In the capital markets industry, the settlement cycle refers to the period of time between the trade date (T) and the settlement date (T+X), during which the buyer must make payment and the seller must deliver the security. Currently, the standard settlement cycle is T+2, meaning that settlement occurs two days after the trade date.
However, the US Securities and Exchange Commission (SEC) has mandated that the industry transition to a T+1 settlement cycle due to the change set to take effect in Q3 of 2023. While this transition may seem like a simple change, there are hidden challenges that market participants may not be aware of.
In this article, we will explore the hidden challenges of the T+1 transition in capital markets.
What is the T+1 transition? What does it mean for capital markets?
T+1 refers to the settlement cycle for securities transactions. T stands for the day on which the transaction occurred, and the number refers to the number of business days it takes for the settlement of the transaction. The current settlement cycle is T+2, which means that it takes two business days after the transaction for the settlement to occur. The T+1 transition will reduce the settlement cycle to just one business day after the transaction.
One of the key benefits of the T+1 settlement cycle is that it will reduce the risk of settlement failures. Settlement failures occur when a trade is not settled on the agreed-upon settlement date, which can cause financial losses for market participants. With the T+1 settlement cycle, the risk of settlement failures will be reduced as the settlement will occur on the next business day.
Challenges of T+1 transition
While the transition to T+1 has some benefits, it is surrounded with challenges too.
One of the biggest challenges is the need for real-time information. In a T+2 settlement cycle, market participants have two days to reconcile their books and records. With the transition to T+1, market participants will need to have access to real-time information to reconcile their books and records within one day. This requires significant investment in technology and infrastructure to ensure that market participants have access to real-time information.
Another challenge of the T+1 transition is the need for operational efficiency. With a T+1 settlement cycle, market participants will need to ensure that their operational processes are efficient and streamlined to meet the shorter settlement cycle. This requires investment in automation and process optimization to reduce the risk of errors and delays in the settlement process.
The T+1 transition also has implications for collateral management. Collateral management is the process of using assets to manage counterparty risk in securities transactions. In these transactions, collateral serves as security for the repayment of a loan in the event of default.
In other words, if one party defaults on their obligation to pay, the other party can seize the collateral as compensation. With the transition to a T+1 settlement cycle, collateral will need to be managed more efficiently to ensure timely delivery and settlement of securities. The reduction in settlement time from T+2 to T+1 means that there is less time for parties to manage and transfer collateral, which could lead to increased operational and liquidity risks.
With the transition to T+1, collateral management processes will need to be updated to ensure that market participants have access to real-time information on collateral balances and transactions. This requires investment in technology and infrastructure to ensure that collateral management processes are efficient and effective in a T+1 settlement cycle.
Last but not the least, another challenge of the T+1 transition is the need for coordination between market participants. In a T+2 settlement cycle, market participants have two days to coordinate their activities and ensure that settlement occurs on the agreed-upon settlement date. With the transition to T+1, market participants will need to coordinate their activities in real-time to ensure that settlement occurs on the next business day. This requires significant investment in communication and coordination tools to ensure that market participants can collaborate effectively in a T+1 settlement cycle.
In conclusion, the transition to the T+1 settlement cycle in capital markets is not without its challenges. Market participants will need to invest in technology, infrastructure, and operational processes to ensure that they can meet the shorter settlement cycle.
Real-time information, operational efficiency, collateral management, and coordination between market participants are all challenges that need to be addressed in the T+1 transition. While the benefits of the T+1 settlement cycle are clear, market participants need to be aware of the hidden challenges to ensure a smooth transition.