US move to T+1 puts pressure on Europe
At the end of May, the US will move to T+1 settlements, halving the time it takes for securities settlements to clear. The change has been heralded by Securities and Exchange Commission (SEC) chair Gary Gensler as hugely advantageous, offering a way to save money, lower risk, increase efficiency, boost liquidity, and promote resiliency[1]. But Europe, UK and Swiss regulators aren’t so sure that they’re ready to follow suit.
Gensler’s remarks came in a speech to the European Commission in which he urged the bloc to join him in “clearing out the market plumbing” of clearing and settlement.
“For those of you debating this in Europe, I think your market plumbing would benefit,” he said, after a speech in which he said events like restrictions on buying activity during the GameStop short squeeze would be less likely to happen in a shorter clearing cycle.
European investment community reserved on T+1 change
However, a recent report from the European Securities and Markets Authority (ESMA) on responses to the same move in Europe showed a mixed reaction to the prospect[2]. ESMA said that there was “a strong demand for a clear signal from the regulatory front at the start of the work and clear coordination between regulators and the industry” if the change was to be adopted. But its report also pointed out that respondents were concerned about operational impacts beyond simple adaptations.
“Several respondents suggested that a shorter settlement cycle would directly reduce the available liquidity, due to the impact on market makers. The reduced time frame to locate and borrow financial instruments when short-selling would reduce their capacity to hedge certain instruments and ultimately imply higher spreads,” the report said.
Interestingly, another of the reasons that the investment community is hesitant is due to the difference in settlement periods between the UK and the EU - an issue that’s already going to be present in the upcoming difference between the US and the EU. Participants argued that misaligned settlement cycles between financial instruments or between the EU and the UK could increase the risk of failed trades and would directly impact market makers’ ability to hedge their positions.
Risks in misalignment
The European Fund and Asset Management Association (EFAMA) has already warned that there will be issues when the US clearing schedule changes. Research from the body found that up to 40% of European fund managers’ daily FX flows might have to settle outside the protection of the CLS platform[3]. On a regular trading day, this could mean up to USD50-70 billion, but in volatile markets, the figure could reach the hundreds of billions.
“Increased FX settlement risk carries systemic implications as previous episodes in history have shown,” EFAMA warned.
EFAMA is talking about Herstatt risk, the settlement risk associated with trading FX across different timezones. Herstatt was a German regional bank whose insolvency in 1974 caused a major chain reaction across global payment and settlement systems. The bank had racked up losses from short positions against the US dollar in forward contracts and when the Bundesbank was persuaded it couldn’t be saved, it was shut down. Unfortunately, the bank was closed at 4.30pm in Germany, which was 10.30am in New York. Herstatt had already taken on FX claims in European time but hadn’t made the US dollar transfers to counterparties in New York, causing a panic[4].
Herstatt risk is mitigated today by the CLS platform, which uses a payment-versus-payment (PvP) system so two counterparties can trade exchange payments simultaneously. But with the misaligned settlement periods, around 40% of European fund managers would not have been able to get their trades into CLS by its internal deadline, according to the EFAMA’s survey of Q1 2024.
The pressure to keep up
Once the US makes the move, half of the world’s capital markets will settle on T+1, including India, Israel and parts of Asia. But the EU is somewhat caught in the middle, as it doesn’t want to misalign with the capital markets union, so it needs to coordinate with the UK and Swiss regimes.
In the UK, the Accelerated Settlements Taskforce is currently assessing the move to T+1 and a full report and recommendations are expected by the end of the year[5]. Switzerland is also analysing the move and has indicated that it wants to try to coordinate with the EU.
Given the risks with misalignment, it may be a question of when, not if, Europe moves towards T+1. But it’s a significant logistical challenge because of the greater number of exchanges, clearers, and settlement houses in Europe compared to the US.
ESMA has said that it still needs to assess and better understand “the impacts on securities lending and borrowing, market making, and the repo market; FX trading; cross-border activities; corporate actions standards; and, benefits resulting from margin reductions for cleared transactions”[6]. It expects to publish a full report on the potential move by 17 January 2025.
Bibliography
[1] SEC “Time is Money. Time is Risk” Prepared Remarks before the European Commission
[2] ESMA Feedback statement of the Call for evidence on shortening the settlement cycle
[3] EFAMA US move to T+1 creates FX settlement risks for European asset managers
[4] Oxford Academy Summer in the City: Banking Failures of 1974 and the Development of International Banking Supervision
[5] GOV.UK Accelerated Settlement Taskforce
[6] ESMA Feedback statement of the Call for evidence on shortening the settlement cycle
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