Should Europe join the race towards shorter settlement cycles?
28 Sep 2022
AFME’s manager of post-trade, Pablo Garcia outlines how a transition from T+2 to T+1 would represent both a considerable time constraint and model shift for Europe’s financial services industry
Image: AFME
Significant technological advances have changed the way we work, live, and interact. This is no different for securities markets, where the industry continues to seek opportunities to improve efficiency through advancements in technology and standardisation. Recently, for example, the US, Canada, and India announced their intentions to shorten settlement cycles to one business day (T+1), while most securities transactions are currently settled within two business days.
The US and Canada plan to adopt T+1 in what is understood to be a ‘Big Bang’ implementation in late 2024. The move to accelerated settlement cycles is seen as a way to lower risks to financial systems and drive greater efficiencies in post-trade processes. The question arises as to whether Europe should follow suit.
The European region is characterised by a multitude of currencies, market infrastructures, and distinct legal frameworks. Compared to the US, Canada, or India, which are single national markets, Europe’s capital markets are notable for their diversity, the complexity of their legal, fiscal and regulatory frameworks, and for their large number of regulatory, supervisory, and infrastructure bodies.
These structural differences have historically brought challenges when it comes to the harmonisation and efficiency of post-trade in European financial markets, making the adoption of T+1 in Europe a more complex proposition.
The case for and against T+1 settlement cycles in Europe is not straightforward. While many of the benefits of the US adopting T+1 stand for Europe, there are simply more complexities to consider.
What is a settlement cycle?
Simply explained, a settlement cycle is the time period between transaction agreement execution by a buyer and a seller (the trade date) and transaction completion, where securities and cash are exchanged (the settlement date). This process is not much different to that of any other commercial transaction that may occur across a shop counter.
However, while in a shop the transfer of cash and goods happens simultaneously, the settlement process of securities transactions occurs at a different time to the execution of the trade. There is a window between trading and settlement which allows for several important processing steps to take place, ensuring a high degree of control and efficiency, as is required for processing high volumes and values of securities transactions.
European markets were operating on a three business-day settlement cycle (T+3) until 2014, when the majority of European markets adopted a two business-day approach (T+2) in preparation for the direct application of Article 5 of the Central Securities Depositories Regulation (CSDR).
The US followed suit and adopted T+2 in 2017. Over the years, advancements in technology and standardisation have allowed for this window to be reduced.
More efficient and competitive capital markets
There are immediate benefits to Europe moving to T+1. Reducing risk is a notable example, which the US has cited as one of its main reasons for moving to T+1. In recent years, capital markets have been characterised by periods of significant increases in trading volume and volatility, increasing levels of counterparty risk. Reducing the number of days between trade execution and settlement could lead to a reduction of risk across the settlement ecosystem, especially during periods of market volatility.
By reducing firms’ open exposures over the settlement period, there will also be a reduction in costs. Decreasing the margin requirements could lead to market participants better managing capital and liquidity risk.
Modern capital markets are becoming more accessible than ever, with much of the transactional world moving towards real-time operations, and many emerging asset classes – such as crypto-currencies – offering investors instant settlement. Against this background, T+1 settlement may contribute towards the continued attractiveness and relevance of traditional financial markets.
Settlement cycles have gradually reduced over time, driving further advancement in post-trade efficiency at each stage. The adoption of T+1 would necessitate renewed industry focus to automate manual processes, and to create and adopt industry standards.
Significant challenges for Europe
A transition from T+2 to T+1 would represent a considerable time constraint and model shift, because there would be significantly fewer hours between trading and the beginning of the settlement cycle for post-trade operational processes. There are many post-trade activities that need to take place between the close of trading and the beginning of settlement. Being able to modify systems and processes to accomplish all of these activities during a shorter time frame will be a serious undertaking. The compressed timeline for the completion of operational processes, as well as the reduced opportunity to complete securities lending transactions to cover short positions, could potentially lead to an increase in the number of settlement fails in the market. At a regulatory level, these failures could incur cash penalties under CSDR rules, as well as having risk-weighted assets implications under Basel III requirements.
A compression of the settlement cycle would create operational complexities for all firms transacting in European securities markets, but in particular for investors from other regions, for whom time zone differences will impact the possibility of same-day matching processes and vastly reduce the time available to communicate and resolve any breaks or exceptions.
Industry collaboration is the next step
Before making any decisions on the future of settlement cycles, Europe needs to do some preparation. One of the first steps should be to conduct an industry-wide consultation to identify and quantify the potential challenges, followed by a robust cost-benefit analysis. It will also be crucial for global market participants to give their feedback to ensure that a migration to T+1 will not hurt the competitiveness of European markets, or diminish their attractiveness to global investors. The interconnected and complex nature of European capital markets shows how challenging it might be to implement a shorter settlement cycle in Europe. The barriers to timely settlement on a T+2 basis need to be fully understood and overcome before moving to T+1 in order to avoid exacerbating existing issues.
