The U.S. Securities and Exchange Commission (SEC) on March 22, 2017 adopted amendments to Rule 15c6- 1(a) under the Securities Exchange Act of 1934 (Exchange Act), to shorten the standard settlement cycle for securities transactions by broker-dealers from three business days after the trade date (T+3) to two business days following the trade date (T+2).1 The amendments are a response to changes in markets, technology, operations and infrastructure since the T+3 requirement was put in place in 1993. The amendments are intended both to reduce credit, market and liquidity risk (thereby reducing systemic risks) and to encourage technological development (to further reduce settlement times in the future). The amendments become effective May 30, 2017, with a compliance date for broker-dealers of September 5, 2017.
The process of modern clearance and settlement has its roots in the so-called “paperwork crisis” of the late 1960’s,2 to which the industry and Congress responded with a series of measures designed to eliminate problems that had caused the crisis and reduce risks in the settlement process.
The industry responded with increased automation and computerization as well as the 1973 creation of the Depository Trust Corporation (DTC), which provides: centralized, electronic recordkeeping; trading of uncertificated securities; and book-entry clearance and settlement. Congress acted to supervise and regulate the clearance and settlement process in 1975 amendments to the Exchange Act (1975 Amendments), providing the SEC with oversight and regulatory authority over clearance and settlement entities and mandating the establishment of a national clearance and settlement system. The National Securities Clearing Corporation (NSCC), established in 1976 as a result, acts as the central counterparty (CCP) for most securities transactions. Together, DTC and NSCC form the main infrastructure for U.S. securities market clearance, counterparty and settlement systems, and eliminate many of the problems that led to the paperwork crisis.
By the 1990’s, the SEC had determined that significant counterparty risk was created by the then-prevailing T+5 settlement cycle and reasoned that resilience and efficiency in the clearance and settlement system could be enhanced by reducing transaction settlement time. The SEC first acted to establish a mandatory settlement cycle by adopting Exchange Act Rule 15c6-1 in 1993, which shortened the settlement cycle to T+3. More than a decade later, in 2004, the SEC published a concept release seeking comment on the possibility of an even briefer settlement cycle, as well as methods to facilitate the transition to straight-through processing (STP), a proposed method of fully automating the trade process, allowing for ever-greater speed and efficiency.3
Congress took further action to regulate the national clearing and settlement systems with the Payment, Clearing and Settlement Supervision Act in 2010, which designated registered clearing agencies providing CCP or central securities depository (CSD) services as “financial market utilities” (FMUs). As described in the Adopting Release, FMUs “centralize clearance and settlement activities and enable market participants to reduce costs, increase operational efficiency and manage risks more effectively.” This 2010 Act also generally requires the registration of intermediaries providing “matching” services – the Matching/Electronic Trade Confirmation (ETC) Provider effects trade settlement by comparing a broker-dealer’s trade details with an institutional investor’s instructions, and generating a trade confirmation if the pair matches.
T+2: Effects on Markets and Market Participants
First proposed in September 2016,4 the amended Rule 15c6-1 requires that securities (including stocks, corporate bonds, unit investment trusts, mutual funds, exchange-traded funds, American depository receipts, and options) are traded on the T+2 settlement cycle.5 This change to a T+2 settlement cycle is expected to significantly benefit financial markets and individual market participants, albeit with certain limited potential downsides.
T+2 is expected to reduce several types of risk for CCPs, including the following:
- Credit Risk. Under the T+2 regime, risks to CCPs are expected to be lessened by the shortened time during which defaults can occur prior to a trade’s settlement. Reducing the time each party is exposed to its counterparty decreases the party’s exposure to the risk of its counterparty’s failure prior to settlement. Further, the faster turnaround should free CCP resources to meet settlement obligations, reducing the CCP’s own credit risk.
- Market Risk. The T+2 regime is expected to reduce the market risk experienced by all market participants, as the shortened time between order execution and settlement decreases the risk of price volatility while a trade is awaiting settlement.
- Liquidity Risk. The shortened time between order placement and settlement – and corresponding credit and default risk reduction – should make it less likely that a CCP will have to deploy its own resources to meet settlement obligations.
Broker-dealers that are CCP members are also expected to experience trade cost and risk reductions under T+2. In particular, because CCPs collect contributions from their members to offset the fails experienced by an individual member, reducing the number of fails is expected to result in a lower number of offsetting payments, and thus the amount necessary to be collected. Because a shorter settlement cycle decreases the number of unsettled trades at any one time, the chances of any trade failing are reduced for each trade, which may, in turn, lessen the amount of member contributions and result in lower trading costs overall.
Institutional and Retail Investors; Introducing Brokers
Institutional and retail investors as well as introducing brokers may expect a net benefit from a reduction of liquidity risk and the corresponding associated costs. Further, all investors should benefit from faster access to securities and funds, together with reduced margin charges.
