As of May 28, 2024, investors will need to settle US equity transactions within a fraction of the time they currently do, after the US Securities and Exchange Commission (SEC) declared this the deadline for securities from the prevailing trade plus two-day (T+2) regime to move to a T+1 settlement schedule.
The move from SEC chair Gary Gensler comes in a bid to make markets safer for end investors following the snags some experienced during the Covid-19 pandemic’s meme stock frenzy. But it is also a major headache for investors outside the US, who must buy or sell dollars to trade US equities. They will have to figure out a way to synchronise currency and equity settlement schedules. This is a challenging task, because the shake-up in stocks leaves foreign exchange (FX) traders with barely any time to hedge and process trades.
With this shift, the SEC is unintentionally shining the spotlight on one of the dustiest corners of the $7.5tn-a-day global FX market: settlement.
However, Continuous Linked Settlement (CLS), the utility for ensuring both sides of currency trades get paid, is not making operational changes to accommodate the new timelines, according to a CLS spokesperson. This is forcing large asset managers to rethink how and when they trade FX. Otherwise, they will face a whole host of new risks, including the risk of counterparties failing to pay for their side of trades.
“We are making this move to T+1 to reduce settlement risk, but that forces us on the FX side … to cut away from CLS, so it’s a bit of a conundrum at this point,” says Inés de Trémiolles, head of trading at BNP Paribas Asset Management. “I think, overall, this will mean increased transaction costs.”
Post-trade squeeze
The move to T+1 in US equities dramatically reduces the time available for investors to process trades after execution and to perform checks, compare and confirm positions with counterparties, and to finally settle. According to a 2022 study from the Association for Financial Markets in Europe, back offices will have just two hours to do all post-trade work in equities instead of the 12 hours they currently have, which translates to an 82% reduction in available time.
The SEC’s announcement has spurred a rapid automation drive in US equities, as investors and large asset managers scrambled to give a hi-tech makeover to the time-consuming and manual post-trade steps they have to perform, such as reconciliation and confirmations. There are few concerns on this front, as the long-overdue tech upgrades are well on their way. But for international investors based outside the US, the shift in equity markets is forcing a review and potentially a rethink of the whole currency-trading lifecycle, because the new timelines do not fit the existing mould for settling trades.
“FX is among the areas where the biggest issues arise from this switch; this is where people are trying to figure out what the impact will be,” says Brijen Puri, a managing director at JPMorgan.
For FX hedges related to the US equity flows, it looks like we will only have one hour to trade
There are two main issues that investors are grappling with: meeting deadlines for submitting trades to custodians and CLS; and balancing that need of settlement security with best execution duties. And if they cannot synchronise equity and FX settlement cycles, they will have to consider pre-funding equity transactions, which will greatly increase operational complexity.
The crux of the problem is that FX markets are global and investors have to deal with time differences. Under the T+2 settlement regime, superfunds in Australia, for example, have at least 12 hours to hedge US equity purchases in currency markets, do post-trade checks and submit the trades to their custodians to send to CLS. This way, they benefit from trading in the best liquidity during European hours, which keeps transaction costs low, and they also bear no settlement risk as the trades are covered by CLS.
By cutting the time for settling US equities, the time for the FX trade lifecycle compresses dramatically, or investors have to take on settlement risk themselves. And because there is such a rush to meet deadlines, the odds of failed trades also nudge higher.
“For FX hedges related to the US equity flows, it looks like we will only have one hour to trade, unless we execute the FX hedges on next day for settlement T+0. And obviously T+0 is not a good option for anyone because T+0 means that you’re out of CLS,” explains Ms de Trémiolles.
Execution deadline
A quirk of US equity trading is that most trades are executed just before the New York close at 16:00 Eastern Time, which is 22:00 Central European Time (CET). Investors will then have to hedge these trades in currency markets, which are dormant at that time, and rush to submit them for settlement if they want to match the T+1 schedule of US equities with their FX trades. The cut-off time for CLS is midnight CET, but investors have to meet earlier deadlines set by their custodians for their trades to be sent to CLS.
“Managers that choose to miss, or end up missing, the CLS cut-off will have to settle bilaterally. And in that context, the one key potential point of failure is that the executing desk you want to deal with may not have bilateral credit lines with all the funds in question,” says Alex Knight, head of Europe, the Middle East and Africa and global sales at Baton Systems, a fintech looking to digitally transform post-trade processing using distributed ledger technology.
Likewise, Basu Choudhury, head of partnerships and strategic initiatives at post-trade services company Osttra, argues that the move in equities “re-bilateralises” FX settlement. However, this is not the direction that regulators want participants to travel.
FX settlement — a history
Settlement in FX has not been front-page news since 1974, when the collapse of Herstatt Bank led to the seizure of international markets. German authorities closed Herstatt down before the bank could transfer dollars to its counterparties to pay for its side of currency trades, even though it had already received the German marks. International payments were frozen, lending rates spiked and credit lines were pulled.