Successful implementation will depend on a high degree of coordination and agreement from all stakeholders. Ideally, a cross-industry taskforce, with representation from all market participants, should be established to drive forward the initiatives. A rushed or uncoordinated approach could result in increased risks, costs, and inefficiencies in European capital markets.
The US and Canada plan to adopt T+1 in what is understood to be a ‘Big Bang’ implementation in late 2024. The move to accelerated settlement cycles is seen as a way to lower risks to financial systems and drive greater efficiencies in post-trade processes. The question arises as to whether Europe should follow suit.
The European region is characterised by a multitude of currencies, market infrastructures, and distinct legal frameworks. Compared to the US, Canada, or India, which are single national markets, Europe’s capital markets are notable for their diversity, the complexity of their legal, fiscal and regulatory frameworks, and for their large number of regulatory, supervisory, and infrastructure bodies.
These structural differences have historically brought challenges when it comes to the harmonisation and efficiency of post-trade in European financial markets, making the adoption of T+1 in Europe a more complex proposition.
The case for and against T+1 settlement cycles in Europe is not straightforward. While many of the benefits of the US adopting T+1 stand for Europe, there are simply more complexities to consider.
What is a settlement cycle?
Simply explained, a settlement cycle is the time period between transaction agreement execution by a buyer and a seller (the trade date) and transaction completion, where securities and cash are exchanged (the settlement date). This process is not much different to that of any other commercial transaction that may occur across a shop counter.
However, while in a shop the transfer of cash and goods happens simultaneously, the settlement process of securities transactions occurs at a different time to the execution of the trade. There is a window between trading and settlement which allows for several important processing steps to take place, ensuring a high degree of control and efficiency, as is required for processing high volumes and values of securities transactions.
European markets were operating on a three business-day settlement cycle (T+3) until 2014, when the majority of European markets adopted a two business-day approach (T+2) in preparation for the direct application of Article 5 of the Central Securities Depositories Regulation (CSDR).
The US followed suit and adopted T+2 in 2017. Over the years, advancements in technology and standardisation have allowed for this window to be reduced.
More efficient and competitive capital markets
There are immediate benefits to Europe moving to T+1. Reducing risk is a notable example, which the US has cited as one of its main reasons for moving to T+1. In recent years, capital markets have been characterised by periods of significant increases in trading volume and volatility, increasing levels of counterparty risk. Reducing the number of days between trade execution and settlement could lead to a reduction of risk across the settlement ecosystem, especially during periods of market volatility.
By reducing firms’ open exposures over the settlement period, there will also be a reduction in costs. Decreasing the margin requirements could lead to market participants better managing capital and liquidity risk.
Modern capital markets are becoming more accessible than ever, with much of the transactional world moving towards real-time operations, and many emerging asset classes – such as crypto-currencies – offering investors instant settlement. Against this background, T+1 settlement may contribute towards the continued attractiveness and relevance of traditional financial markets.
Settlement cycles have gradually reduced over time, driving further advancement in post-trade efficiency at each stage. The adoption of T+1 would necessitate renewed industry focus to automate manual processes, and to create and adopt industry standards.
Significant challenges for Europe
A transition from T+2 to T+1 would represent a considerable time constraint and model shift, because there would be significantly fewer hours between trading and the beginning of the settlement cycle for post-trade operational processes. There are many post-trade activities that need to take place between the close of trading and the beginning of settlement. Being able to modify systems and processes to accomplish all of these activities during a shorter time frame will be a serious undertaking. The compressed timeline for the completion of operational processes, as well as the reduced opportunity to complete securities lending transactions to cover short positions, could potentially lead to an increase in the number of settlement fails in the market. At a regulatory level, these failures could incur cash penalties under CSDR rules, as well as having risk-weighted assets implications under Basel III requirements.
A compression of the settlement cycle would create operational complexities for all firms transacting in European securities markets, but in particular for investors from other regions, for whom time zone differences will impact the possibility of same-day matching processes and vastly reduce the time available to communicate and resolve any breaks or exceptions.
Industry collaboration is the next step
Before making any decisions on the future of settlement cycles, Europe needs to do some preparation. One of the first steps should be to conduct an industry-wide consultation to identify and quantify the potential challenges, followed by a robust cost-benefit analysis. It will also be crucial for global market participants to give their feedback to ensure that a migration to T+1 will not hurt the competitiveness of European markets, or diminish their attractiveness to global investors. The interconnected and complex nature of European capital markets shows how challenging it might be to implement a shorter settlement cycle in Europe. The barriers to timely settlement on a T+2 basis need to be fully understood and overcome before moving to T+1 in order to avoid exacerbating existing issues.
Successful implementation will depend on a high degree of coordination and agreement from all stakeholders. Ideally, a cross-industry taskforce, with representation from all market participants, should be established to drive forward the initiatives. A rushed or uncoordinated approach could result in increased risks, costs, and inefficiencies in European capital markets.
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