- Institutional Investors. Institutional investors are expected to benefit from shrinking the “funding gap” that results from mismatched settlement cycles. Most mutual funds will directly benefit, as they currently operate with a settlement cycle for their portfolio securities of T+3, but typically settle shares issued to investors on the business day after the trade is made (T+1) due to NSCC requirements.6 This disparity in settlement times leaves a “funding gap” because a mutual fund is required to pay out to investors faster (on T+1) than it is able to receive cash for liquidated securities (on T+3) – thus requiring a mutual fund to maintain additional cash or else run the risk of being unable to pay redemptions when due. Reducing the settlement cycle for portfolio securities to T+2 should improve capital management and reduce liquidity and redemption risks for mutual funds. However, institutional investors will also want to review their own trade affirmation processes to ensure they have the operational capabilities to transition smoothly to a T+2 environment.
- Retail Investors. The Adopting Release notes that individual investors who use paper checks to pay for transactions may be affected under the new regime, by being pressured to use electronic payment transfer systems that may introduce those investors to new risks and costs. While acknowledging this concern, the SEC believes that the benefits for individual investors in risk reduction, reduced costs, and faster access to funds and securities following execution, outweigh any potential downside.
Ancillary and Systemic Benefits
The shorter settlement cycle would also provide the benefit of harmonizing U.S. markets with other countries that already have moved to T+2 or plan to do so.7 Further, by reducing the total volume and value of outstanding unsettled trades at any one moment, the shorter settlement cycle should better insulate the financial sector from systemic consequences and market disruptions should an individual counterparty fail. In addition, the Adopting Release expresses the SEC’s belief that the shorter settlement period would allow for the further development of the technology, operations and market infrastructure necessary to continue to even shorter settlement times – thereby providing additional benefits of the kind afforded by the transition to T+2, and eventually paving the road to STP.
Further Effects of the T+2 Settlement Cycle
Certain parties and transactions will be unaffected by the move to T+2. For instance, mutual funds that currently settle redemptions to investors on T+1 will be substantially unaffected by the change, other than to the extent the shortened trading cycle reduces the funding gap, decreases costs across the financial system and reduces systemic financial risk.
In addition, although T+2 does not change the language of the “override provision” of Rule 15c6-1, concern was expressed by commenters regarding the application of this provision going forward. The override provision of Rule 15c6-1(a) and (d) permits broker-dealers to set a settlement date for a given transaction beyond the mandatory cycle in certain circumstances, provided the parties expressly agree at the time of the transaction. In the Proposing Release, the SEC stated that the override provision was intended to apply only to “unusual transactions.” However, as noted in the SIFMA Comment Letter responding to the Proposing Release, the override provision is not used solely in “unusual” circumstances, but is a part of regular market practice for certain primary firm commitment offerings, particularly convertible debt, preferred equity, options on securities and fixed income offerings. The SEC clarified, however, that the statement in the Proposing Release applies only with respect to the override provisions of Rule 15c6-1(a) (regarding general override provision for extended settlement) and not to Rule 15c6-1(d) (which applies specifically to the types of firm commitment offerings regarded as market practice in the SIFMA Comment Letter).
T+2 will also influence compliance with other SEC Rules. In particular, Regulation SHO imposes certain obligations based on the trade or settlement date. For instance, moving to T+2 will shorten the turnaround time for loaned, but recalled, securities. Such a change would also accelerate close-out periods in Rule 204. The SEC, however, has clarified that recalls initiated by no later than the day before the settlement date allow a sale to be marked “long,” provided the seller is otherwise net long under Rule 200(c) – this should ensure that loaned, but recalled, securities are available by T+4. T+2 may also change a broker-dealer’s responsibilities under certain financial responsibility rules (such as Exchange Act Rule 15c3-3) – this will mean that a broker-dealer must obtain possession and control of customer securities or close out a transaction in 12 days, rather than 13 days.
Disaffirmations by prime brokers will be accelerated under the move to T+2. Under the Prime Broker no-action letter,8 prime brokers have the right to “disaffirm” all previously affirmed institutional trades of a customer reported by an executing broker for clearance and settlement. This disaffirmation may occur until the settlement date. Accordingly, beginning in September, prime brokers’ disaffirmations will be accelerated.
Finally, it is unlikely that the move to T+2 will require broker-dealers to change practices under Exchange Act Rule 10b-10. This rule requires broker-dealers to send trade confirmations to a customer “at or before the completion of the transaction.” While acknowledging that the T+2 settlement cycle gives broker-dealers a shorter timeframe in which to comply with the requirements of Rule 10b-10, the SEC noted that most brokers already send electronic trade confirmations on the trade date or physical confirms on T+1, and thus the change to T+2 should not affect current practices.