As of 6 October 2014, UK and Irish Central Securities Depositories (CSDs) will shorten their settlement periods from three days to two – expressed ‘T+2’ in industry notation. At the same time, securities that settle via the Euroclear system in Belgium, France and Holland will also adopt T+2, acting as forerunners to the pan-European Target2-Securities legislation that will come into force in 2015.
Currently, many CSDs in Europe settle at T+3, though notably the main market in Germany settles at T+2. This situation points to two problems the European Commission (EC) is trying to overcome: the adoption among 45%-65% of the market of a T+3 system, considered too long (for reasons stated later) and the lack of pan-European harmony in settlement times among CSDs.
When an investor places an order to buy a security, it first goes into clearing – the process of transmitting, reconciling and, in some cases, confirming transfer orders. If this is successful, the order is then settled – it is processed with the aim of discharging participants’ obligations through the transfer of funds and/or securities.
Why the move?
According to studies and consultations conducted by the EC, longer settlement times generally mean greater counterparty risk – the chance that the counterparty to a trade will default between trade and settlement – and hence T+2 is a more desirable time frame than T+3. According to Gary Wright from BISS Research, T+1 – or even T+0 – are desirable goals too, but currently technology is unable to support such a system. “My concern is that the move is meant to reduce risk,” he says. “However, in losing a day of counterparty risk, we increase the likelihood of operational risk – for T+2, the data has to be spot on and available on trade day. For instance, not all firms are using an electronic form of confirmation – especially broker-dealers. A lot of them are still using third-party suppliers to do confirmation for them. Added with the complexity of multiple accounts for larger transactions, the communication has to be a damn sight better than it is today. Even with T+3, a lot of trade fails can be traced back to operational risk.”
Kevin Milne, owner of Due Diligence Reports, sees things differently: “It still staggers me that we’re talking about T+2 being a good thing. In this age we have electronic CSDs – buying and selling equities shouldn’t be that much more difficult than a cash transfer, and should be almost instant. Why that doesn’t happen electronically in securities markets is quite astonishing. Most general clearing members are linked via CSDs, so the fact that there are multiple parties involved shouldn’t be a problem either.”
According to the EC, the disharmony between settlement periods among member states also poses a number of problems. Of particular note is the processing of dividend payments. A buyer acquires the share either cum dividend (at a higher price) or ex dividend (at a lower price). Post-trade processes in each market ensure that the dividend arrives at the right place (the ‘cum’ buyer or the ‘ex’ seller) – however, the EC is worried that this does not always work between national markets with different settlement periods. As a consequence, a dividend can be paid out to the wrong person. According to analysis by members of the European Securities Forum in 2005, compensation payments amount to billions of euros per year, with associated costs in the tens of millions of euros.
Tim Beckwith, Post Trade Manager at London Stock Exchange Group, says: “A T+1 settlement cycle was regarded as too short for standard equity transactions particularly due to the mismatch with other global markets and foreign exchange transactions. London Stock Exchange does however operate certain services on a standard T+1 settlement cycle today, including Gilts and UK Rights Issues.”
Milne, however, is sceptical, and believes the payment of dividends should not pose a problem. Indeed, as with coupon payments for bonds, this could even be made instant. Instead, he sees longer settlement periods as crucial to the business models of many clearing and settlement houses: “What tends to happen with T+3 is that in those three days a lot of reconciliations happen. A lot of the processes for settlement – the checking and re-checking of funds and ownership of assets – are in place because of the delay. They aren’t processes that have to happen. Preserving the same processes from T+3 to T+2 is like running harder and praying.”
Risky business
The EC also argues that differences in settlement periods increase the complexity of cross-border transactions and create additional operational risks and back-office costs as a standard settlement period in a national market is transferred into a non-standard period for a cross-border transaction.
However, risk is something that Wright claims is not easily eliminated: “Politicians and regulators are in a bit of a blind panic to try and reduce risk. But they are looking at risks in isolation and just moving them downstream. For instance, with T+2 you could repeat the problem in 1987, where there was a backlog of interlinked transactions that failed because the one at the beginning of the queue failed.”
According to Wright, the move from T+3 to T+2 leaves some firms in a difficult situation: “They need a strategic understanding of what’s required in operations. They must have the funds to invest in the right systems – and know what to invest in.”
Beckwith adds: “For the London Stock Exchange and the CCPs, reducing the settlement cycle as mentioned is very much a static change and members of the London Stock Exchange will need to ensure that all settlements versus the CCPs are matched at the CSD before T+2, to ensure settlement occurs on the contractual settlement date.”