Implications of Changes to US Settlement Regime for Irish Funds
The Securities and Exchange Commission announced that from 28 May 2024 the United States will move from a T+2 to a T+1 settlement cycle for settling trades in securities in an attempt to reduce credit, market and liquidity risks arising from unsettled securities trades. The move will have wider practical implications for those trading in US securities, including Irish domiciled investment funds.
T+1 – What does it mean?
The move to a T+1 settlement cycle means that the period between the trade date (being “T”) for US securities (i.e. when a transaction is agreed and executed by a buyer and vendor) and the settlement date (when the transaction is completed, and the relevant securities and cash are exchanged) will be reduced to one business day. Most settlement regimes for securities globally will continue to operate on a T+2 settlement cycle.
In addition to seeking to reduce credit, market and liquidity risks as mentioned above, the move to a T+1 settlement cycle should free up capital by reducing the length of time capital must be held to cover open trading positions in US securities and facilitate market operations being more efficient.
Implications for EU investment funds
The potential implications of the transition to a T+1 settlement cycle for Irish domiciled investment funds are as follows:
- Post-trade processing time for US securities will be reduced, necessitating greater numbers of overnight settlements. This will result in cash needing to be in place in a shorter timeframe. For funds with significant holdings in US securities, this is especially concerning as much larger cash sums will need to be in place, putting added pressure on liquidity processes.
This is of particular importance in the context of a UCITS, which is prohibited from borrowing more than 10 per cent of its net asset value and only on a temporary basis. Any temporary borrowing which is necessitated by a failure to settle subscription proceeds would need to be carefully monitored to ensure that the borrowing limit is not breached.
- Liquidity and cash management processes for the trading of US securities will be compressed which may be challenging for cross-currency transactions with a foreign-exchange (“FX”) element. Delays in confirmations of security purchases could cause significant knock-on effects to cross-currency transactions with an FX element. As similarly highlighted in the above sub-paragraph 1, these challenges will be exponentially greater for funds with larger exposures to holdings in US securities.
The compressed timeframe will also mean there is less time for brokers to identify and cover short positions.
- Investors in the Asia-Pacific region may effectively find themselves operating on a T+0 basis when trading in US securities as there will be very little time between trading and settlement due to the significant time zone differences working from west to east and back again. As the European overnight settlement process in a T+1 settlement cycle would begin during the US working day, the time until market close to remediate any settlement matching inconsistencies and situations which deviate from inventory policy is greatly reduced. The time left to address reconciliations to ensure the accuracy and validity of financial information is also tightened, placing strains on a fund’s ability to maintain compliance with its reconciliation reporting requirements.
- As funds are often composed of underlying securities from several jurisdictions, time zone differences, different market holidays, complexities in cross-border settlement all contribute to delays of settlement of the underlying constituents of trades with funds. These would be even more pronounced in a T+1 environment meaning that traders will need to be cognisant of these factors in advance of making each individual trade to ensure compliance with the T+1 settlement regime.
Generally speaking, the above implications may contribute to an increase in failed trades if processes have not been tailored to the new settlement cycle, meaning that the reduction in credit and market risk as a result of the transition to a T+1 settlement cycle may increase regulatory and settlement risk. An increase in failed trades may in turn result in an increase in penalties payable under the Central Securities Depositary Regulation (“CSDR”) which typically range from 0.5 basis points to 1 basis point and are payable by the party responsible for the failure.
In advance of 28 May 2024, those involved in the running of funds with exposure to US securities will need to ensure that the trading and settlement procedures (and ancillary provisions) contained in their prospectuses, supplements and third-party agreements are updated with new provisions which align with a T+1 settlement regime in the US. Therefore, it is critical to have all such changes submitted to the Central Bank of Ireland (“Central Bank”) for its review and approval well in advance of the 28 May 2024 cycle change date. The timeframes between making such submissions and their approval by the Central Bank must be accounted for when considering these updates and the date by which they need to be in effect.
In terms of internal trading procedures, market participants are encouraged to undertake critical reviews of their technologies, business processes and legal arrangements with counterparties and other financial service providers to mitigate against the increased risk of failed settlements and the cash penalties that incur as a result. In particular, reviews of trade notification procedures are of utmost importance given how little room for error/delay there is in a T+1 settlement regime. These must also factor-in cross-border and FX complexities. The compressed post-trade processing window reduces room for error and should be used to encourage best practices.
While market participants are currently preparing for the switch in the US settlement regime, the European Securities and Markets Authority (“ESMA”) has issued a call for evidence to gather both data and stakeholders’ views on:
- the potential impacts of changing the EU settlement cycles;
- the costs and benefits of shorter settlement cycles in the EU;
- how and when shorter settlement cycles could feasibly be imposed in the EU; and
- how have the EU’s capital markets been impacted by international changes to settlement regimes.
ESMA has imposed a deadline of 15 December 2023 by which date all evidence and comments will need to be submitted. Contributions to this call for evidence are vitally important as any such shortening of the EU settlement cycle will be more complex than elsewhere due to the larger numbers of exchanges, central securities depositaries, local currencies, and central clearing counterparties in Europe.
To discuss any aspect of the changes further, please get in touch with your usual Arthur Cox contact.