All counterparties in the equity derivatives market should be aware that the International Swaps and Derivatives Association, Inc. (“ISDA”) opened the ISDA 2017 OTC Equity Derivatives T+2 Settlement Cycle Protocol (the “T+2 Protocol”) for adherence on July 28, 2017. The T+2 Protocol is designed to facilitate the amendment of existing confirmations for certain OTC equity derivatives transactions to adjust the settlement cycle from T+3 to T+2 for certain referenced underlying securities. The amendment is necessary to align settlement cycles under OTC equity derivatives transaction with the new settlement cycle for securities traded in the United States, Canada, Mexico and Peru scheduled to occur on September 5, 2017.
In 1995, the settlement cycle for most securities traded in the U.S. was reduced from five business days after the trade date (T+5) to T+3. In recent years, financial industry participants have assessed the viability of further shortening the standard settlement cycle for securities in order to reduce operational risk and better mitigate systemic risk. In 2014, the Depository Trust Clearing Corporation announced the formation of an Industry Steering Committee comprised of service providers and buy-side and sell-side participants to move the implementation of "T+2" as a standard settlement cycle forward1.
Following consideration of a proposed rule, in March 2017 the Securities and Exchange Commission, with strong industry consensus, adopted an amendment to Rule 15c6-1 (a) to shorten the standard settlement cycle from three business days to two business days2. As amended, the rule will, effective September 5, 2017, prohibit a broker-dealer from entering a trade for the purchase or sale of securities (including corporate bonds and equities, but excluding U.S. Treasuries) that provides for settlement after T+2. The change will align the settlement cycle in the U.S. with that in Europe and much of Asia.
ISDA T+2 PROTOCOL
The move to a T+2 settlement cycle will necessitate amendments to confirmations and master confirmation agreements for many OTC equity derivatives transactions to ensure alignment with any underlying hedge transactions. OTC equity derivatives transaction documentation typically references "Cash Settlement Payment Dates" or "Settlement Dates" as three "Determination Days" after a "Valuation Reference Day". The reference to three Determination Days reflects that the underlying securities would be expected to settle in three business days.
The T+2 Protocol operates like other ISDA protocols by providing a market-wide platform for derivatives market participants to efficiently amend relevant trading documentation. The T+2 Protocol facilitates such amendments on a multilateral basis and is comparable in structure to prior ISDA protocols.
The T+2 Protocol applies to transactions that meet the following characteristics:
- incorporate the 2002 ISDA Equity Derivatives Definitions;
- relate to a single share, basket of shares, index, basket of indices or basket of shares and indices;
- has at least one exchange or quotation system which is located in the United States, Canada, Mexico or Peru;
- do not relate to a single index or basket of shares, indices or shares and indices for which any exchange or quotation system (other than those located in the United States, Canada, Mexico or Peru) has a standard settlement cycle longer than T+2; and
- is not confirmed using MarkitWire or any other service under MarkitSERV.
Pursuant to the T+2 Protocol, relevant references to "three" in relation to Determination Days are replaced by "two". The amendments under the T+2 Protocol apply only to transactions entered into before September 5, 2017.
RECOMMENDED NEXT STEPS
Prior to September 5, 2017, market participants should review their trading documentation for OTC equity derivatives transactions to determine if they wish to adhere to the T+2 Protocol. Given the short timeframe involved - and the fact that personnel is often short handed in August - we recommend that firms consider adherence as soon as possible. More broadly, middle office and operations professionals at firms should ensure that processes are in place to allow for securities settlement in accordance with the impending shortened settlement cycle.