PrefBlog

The SEC has announced:

The Securities and Exchange Commission today adopted rule changes to shorten the standard settlement cycle for most broker-dealer transactions in securities from two business days after the trade date (T+2) to one (T+1). The final rule is designed to benefit investors and reduce the credit, market, and liquidity risks in securities transactions faced by market participants.

“I support this rulemaking because it will reduce latency, lower risk, and promote efficiency as well as greater liquidity in the markets,” said SEC Chair Gary Gensler. “Today’s adoption addresses one of the four areas the staff recommended the Commission address in response to the meme stock events of 2021. Taken together, these amendments will make our market plumbing more resilient, timely, orderly, and efficient.”

In addition to shortening the standard settlement cycle, the final rules will improve the processing of institutional trades. Specifically, the final rules will require a broker-dealer to either enter into written agreements or establish, maintain, and enforce written policies and procedures reasonably designed to ensure the completion of allocations, confirmations, and affirmations as soon as technologically practicable and no later than the end of trade date. The final rules also require registered investment advisers to make and keep records of the allocations, confirmations, and affirmations for certain securities transactions.

Further, the final rules add a new requirement to facilitate straight-through processing, which applies to certain types of clearing agencies that provide central matching services. The final rules will require central matching service providers to establish, implement, maintain, and enforce new policies and procedures reasonably designed to facilitate straight-through processing and require them to submit an annual report to the Commission that describes and quantifies progress with respect to straight-through processing.

The adopting release is published on SEC.gov and will be published in the Federal Register. The final rules will become effective 60 days after publication in the Federal Register. The compliance date for the final rules is May 28, 2024.

This is wonderful news, albeit of more interest to institutional investors and their fund managers than to retail. Back in my Canada bond trading days, it was unusual, but not unknown, for clients of the firm to have trades totalling 100-million per side (buy and sell) with a single dealer. Say the market has moved by a buck after trade time but before settlement. Then one side has a loss of 1-million odd, and the other side has a gain of about the same amount. Now say the dealer goes bust before the trade gets settled. The losing side of the trade would settle, but the winning side … maybe. When Confederation Life went bust in the nineties, if you had an outstanding FX trade that you were losing money on, it settled. If you were winning … get in line, buddy! So this is a risk that is reduced by faster settlement.

There are implications for retail, though … everybody remembers the Robin Hood / Meme Stock problem, when Robin Hood suddenly started getting very fussy about what orders they would accept … and although you’ll find lots of vitriol on the web directed at them by newbie retails, you’ll also learn that few of these guys understood the problem: the problem was that clearing corporations demand collateral to mitigate the settlement risk described above:

New York markets had just fired up, and the investing world was tuning in for Thursday’s episode of the continuing drama: Legions of Robinhood Markets investors versus hedge-fund Goliaths.

But within minutes, a shock wave invisible to the outside world rattled the mechanics of Wall Street — sending Robinhood rushing for more than $1 billion of additional cash. The stock market’s central clearing hub had demanded large sums of collateral from brokerages including Robinhood that for weeks had facilitated spectacular jumps in shares such as GameStop Corp.

The Silicon Valley venture with the wildly popular no-fee trading app came to a crossroads. It reined in the risk to itself by banning certain trades and unwinding client bets — igniting an outcry from customers and even U.S. political leaders. By that night, word was emerging that Robinhood had raised more than $1 billion from existing investors and drawn hundreds of millions more from bank credit lines to weather the storm.
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The question is whether such critics will dig into the industry’s inner workings, where pressure mounted on Robinhood and other firms to limit certain trades. That would put a rare spotlight on arcane parts of the market designed to prevent catastrophe, such as the Depository Trust & Clearing Corp.

One key consideration for brokers, particularly around high-flying and volatile stocks like GameStop, is in the money they must put up with the DTCC while waiting a few days for stock transactions to settle. Those outlays, which behave like margin in a brokerage account, can create a cash crunch on volatile days, say when GameStop falls from $483 to $112 like it did at one point during Thursday’s session.
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The trouble on Thursday began around 10 a.m., when after days of turbulence, the DTCC demanded significantly more collateral from member brokers, according to two people familiar with the matter.

