Back in 2014, the Central Securities Depositories Regulation (CSDR) introduced for the first time a requirement for all transactions in transferable securities which are executed on trading venues to be settled by no later than the second business day after the trade date (known as T+2).
In February 2022, the United States Securities and Exchange Commission (US SEC) shared a proposal which aimed to rule changes to reduce risks (such as credit, market, and liquidity risks in securities transactions faced by market participants and American investors) in the clearance and settlement of securities by shortening the standard settlement cycle for most broker-dealer transactions in securities from T+2 to one business day after the trade date (T+1). One year later, this rule was officially adopted, changing the American settlement cycle from T+2 to T+1.
Due to the interconnectivity of the markets, the new rule, which comes into force on 29 May 2024, will impact several countries all over the world. Other jurisdictions, such as Canada and Mexico, also plan to shorten their settlement cycle, meanwhile others have already started the transition.1 In this context, it is necessary to identify the impacts for EU stakeholders of the coexistence of T+2 and shorter settlement cycles, as well as of the shortening of the EU settlement cycle; for this reason, on 5 October 2023, European Securities and Markets Authorities (ESMA) published a Call for evidence on shortening the settlement cycle in order to understand the possible impacts, costs and benefits that a change from T+2 into T+1 could have in Europe.
What does the ESMA Call for evidence say about the topic?
According to ESMA, shortening the settlement cycle in Europe might be more challenging than in other jurisdictions since Europe has a more complex post-trade landscape2 with lots of market infrastructures, several currencies and a common settlement platform (T2S) which does not support all the currencies and in which not all EU central securities depositories (CSDs) participate.
In addition, CSDR introduced several provisions to prevent settlement fails3 and ESMA has been made aware that settlement fails might increase if a shorter settlement cycle is implemented in the EU (which could also lead to a cost increase due to cash penalties).
As indicated in the Call for evidence, several CSDs and central counterparties (CCPs) have affirmed that shortening the settlement cycle would have no major impact for them, however some representatives of the asset management industry have raised concerns regarding the costs they would incur and the difficulties it would entail for them to operate in a shorter settlement cycle.4
On the other hand, ESMA argues that moving to a shorter settlement cycle might reduce the counterparty risk5, increase settlement efficiency, lower collateral requirements, eliminate issues associated with unharmonized settlement cycles and promote international harmonization increasing the attractiveness of EU markets.
Back in 2014, the Central Securities Depositories Regulation (CSDR) introduced for the first time a requirement for all transactions in transferable securities which are executed on trading venues to be settled by no later than the second business day after the trade date (known as T+2).
In February 2022, the United States Securities and Exchange Commission (US SEC) shared a proposal which aimed to rule changes to reduce risks (such as credit, market, and liquidity risks in securities transactions faced by market participants and American investors) in the clearance and settlement of securities by shortening the standard settlement cycle for most broker-dealer transactions in securities from T+2 to one business day after the trade date (T+1). One year later, this rule was officially adopted changing the American settlement cycle from T+2 to T+1.
Due to the interconnectivity of the markets, the new rule, which comes into force on 29 May 2024, will impact several countries all over the world. Other jurisdictions, such as Canada and Mexico, also plan to shorten their settlement cycle, meanwhile others have already started the transition . In this context, it is necessary to identify the impacts for EU stakeholders of the coexistence of T+2 and shorter settlement cycles, as well as of the shortening of the EU settlement cycle; for this reason, on 5 October 2023, ESMA published a Call for evidence on shortening the settlement cycle in order to understand the possible impacts, costs and benefits that a change from T+2 into T+1 could have in Europe.
What does ESMA Call for evidence say about the topic?
According to ESMA, shortening the settlement cycle in Europe might be more challenging than in other jurisdictions since Europe has a more complex post-trade landscape with lots of market infrastructures, several currencies and a common settlement platform (T2S) which does not support all the currencies and in which not all EU central securities depositories (CSDs) participate.
In addition, CSDR introduced several provisions to prevent settlement fails and ESMA has been made aware that settlement fails might increase if a shorter settlement cycle is implemented in EU (which could also lead to a cost increase due to cash penalties).
As indicated in the Call for evidence, several CSDs and central counterparties (CCPs) have affirmed that shortening the settlement cycle would have no major impact for them, however some representatives of the asset management industry have raised concerns regarding the costs they would incur and the difficulties it would entail for them to operate in a shorter settlement cycle .
On the other hand, ESMA argues that moving to a shorter settlement cycle might reduce the counterparty risk , increase settlement efficiency, lower collateral requirements, eliminate issues associated with unharmonized settlement cycles and promote international harmonization increasing the attractiveness of EU markets.
How might a shift to T+1 settlement impact Europe?
