In December 2015, the “T+2 Industry Steering Committee” published its Implementation Playbook. The Playbook is intended to provide, among other things, a timeline and milestones that market participants should consider in order to migrate to a two-day settlement cycle for different securities. The migration is intended to be completed by the end of the third quarter of 2017.
In this article, we discuss a few aspects of T+2 settlements especially relevant to structured notes.
Impact on Initial Issuances
First, the Playbook is principally directed at secondary market trades. (Similarly, SEC Rule 15c6-1 governs sales in the secondary market.) However, for many transactions, a change in the settlement cycle for secondary market trades is likely to trigger a similar change for the initial settlement. This arises from the fact that, even though structured notes are usually designed to be “buy and hold” instruments, it is possible that an investor may seek to sell a structured note on the same date that the investor agreed to purchase it or shortly thereafter. In order to facilitate the closing of the secondary sale, some market participants will conform the time period for the initial settlement to that of the secondary market.
Benefits of T+2 Initial Settlement
Many believe that a T+2 settlement cycle is likely to yield benefits to the investment community, including reduced credit and counterparty risk, operational process improvements, cash deployment efficiencies, increased market liquidity, lower collateral requirements, and enhanced global settlement harmonization (as discussed in the Playbook).
In the area of structured notes, the shorter settlement period may somewhat reduce the disparity between the level of a reference asset on the pricing date and its level on the settlement date. Similarly, the issuer’s “initial estimated value” of the notes on the pricing date will possibly align more closely with the value on the settlement date. An issuer that keys its blackout period to settlement dates, as opposed to only the pricing date, will obtain one more day in which notes may be offered.1
Many Offerings Currently Close on a T+2 Basis
We note that many structured note offerings currently close on a T+2 basis. (And T+1 is not entirely unheard of either.) Offerings typically close on this schedule when they price towards the end of the month, and the parties wish to complete the settlement by month-end. This often occurs in the case of reverse inquiry transactions that are arranged near month-end, and the timing of the parties’ meeting of the minds as to the terms of the notes does not permit the offering to close by month-end if a T+3 schedule is used. Many broadly-marketed “calendar offerings” also close on this schedule as well. Accordingly, a T+2 settlement cycle would not be completely new to the structured note market.
Platforms Structured Without Regard to the T+3 Cycle
Of course, many offerings currently close on a T+5 schedule (or longer settlement cycle), and some broker-dealer manufacturers of structured notes have T+5 as a default schedule for most of their offerings. These market participants may or may not wish to reduce their typical settlement cycle if and when T+2 becomes the law of the land. It is unlikely that they will be required by any new regulations to make such a change.
Impact on Valuation Dates and Observation Dates?
To the extent that the settlement cycle changes, some market participants may seek to shorten other time periods relevant to structured notes. For example, the standard periods between (a) interest observation dates and interest payment dates and (b) final valuation dates and maturity dates may be shortened as well to match the new T+2 cycle. However, issuers, calculation agents and paying agents will need to review carefully their procedures and capabilities before making any changes of this kind.
Towards a Quicker Settlement Cycle
Shortening the settlement cycle by one business day adds a bit of urgency to ensuring that all necessary documents and signatures required for settlement are ready for use. Initial drafts of any relevant forms of notes, officer certificates, legal opinions and closing instructions will need to be accelerated accordingly, and members of the working group will be encouraged, when practicable, to have these pieces in motion before pricing occurs.
In many cases, the final pricing supplement is itself a “closing document.” This can occur when the form of pricing supplement is attached to a form of note for the issuance in order to incorporate by reference the economic terms into the note. Alternatively, a program may utilize a “master note” form, which contemplates a single note for an entire MTN series, with each relevant pricing supplement forming a part of that master note. In these cases, a T+2 settlement cycle would mean that the final pricing supplement must be ready for use approximately one-and-a-half business days after the pricing, since the settlement will occur on the morning of the second business day after the pricing.
The change to the settlement cycle may encourage more issuers to utilize the master note format, as there will likely be fewer documents to create and complete during a shorter settlement window. In addition, the master note format does not require an officer’s signature on the note itself.
Market participants will need to review carefully their document suite and procedures to ensure that any accelerated closings will be completed smoothly under the new regime.