For most market participants, the primary impact of the move to a T+2 settlement cycle will be changes to operational procedures and practices.

On March 22, the Securities and Exchange Commission (SEC) adopted a rule amendment that will shorten the standard settlement cycle by one business day for most broker-dealer securities transactions. The standard settlement cycle for these transactions is currently three business days, which is known as T+3. Amended Rule 15c6-1(a) shortens the settlement cycle to two business days, which will be known as T+2. The amendment does not change the settlement cycle for cash-only firm commitment offerings, such as traditional public offerings of equity or debt securities by issuers.

When Is the Compliance Date?

Broker-dealers will be required to comply with the amended rule beginning on September 5, 2017, and, in turn, they will require their customers to comply with the amended rule by that date.

Why the Amended Rule?

According to the SEC, the amended rule is intended to reduce credit, market and liquidity risk in the public securities markets and should result in a reduction in systemic risk for U.S. market participants. In particular, the change to T+2 should reduce both the number of unsettled trades and the average time a trade remains unsettled, which will reduce risks both for clearing agencies and central counterparties, such as the Depository Trust Company, and for their participants, such as broker-dealers. This reduction in risk may permit a reduction in the collateral that is posted as part of the trade settlement process, which would make executing securities trades more capital efficient. In addition, faster settlement periods should result in faster “cash in hand” to sellers of securities.

The amended rule will also reduce certain timing mismatches in the securities industry. There are a number of financial products in the United States that currently settle on a shorter cycle than T+3. For example, most mutual funds settle on a T+1 basis and are subject to a liquidity mismatch between the time they must settle with their own redeeming investors and the time they receive cash from the related sale of their own securities holdings. The SEC also noted that a number of foreign markets are current T+2 and that, by aligning settlement cycles, efficiencies should result.

What Is “Settlement”?

When you buy or sell securities, “settlement” means the legal transfer of securities to the buyer’s account and cash in payment to the seller’s account. At the time the trade settles, the buyer either must have sufficient cash on deposit with its broker to pay for the securities or must have a financing arrangement in place with its broker, such as a margin account. Since 1993, the settlement cycle — the time between the transaction date and the settlement date — for most securities transactions has been three business days, often referred to as T+3. Under T+3, if you sold securities on Monday, the transaction would settle on Thursday. Under T+2, if you sold shares on Monday, the securities would settle on Wednesday.

What Will Change?

The settlement cycle for most securities transactions will shorten by one day. This has a number of implications for other aspects of the securities markets. The amended rule is styled as a prohibition of a broker-dealer’s effecting or entering into a contract for the purchase or sale of a security that provides for payment of funds and delivery of securities later than T+2, unless otherwise expressly agreed to by the parties at the time of the transaction. In effect, unless otherwise agreed, purchases or sales of securities will settle on T+2, and, for securities law purposes, “settlement date” will generally mean T+2. Parties will be able to agree to longer settlement cycles if they so desire. The new T+2 requirement does not apply to certain categories of securities, including mutual funds and securities defined as “exempted securities” under the Securities Exchange Act of 1934, such as securities that are guaranteed by the U.S. government.

Does the Change Impact Other Rules and Processes?

A number of other Exchange Act and Securities Act of 1933 rules use “settlement date” and will be impacted by the amended rule. These include:

  • various aspects of Regulation SHO (the rules governing short sales), such as the date by which a fail-to-deliver must be closed out under Rule 204 (including with respect to a short sale) and the time within which a loaned security must be recalled in order for a sale of the security to be marked “long” under Rule 200(g)

  • certain broker-dealer financial responsibility and customer protection rules, such as the date by which a broker-dealer must close out a customer sell order under Rule 15c3-3 if the customer has not yet delivered the securities (the permissible window will be effectively shortened from 13 business days to 12 business days).

If you utilize the services of a prime broker to settle trades executed away from the prime broker by an executing broker, the new use of T+2 settlement will change various timing aspects of the affirmation and settlement process. In particular, prime brokers may require trades to be affirmed by you within a shorter window than they currently permit. You may want to contact your prime broker before the switch to T+2 is effective in order to conform your processes. According to the adopting release for the amended rule, the SEC is considering whether changes are necessary with respect to prime brokerage procedures and whether related changes are necessary to the well-known “prime brokerage letter,” which is relied on by the securities industry for regulatory guidance with prime brokerage.

Pepper Points

  • For most market participants, the primary impact of the move to a T+2 settlement cycle will be changes to operational procedures and practices.

  • We urge buy-side clients to contact their prime brokers and dealers to determine whether any modifications must be made to their operations and procedures. It is possible that modifications will be required to software and other systems that may take time to implement.

  • We encourage those thinking about T+2 and other securities trading issues to speak with experienced regulatory counsel to discuss possible concerns in greater detail. Pepper Hamilton can help.