Since the launch of the proposal, the industry has been discussing the possible impacts and solutions for a transition to T+1. In this sense, the European Fund and Asset Management Association (EFAMA) published, in August 2023, a memo highlighting that the possible impacts in Europe of a US shift to T+1 might be, inter alia:
- A transfer of risk away from market risk to other areas, including settlement risk and operational risks
- A need to cover US trading hours, whether through night desks in Europe or expanded US operations
- An automatic increase in the cost of trading for funds and ETFs to make up for the funding gap associated with T+2 settlement for funds and T+1 settlement for US securities
- A reduction in securities lending to mitigate against settlement fails when faced with shorter recall periods, and a resultant performance drag on funds
- Regulatory uncertainty when it comes to UCITS cash breaches resulting from the settlement misalignment
- Regulatory uncertainty as concerns the US SEC when it comes to the possibility to request extended settlement for EU funds
- Holidays in non-US jurisdictions will make it very difficult to comply with T+1 settlement (need to have clear exemptions)
EFAMA also drew market participants’ attention to other issues regarding the trading matching process and the cash flows. Since the US SEC proposal not only reduces the settlement cycle to T+1, but also imposes other provisions, such as a prohibition to broker dealers from entering into a trade unless the contract requires same-day allocation, confirmation and affirmation on trade date,6 this may be a challenge to EU entities, which will be required to complete the trading matching (including confirmation and affirmation) within the same day.
In addition, the different time zones may also hinder the trade matching since late offers will be out of EU business hours, which may require EU entities with no branch in the US to either extend their working hours, fully automate the process or rely on third parties to cover part of the process.
Regarding the cash flows, the misalignment of settlement cycles might cause liquidity/cash flow mismatches. For instance, the different settlement cycles between an EU fund (T+2) and US securities (T+1) may lead, in certain cases, to inflows of cash into the fund (leaving it with excess cash balances), potentially breaching investment rules.
What are the possible costs the industry may incur?
In its memo, EFAMA is of the view that, in the context of a US shift into T+1 settlement, fund managers’ costs may increase due to several arrangements they will need to enter into in order to accommodate the changes caused by the different settlement cycles.
Some examples of costs fund managers may incur are those related to:
- Extending the working hours in Europe to cover US hours
- Expanding operations in North America or outsourcing to US-based third-party entities
- Technology updates
- Cash breaches with obligation to report to the regulator
Can the DLT Pilot Regime provide the market with solutions?
Applicable since March 2023, the Regulation (EU) 2022/858 of the European Parliament and of the Council of 30 May 2022 on a pilot regime for market infrastructures based on distributed ledger technology (DLT Regulation) establishes, inter alia, the DLT settlement system which settles transactions in DLT financial instruments7 at close to real-time or intraday and in any case no later than on the second business day after the conclusion of the trade.
The DLT settlement system is expected to be able to work in T+0, supporting settlement at a 24/7 shift which would obviate the need of extending working hours to cover different time zones.
In this sense, some Member States have been developing solutions to improve securities digitalization in order to allow the issuance of shares via DLT. As an example, the German Financing for the Future Act (Zukunftsfinanzierungsgesetz), approved in August 2023, expands the possibility of issuing electronic securities to also include shares.
Next steps
Given the high level of interaction with non-EU jurisdictions, in particular with the US and the UK, it is necessary to identify the impacts for EU stakeholders of the coexistence of T+2 and shorter settlement cycles, as well as of the shortening of the EU settlement cycle. Beyond the Call for evidence, ESMA has requested the views of its Post-trade Consultative Working Group on how a potential transition to T+1 should be carried out in the EU.
ESMA intends to submit to the European Commission and publish a final report on the feedback received through the Call for evidence by the end of 2024. In addition, ESMA is of the view that any change towards a shorter settlement cycle might require EU regulator coordination due to the complexity and specificities of the EU market.
How EY can help
- Perform impact assessments regarding IT infrastructure, data architecture, margin and collateral requirements and service provider landscape
- Design a target end-to-end settlement process to comply with a T+1 timeline
- Define an appropriate governance and control framework
- Prepare client and stakeholder outreach and communication
- Assess the strategic potential for innovative settlement technology options (including DLT)
1For example, India is applying a phased approach and China is reducing the settlement cycle only for some securities.
2According to EFAMA Memo issued in August 2023, there are 29 CSDs in Europe meanwhile there are only 2 in the United States; just 1 CCP in the United States versus 16 in Europe.
3The US SEC has not incorporated settlement fail penalties yet, however it has hinted that if failures spike, it might intervene.
4The Call for evidence mentions that reducing the duration of the securities settlement cycle might entail costs for market players and require further automation. Such costs could be passed on to clients/end investors.
5In its Memo of August 2023, EFAMA argues that instead of reducing the risks, shortening the settlement cycle would rather transfer costs and risks from retail brokers and proprietary trading firms to the asset managers that represent the savers of Europe with new risks generated on FX settlement and operational risks.
6https://www.sec.gov/files/rules/final/2023/34-96930.pdf (page, 102).
7DLT financial instrument is a financial instrument that is issued, recorded, transferred and stored using distributed ledger technology.
