The US Will Soon Be Settling Trades within a Day – What Does That Mean for Europe?

Buying a security isn’t purely a transaction between the buyer and the seller. In actual fact, there are additional parties – known as intermediaries – involved in a trade. Over the course of the two-day period, they ensure that both contracting parties can fulfil their obligations. The parties involved in this process are often in different time zones. One of the most important processes in the post-trade environment is Clearing: All the trades that are made on a given day are sent to a Central Counterparty (CCP). The CCP acts as an intermediary between the two contracting parties, and guarantees smooth processing of the trade to both the buyer and the seller. In other words, the CCP assumes the counterparty risk. So, if one of the two contracting parties cannot meet their obligations within the two days, the CCP steps in and acts as an insurance policy.

The US is now set to change. As of May 28, 2024.  Why are they taking this step? A number of advantages are expected from it. Here are the five most important ones.

1. Risk Reduction

T+1 reduces the time between the execution and settlement of a trade. That means less time for market conditions to change. Risk is reduced.

2. Cost Savings

With a reduction in the time frame, capital is tied up for a shorter period. This leads to lower operating costs and fewer margin calls due to price changes.

3. Greater Stability

T+1 is expected to lead to greater stability in the financial market since it reduces counterparty risk and susceptibility to market volatility, and makes it possible to identify issues and solutions more quickly.

4. Modernization and Harmonization of Infrastructure

Shortening the settlement cycle requires an improvement to the systems and procedures of all parties involved, and promotes the adoption of advanced and automated technologies.

5. More Liquidity and Better Use of Capital

Capital is more readily available with T+1. This creates more opportunities to leverage capital, and increases overall market liquidity. Investors have faster access to funds and can invest or trade more efficiently. 

The introduction of T+1 in the US has naturally fueled discussion in Europe regarding possible adoption. The sector is currently discussing the possibility. According to experts, however, it could be a few years before Europe follows suit. At the annual Network Forum in Athens, an event where industry figures from Custody, Settlement, and Post-Trade convene, 69% of participants said they didn’t expect to see European adoption of T+1 before 2028. That’s primarily due to outdated processes in the case of some market participants. In some cases, these orders are still processed by fax. What still seems to work with T+2 would have to be upgraded to modern processes with T+1, which could take some time.

Integration of T+1 brings a number of challenges in addition to the requisite technological upgrades. These include:

• Time Pressure

This mostly relates to international trade between different time zones. Take Asia and the US as an example. With T+2, the two continents share roughly 12 working hours between the trade and settlement dates. According to the Association for Financial Markets in Europe (AFME), with T+1 this is reduced by 83% - from 12 hours to 2 hours. This means that if operational issues crop up, it would be much more difficult to resolve them in a timely manner.

• The Forex Market Works with T+2

If the FX market doesn’t switch to T+1 at the same time, foreign currency investors would have to provide money up front. That requires more liquidity and increases fluctuation risks.

• Corporate Events

Corporate Events (such as dividend payments or stock splits) function as follows in the T+2 environment: The payment (of dividends, for example) occurs on the date T+2. The Record Date (date on which it is determined who is entitled to a dividend) is one day before the distribution date – S-1. The Ex-Date (first day without the right to the current dividend) is two days before the distribution (S-2). With T+1, this process would have to be changed, which could pose a major challenge.

• Settlement Failures

With T+1, there is less time available to address problems. That would most likely lead to more failed settlements. This relates to ETFs above all. That’s because in the current T+2 environment, some ETFs already have a settlement failure rate of 30-40%.

Atomic Settlement means settling trades instantly. In other words, a trade is settled immediately after clicking on either “Buy” or “Sell”. That’s already possible with Distributed Ledger Technology (DLT). The big question that arises here is: If the switch to T+1 really isn’t going to happen before 2028, why not go to Atomic Settlement right away? The infrastructure would already exist with SIX Digital Exchange (SDX), for example. Netting is one reason.

Netting just means simplifying transactions by combining them. Let’s look at an example. Company A owes 50,000 Swiss francs to company B. Meanwhile, company B owes company A 30,000 Swiss francs. Instead of executing both payments, the payments are combined. So, company A pays 20,000 Swiss francs to company B, and all debts are settled. CCPs use exactly the same principle today when they trade, for both payment and security legs. This results in a large majority of trades not having to be settled. With atomic settlement, things are different. Out of 100 trades, 100 would have to be settled (gross settlement). That would put enormous pressure on liquidity and the availability of securities. 

Europe is waiting on US integration first. At the same time, of course, there’s discussion of potentially switching in order to remain competitive. In theory, T+1 reduces risks. In practice, however, there are many challenges. These now have to be weighed out. One thing is certain – T+2 will definitely not remain the status quo forever. Right now, however, nobody can predict exactly how long it will be before there’s a global transition – be it to T+1, or straight to atomic settlement.