A spokesman for the DTCC wouldn’t specify how much it required from specific firms but said that by the end of the day industrywide collateral requirements jumped to $33.5 billion, up from $26 billion.

Brokerage executives rushed to figure out how to come up with the funds. Robinhood’s reaction drew the most public attention, but the firm wasn’t alone in limiting trading of stocks such as GameStop and AMC Entertainment Holdings Inc.

In fact, Charles Schwab Corp.’s TD Ameritrade curbed transactions in both of those companies on Wednesday. Interactive Brokers Group Inc. and Morgan Stanley’s E*Trade took similar action Thursday.

So, faster settlement will alleviate, to a large degree, the amount of settlement risk there is in the system and, hopefully, reduce the chance of serious volatility freezing the markets.

There was a lot of self-congratulation. Chair Gary Gensler stated:

First, the amendments will shorten the standard settlement cycle by half, from two business days (“T+2”) to one business day (“T+1”). The amendments also will halve the settlement cycle for trades relating to initial public offerings, from T+4 to T+2. As they say, time is money. Halving these settlement cycles will reduce the amount of margin that counterparties need to place with the clearinghouse. This lowers risk in the system and frees up liquidity elsewhere in the market.

Now, that’s not to say this change will be new; in fact, this change simply brings us back to the T+1 settlement cycle our markets used up until the 1920s. It also aligns with the T+1 cycle used in the $24 trillion Treasury market.
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Today’s adoption addresses one of the four areas the staff recommended the Commission address in response to the meme stock events of 2021. Further, the implementation for these amendments will be set to after Memorial Day weekend (May 28, 2024). This implementation comes more than three years after key industry members first proposed shortening the settlement cycle, and a year and a quarter from now, providing sufficient time in my view for the transition. Further easing the transition, the implementation date will occur during a three-day holiday weekend.

Commissioner Jaime Lizárraga stated:

Why does this matter to the investing public? Because buyers and sellers of securities will receive their cash and securities a day earlier under T+1 than they do currently. And because market participants can allocate their capital more quickly and efficiently. Based on the public comments to the proposal, these benefits accrue to retail investors in particular.

Reducing the current settlement time in half will alleviate some of the downsides of the current T+2 cycle, such as counterparty, market, liquidity, credit, and other risks. A longer settlement time also requires risk management tools, such as margin requirements, that carry significant costs. Shortening the settlement cycle not only helps reduce these risks and costs but lowers volatility and makes our markets more fair and efficient.

The risks of longer settlement times are not just theoretical. In January 2021, unprecedented price volatility in so-called “meme stocks” challenged many retail investors’ faith in our in financial markets. Clearing agencies in equities and options experienced record volumes cleared. In the face of high volume and volatility, market utilities had to issue significant margin calls. In reaction to these margin calls, certain brokers restricted trading in some, or all, of the meme stocks. According to media reports, at least one broker’s decisions to halt trading came at the peak of the market and infuriated many retail investors. Investors have filed approximately 50 class action lawsuits claiming substantial harm from this broker’s trading halt.

Commissioner Caroline A. Crenshaw stated (with lots of valuable footnotes):

Specifically, a shorter settlement cycle should reduce the number of outstanding unsettled trades, reduce clearing agency margin requirements, and allow investors quicker access to their securities and funds. Longer settlement periods, on the other hand, are associated with increased counterparty default risk, market risk, liquidity risk, credit risk, and overall systemic risk.[7]

Commenters were overwhelmingly in favor of shortening the settlement cycle.[8] We received supportive comments from a broad range of stakeholders, including individual investors, investor advocates, clearing agencies, and broker-dealers.[9] Some commenters raised concerns regarding the proposed changes related to the processing of institutional trades,[10] firm commitment offerings,[11] and security-based swaps,[12] and the final rule reflects certain changes from the proposal in response to those comments. A number of commenters also raised concerns about the implementation timeline, which has been extended by several months from the proposed date to facilitate a smooth transition.[13] The new compliance date would provide market participants more than fifteen months to prepare for the transition.[14]

