T+1 Cycle Exposes Market to FX Settlement Risks

On 15 February, the US Securities and Exchange Commission 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 new cycle, which has a final implementation date of 28 May 2024, is intended to reduce credit, market, and liquidity risks in securities transactions. But, it has also raised concerns over FX risk, with Ricky Ellis, the Head of FX Sales in EMEA at BBH observing that for asset managers and financial institutions in Europe and Asia, the time zone differences make the FX cycle trickier to manage.

In May, the Global Financial Markets Association’s global foreign exchange division (GFXD) warned that accelerating US securities settlement to T+1 raises the risk that transaction funding dependent on FX settlement may not occur in time. Its report stated that cross-border US security transactions with a related FX trade would require the expedited execution of both trades to enable settlement to be completed in the shortened window, with trade matching, confirmation, and payment all to be completed within local currency cut-off times.

A report on foreign portfolio holdings of US securities as of June 2022 released by the US Department of the Treasury in April 2023 reveals the scale of overseas ownership of these assets. Almost $25 billion of long-term and short-term debt securities are owned outside of the US.

Since the US equity market closes at 4pm ET (9pm UK/10pm CET), this will leave very little time on T+1 to match the equity trades and generate and execute the FX required to settle these trades. For those managers who prefer to execute the FX on T+1, Ellis suggests it may require either a local presence to manage that activity in the US trading day or the use of an automated or outsourced solution that can support the required trade management and FX execution.

“While not a panacea for regulatory and operational considerations, currency management providers with automated systems should be able to optimise FX settlements for equity trades to the greatest degree possible within a fund or portfolio,” says Alex Dunegan, the CEO at Lumint Currency Management.

“Some will look for operational simplicity and have their custodians do more management of FX exposures, but this is likely to lead to an increase in transaction costs,” Vurgest stated. “Some will go the other way and want to outsource these operational processes to a specialist FX manager who can reduce transaction costs and manage settlements. The value add is in a manager who can accurately review trade requirements and act in the short time frame needed at minimum cost of execution.”

According to Joe Hoffman, the CEO of Mesirow Currency Management, demand for outsourcing currency management and execution will grow because many investors do not have a 24-hour trading desk or a global operations team that can meet the tight deadlines that will be imposed on investors due to this change.

Many firms do not have the operational processes to speed up workflows to ensure settlement takes place in this new shortened time frame agrees Nathan Vurgest, a Director and Head of Trading at Record Financial Group

According to Chris Gothard, a Partner and Head of Global Markets at BBH, faster settlement is already leading to increased demand for outsourcing currency management providers.

“In recent years there has been an increase in solutions available for FX workflows that many consider operational or rules-based as they are not seen as an area where asset managers can add value, and indeed are a potentially risky distraction,” Gothard added.

For managers that are considering these outsourced solutions, Gothard said it is critical to ensure they deliver the full lifecycle of capabilities: trade calculation and execution to effective and appropriate standards, and all post-trade operational flows as well as robust and easily accessible transparency and oversight mechanisms from basic transaction cost analysis through to more sophisticated analytics.

Halving the US settlement cycle raises the profile of outsourced currency solutions as a way of simplifying the trade and related FX lifecycle, and it seems unlikely that all impacted firms will employ more people to do more work in an environment where capability and capacity can be secured on an outsourced basis suggests Gerard Walsh, the Global Head of Capital Markets Client Solutions at Northern Trust.

“That demand will arise from the desire to reconfigure existing process and to do so without embedding higher cost bases than is truly necessary,” Walsh mentioned. “One obvious way to achieve this and mitigate settlement risk will be to link securities trading and the associated trade-related FX as close in time as possible.”

Walsh recommends managers (especially those domiciled outside of the US and Canada time zone) consider executing the FX trade in a comprehensive trade lifecycle, which he says can be achieved through implementing an automated, tailored and programmatic FX funding mechanism that is linked as close to the underlying transaction as possible, along with flexibility in execution timing and access to global liquidity.

Vikas Srivastava, the Chief Revenue Officer at Integral takes a slightly different view, suggesting that outsourcing currency management is not a silver bullet, especially if the firm the activity is being outsourced to does not have the kind of technology infrastructure required to ensure automated trading needed to achieve T+1 settlement in both the equity and FX leg of a trade.

“Global market participants trading through US markets should be looking at how - with technology - they can solve the automated trading challenge that T+1 poses,” Srivastava declared. “With less than a year until shorter settlement times are introduced in North America, cloud-hosted trading technology solutions can be onboarded in more than enough time giving firms the tech capabilities and agility they need to coordinate the equity and FX trades T+1.”

Firms that choose not to invest in technology to enhance their post-trade processes may choose to deploy additional resources to solve the problem, either in the form of US-based operational staff and/or an outsourced currency manager.

However, Alex Knight, the Head of Sales for the EMEA at Baton Systems reckons that even with this increased allocation of resources by one party, it is the workflow and relationship between the pair of settling parties that is what really needs to be addressed.

"Using a shared single source of truth, with collaborative automated workflows operating in real time has to be the way forward,” Knight concluded.