Meeting the challenge of T+1
13 Dec 2023
Whether you operate funds with a US tilt or purely domestic funds, the shortening of settlement cycles across the financial sector is inevitable.
Image: Calastone’s & ISITC
The end of May 2024 has taken on a new significance for the UK’s fund management industry. It is then that North America’s securities market will shorten their settlement timeframe from trade date plus two days (T+2) to trade date plus one (T+1).
That poses a challenge at two levels. First, how can fund managers telescope the processing of their trading in US shares into a much-shortened timeframe; and second, how should they deal with an increasing mismatch between the securities settlement cycle and their own funds’ subscription and redemption cycles?
Shift from credit risk to operational risk
The thinking behind the move is that this will shorten market participants’ exposure to counterparty risk, prompt greater efficiency and lift liquidity. Brokers and custodians will benefit by having to put up less margin in the settlement system. It will also lower their capital requirements.
But, in a SWIFT Institute paper published earlier this year, titled ‘Industry Preparedness for Accelerated Settlement’, the authors commented: “Fund managers outside the T+1 migration regimes struggle to see how the benefits accruing to brokers and custodians will reach them and their customers, while they see themselves as facing new operational costs and new operational risks.”
Just to add to the pressure, both the UK and the EU are debating whether to follow the US example and move to a T+1 settlement timeframe. A UK taskforce is due to report on this by December 2023.
Gary Wright, one of the authors of the SWIFT paper, says: “Many in the market hope that the taskforce will keep the UK aligned with Europe on T+2. But there may be a political push to differentiate the UK from Europe.”
Pressure to telescope settlement process
How big a challenge will this be for UK fund managers? For those with US-focused or global funds, the window for affirming and reconciling US trades will be desperately short. They may well need a late-night team in place to manage the process.
Then there is the problem of getting dollars in place for new investment when foreign exchange normally takes two days to settle. Selling a UK or European equity in a T+2 settlement cycle and reinvesting the proceeds into the US at T+1 will pose problems. Firms will either have to settle for being out of the market for a time or prefunding the US purchase.
There may be a premium on having a ready source of dollars stateside. Custodians may come up with solutions, stock lending among them.
But the SWIFT paper highlighted the manual and ad hoc processes often relied on here and the tight recall window required.
There are big issues for the exchange-traded fund (ETF) market, too. Gary Wright adds: “If you change the settlement of the underlying, you also impact the derivatives. If an ETF has 40 per cent of its assets in the US on T+1 and the rest in T+2 markets, there will be a funding gap. Some will have FX exposures at T+2. There is cost and market risk here for the investor.”
Implications for the fund settlement cycle
Trading in the US on a T+1 timeframe materially increases the mismatch between the securities settlement cycle and funds’ own subscription and redemption cycles, commonly T+3 and sometimes T+4. Without a shorter settlement cycle, there will be a funding gap that will need to be covered by a cash float or credit line.
Fund managers will need to understand how each product is impacted and what contractual issues are implied by the move to T+1. Does the fund’s documentation allow borrowing? What additional charges and costs are involved? Clients will need to be made aware of any material changes.
There is a regulatory issue too. The Investment Association (IA) has pointed out that “redemptions can mean that the cash is held for additional days before being released to the investor, with potential Client Asset Sourcebook (CASS) considerations”.
CASS is a set of rules focusing on investor protection.
Holding onto, rather than releasing, investors’ cash for an extra day could run counter to the thrust of CASS.
The IA suggests that firms should transition funds with a heavy North American weighting to a T+2 fund settlement cycle by, or soon after, the end of May next year, and that firms should start work on transitioning the rest of their range to T+2 to ‘future proof’ a move to T+1 in UK equities. Firms currently operating on a T+4 cycle that are unable to move to T+2 should consider moving to T+3 “at a minimum”.
John Allan, head of the Innovation and Operations Unit at the IA, points out that firms that choose to transition only their US-centric funds to T+2, while leaving the rest on a T+3 cycle, will have funding issues if investors switch between funds.
“The settlement mismatch may require firms to fund the account in the meantime,” he says. All of this underlines the need for good liquidity management.
Liquidity takes centre stage
Fund settlement delays already require distributors or fund managers to fund cash shortfalls. Failure to keep up with the demands of T+1 will only magnify them.
John Read, founder and managing partner at Prodktr, a treasury specialist provider, says firms need a “centralised front-to-back platform with a single data source of truth”.
He adds that it is also important that someone has ownership of liquidity. “Too often, cash management sits somewhere between the chief investment officer and the chief operating officer.”
Clear visibility over cash becomes ever more essential.
Then there is the matter of ensuring the availability of cash or credit lines.
Traditionally, firms have either left a cash float or collateral with their custodian or agreed a facility with their bank that they can call on for intraday, or sometimes overnight, borrowing.
But credit has become tighter in the past couple of years, while smaller fund management companies may have limited scope for borrowing.
Certainty through automation
“All of this makes it essential that firms build certainty into their payments and settlements,” explains Steve Leggett. “That can only happen in an automated environment where they get a real-time view of what is coming in and going out from the trade date. They can then calculate the eventual settlement sums with near 100 per cent certainty, knowing all reconciliation issues have been dealt with and there can be no surprises on settlement day.”
In an automated environment, the number-juggling between systems is replaced by an automated trade-to-payment reconciliations process and automated management of payments. Once agreed, those payments must be locked in. Automation on this scale is a powerful tool in managing liquidity. “Imagine a world in which you had a clear sight of the cash and liquidity ladder,” Leggett continues. “There are many benefits, but I would say having an elegant way to manage your cash requirements must be at the top.”
