, as the cost for that overnight funding generally would be paid from mutual fund assets.  By moving to T+1 for the portfolio securities settlement, portfolio activity is perfectly aligned with mutual fund share activity, which removes the possibility of detrimental impacts due to timing for the mutual fund shareholders.

Many of these areas are foundational to the efficient and effective market structure that exists today.  The concept of T+0 or end of day settlement may indicate the appearance of maximum efficiency, but our analysis found that in fact it would introduce new operational risk and require fundamental changes and likely increase costs to investors.

Changing these fundamental businesses processes would totally transform the current settlement structure, one which has stood the test of time and operated effectively in both normal and volatile market conditions.  Accelerating the settlement cycle to T+1 is a complex undertaking with real benefits for investors and the markets.  Moving to T+0 could actually result in more risk, while fundamentally changing the investor market experience.

Kenneth E. Bentsen, Jr. is president and CEO of SIFMA, the voice of the nation’s securities industry. He is also chief executive officer of the Global Financial Markets Association (GFMA).