The proposal also included a request for comment on the possibility of settling trades by the end of the trade date, or what we call “T+0.” Some commenters highlighted challenges relating to multi-lateral netting, securities lending practices, and other issues.[15] However, many others expressed support for an eventual move to T+0.[16] While it is clear that T+0 will entail greater operational and technological challenges than the move to T+1, I agree with commenters that such a move may be both desirable and feasible in the future, and I look forward to working with my colleagues and stakeholders toward that important goal.[17]

Commissioner Mark T. Uyeda was a little bitter (bolding added):

While the net benefits of a shorter settlement cycle are clear, T + 1 can potentially increase some operational risks. There will be less time to address errors within the process and, in some circumstances, less time to deal with trading entities that are suddenly confronting massive and unexpected trading losses within the settlement cycle timeframe. There is also less time for regulators to identify and freeze the potential proceeds from potential frauds, such as, insider trading and market manipulation, before those proceeds exit our jurisdiction. These arguments and considerations, however, do not ultimately weigh against shortening the settlement cycle, but they provide reason for ensuring readiness among market participants. This speaks to the implementation date.

Ensuring a smooth transition will take significant investment and systems changes as well as operational and computational testing among broker-dealers, clearing firms, investment advisers, custodians, payment systems, and so on. Detailed planning is required, as is process adjustment, organizational change, and changes in the relationships among market participants. There is asymmetry in terms of costs and benefits—a smooth transition would provide net benefits for investors and U.S. markets to be accrued over the long-term in the future. On the other hand, the downside of a rough, turbulent transition could be steep, and could induce substantial harm in the short-run. That asymmetry cautions us to provide sufficient time to ensure a smooth transition.

Many comment letters have emphasized the need for more time than the Commission proposed.[5] Many have pointed to the 2024 Labor Day weekend as the implementation date. It would have the added advantage that Canada is also moving forward with T + 1 around the same time. Instead, the Commission appears to be ready to adopt May 28, 2024 as the implementation date.[6] In my view, we are in an imprudent rush away from a sensible transition date and, for that reason, I am unable to support the final rule.

Commissioner Hester M. Peirce also complained about implementation (bolding added):

I support the plan to move to T+1, but do not support the proposed timeline for making this change. Shortening the settlement cycle is a way to remove some risk from our markets. Mandating that the change occur in May 2024, however, could pose risks of its own by forcing the transition before market participants are ready. I propose instead a September 3, 2024 implementation date. Let me explain why:

• Although preferable to the proposed March 31, 2024 implementation date, the May 28, 2024 date is still too early. Shortening the settlement cycle by one business day is a big change with implications all across the market. We cannot afford a cavalier approach.
• Many commenters called for a September 3, 2024 date to ensure that the transition would happen with minimal disruption to the markets.
• Tuesday, September 3, 2024 is the first business day after the 3-day Labor Day weekend, and Canada, the only jurisdiction currently planning on moving with us to T+1, shares this 3-day weekend. The transition from T+3 to T+2 occurred successfully over Labor Day weekend in 2017.
• This later date would give other foreign market participants the time to work out some of the challenges they will face from our transition to a shorter settlement cycle than they have in their markets.
• The additional three months will allow more time for firm-specific and coordinated, industry-wide testing, which will make a smoother transition more likely.
• The transition from T+2 to T+1 is likely to present numerous operational challenges—some of them more difficult than in the last transition—related to, among other things, pre- and post-trade processes, securities lending, foreign exchange transactions, and processing corporate actions.
• The transition is happening at the same time the market is processing many other regulatory changes.

I do not have any questions for the staff, but do want to make one final plea to Chair Gensler. Why not adopt a September 3, 2024 compliance date? I will vote for the rule if you make this change.