Fund firms face tough decisions, given the limited time available to plan for T+1 and possibly to transition to a new subscription and redemption settlement cycle. They should avoid sticking plaster fixes in favour of fully automated settlement solutions that manage not only the demands of T+1 but future-proof the business against whatever else is thrown at it.
That poses a challenge at two levels. First, how can fund managers telescope the processing of their trading in US shares into a much-shortened timeframe; and second, how should they deal with an increasing mismatch between the securities settlement cycle and their own funds’ subscription and redemption cycles?
Shift from credit risk to operational risk
The thinking behind the move is that this will shorten market participants’ exposure to counterparty risk, prompt greater efficiency and lift liquidity. Brokers and custodians will benefit by having to put up less margin in the settlement system. It will also lower their capital requirements.
But, in a SWIFT Institute paper published earlier this year, titled ‘Industry Preparedness for Accelerated Settlement’, the authors commented: “Fund managers outside the T+1 migration regimes struggle to see how the benefits accruing to brokers and custodians will reach them and their customers, while they see themselves as facing new operational costs and new operational risks.”
Just to add to the pressure, both the UK and the EU are debating whether to follow the US example and move to a T+1 settlement timeframe. A UK taskforce is due to report on this by December 2023.
Gary Wright, one of the authors of the SWIFT paper, says: “Many in the market hope that the taskforce will keep the UK aligned with Europe on T+2. But there may be a political push to differentiate the UK from Europe.”
Pressure to telescope settlement process
How big a challenge will this be for UK fund managers? For those with US-focused or global funds, the window for affirming and reconciling US trades will be desperately short. They may well need a late-night team in place to manage the process.
Then there is the problem of getting dollars in place for new investment when foreign exchange normally takes two days to settle. Selling a UK or European equity in a T+2 settlement cycle and reinvesting the proceeds into the US at T+1 will pose problems. Firms will either have to settle for being out of the market for a time or prefunding the US purchase.
There may be a premium on having a ready source of dollars stateside. Custodians may come up with solutions, stock lending among them.
But the SWIFT paper highlighted the manual and ad hoc processes often relied on here and the tight recall window required.
There are big issues for the exchange-traded fund (ETF) market, too. Gary Wright adds: “If you change the settlement of the underlying, you also impact the derivatives. If an ETF has 40 per cent of its assets in the US on T+1 and the rest in T+2 markets, there will be a funding gap. Some will have FX exposures at T+2. There is cost and market risk here for the investor.”
Implications for the fund settlement cycle
Trading in the US on a T+1 timeframe materially increases the mismatch between the securities settlement cycle and funds’ own subscription and redemption cycles, commonly T+3 and sometimes T+4. Without a shorter settlement cycle, there will be a funding gap that will need to be covered by a cash float or credit line.
Fund managers will need to understand how each product is impacted and what contractual issues are implied by the move to T+1. Does the fund’s documentation allow borrowing? What additional charges and costs are involved? Clients will need to be made aware of any material changes.
There is a regulatory issue too. The Investment Association (IA) has pointed out that “redemptions can mean that the cash is held for additional days before being released to the investor, with potential Client Asset Sourcebook (CASS) considerations”.
CASS is a set of rules focusing on investor protection.
Holding onto, rather than releasing, investors’ cash for an extra day could run counter to the thrust of CASS.
The IA suggests that firms should transition funds with a heavy North American weighting to a T+2 fund settlement cycle by, or soon after, the end of May next year, and that firms should start work on transitioning the rest of their range to T+2 to ‘future proof’ a move to T+1 in UK equities. Firms currently operating on a T+4 cycle that are unable to move to T+2 should consider moving to T+3 “at a minimum”.
John Allan, head of the Innovation and Operations Unit at the IA, points out that firms that choose to transition only their US-centric funds to T+2, while leaving the rest on a T+3 cycle, will have funding issues if investors switch between funds.
“The settlement mismatch may require firms to fund the account in the meantime,” he says. All of this underlines the need for good liquidity management.
Liquidity takes centre stage
Fund settlement delays already require distributors or fund managers to fund cash shortfalls. Failure to keep up with the demands of T+1 will only magnify them.
John Read, founder and managing partner at Prodktr, a treasury specialist provider, says firms need a “centralised front-to-back platform with a single data source of truth”.
He adds that it is also important that someone has ownership of liquidity. “Too often, cash management sits somewhere between the chief investment officer and the chief operating officer.”
Clear visibility over cash becomes ever more essential.
Then there is the matter of ensuring the availability of cash or credit lines.
Traditionally, firms have either left a cash float or collateral with their custodian or agreed a facility with their bank that they can call on for intraday, or sometimes overnight, borrowing.
But credit has become tighter in the past couple of years, while smaller fund management companies may have limited scope for borrowing.
Certainty through automation
“All of this makes it essential that firms build certainty into their payments and settlements,” explains Steve Leggett. “That can only happen in an automated environment where they get a real-time view of what is coming in and going out from the trade date. They can then calculate the eventual settlement sums with near 100 per cent certainty, knowing all reconciliation issues have been dealt with and there can be no surprises on settlement day.”
In an automated environment, the number-juggling between systems is replaced by an automated trade-to-payment reconciliations process and automated management of payments. Once agreed, those payments must be locked in. Automation on this scale is a powerful tool in managing liquidity. “Imagine a world in which you had a clear sight of the cash and liquidity ladder,” Leggett continues. “There are many benefits, but I would say having an elegant way to manage your cash requirements must be at the top.”
Fund firms face tough decisions, given the limited time available to plan for T+1 and possibly to transition to a new subscription and redemption settlement cycle. They should avoid sticking plaster fixes in favour of fully automated settlement solutions that manage not only the demands of T+1 but future-proof the business against whatever else is thrown at it.
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