In 2002, CLS was born as a utility to settle FX transactions on a payment-versus-payment (PVP) basis, which eliminates settlement risk because it ensures that a payment in a currency only occurs if the payment in the other currency takes place. The establishment of CLS has led to a reduction in settlement risk in FX and currency markets operated smoothly even during the global financial crisis as a result.
But since 2019, the Bank for International Settlements (BIS) has been warning about a rise in FX settlement risks. By last year, the BIS estimated that nearly a third of deliverable currency trades, or $2.2tn, were at risk every day because of sitting outside CLS, up from $1.9tn in 2019.
The BIS noted that “settlement risk remains because existing PVP arrangements are unavailable, or unsuitable for certain trades, or market participants find them too expensive”. It also encouraged continued innovation and the adoption of alternative PVP providers.
The trade-off is between efficiency and choice
BNP Paribas’s Ms de Trémiolles says that if CLS allowed T+0 settlement under its umbrella, the market would think that Christmas had come early. But according to a spokesperson for CLS, “no operational changes are planned for CLS settlement”.
“T+1 trade flows are currently supported, provided payment instructions related to an FX transaction are submitted to CLS by 00:00 CET on the day before the value date,” the company said in an emailed comment.
The spokesperson added that the company has seen various approaches from clients dealing with the shorter timeframes and they encouraged market participants to increase the efficiency of their post-trade processes. But while banks and investors are puzzling over how the shift affects them, CLS sees a negligible impact from the regulatory tweak.
“CLS estimates that less than 1% of the CLS settlement average daily value could be affected by the change,” the spokesperson for CLS told The Banker.
Change strategies
Companies will need a trading desk in the US to be able to trade FX at the US close to hedge equity trades. According to Vincent Bonamy, head of global intermediary services at HSBC, smaller and regional banks are likely to be more affected than the global behemoths, as they tend not to have US trading desks.
On the investor side, large asset managers are expected to be most impacted by the change because they tend to handle their trading themselves, rather than outsourcing execution to a custodian — a route that many smaller firms take. UK broker Baillie Gifford is one of the companies that have announced plans to open a trading presence in the US as a result of the rule change.
“The trade-off is between efficiency and choice,” says JPMorgan’s Mr Puri, noting that there will be clients that open US trading desks and take on additional operational complexity. Others will hand over their trades and the whole process to custodians, in return for relinquishing control over their execution.
But even with a US desk, the problems remain. “Even if they [have a US desk], they may struggle with liquidity at the end of the New York day,” Mr Puri adds.
Best execution
Asset managers are expected to strive for the best potential outcomes in terms of prices and to reduce the costs of transaction to a minimum. In FX markets, costs are expressed in the difference between the bid–ask spread: the gap between prices at which counterparties are prepared to buy and sell their currencies.
The cost of trading currencies is influenced by liquidity conditions, with investors achieving the best prices in the most active time periods. During the global day, liquidity and activity ebbs and flows, hitting a peak when all three regions — Asia, Europe and the US — are active at the same time, around 13:00 CET (see charts).
In contrast, the worst and most expensive time to trade FX is at and after the US close — the exact time that the T+1 move is pushing investors towards. According to New Change FX data, it can be 74% more expensive to trade Australian dollars at that time, compared with the most liquid period.
This is also a period when major banks and exchanges perform maintenance, as it is the least busy hour of the day, and when flash crashes happened in previous years due to lack of liquidity. Due to its notorious lack of liquidity, the hour after the US close is known in trading circles as the “witching hour”.
“I think liquidity will be really, really bad at that time,” says Ms de Trémiolles, “so I’m not really telling people to go ahead and send us as many orders as they like in the witching hour because it just won’t be possible to execute those orders at a reasonable level.”
Executing in this period could increase the risk of failed trades, which, due to the acceleration of pace in the settlement cycles, is already likely to rise.
However, there are options. Investors could give their FX to a custodian and forget about the whole painful episode. Ed McGann, global head of FX, fixed income and equity platform sales at BNY Mellon, says that the bank guarantees “certainty of settlement for FX on a T+1 basis” for clients that use the bank’s FX capabilities.
This is likely to prove an attractive route for smaller and medium-sized managers, leading Osttra’s Mr Choudhury to expect these banks to become larger players in FX trading as a result.
“Custodians that are not currently very big FX dealers could see a huge increase in flow,” he says.
All change in FX liquidity
Another possible solution is to estimate the flows that need to be hedged and trade ahead of the actual equity transactions to ensure good execution quality on the FX leg. Then, the following day, once actual amounts are known, trade a second time to adjust the estimate.
“If the CLS part is not a moving part … I cannot see any other way to actually meet that, unless I rely on the pre-trade transaction cost analysis and hedge based on that, and then adjust,” says Ms de Trémiolles. “[This] would mean that, potentially, we will have increased FX flows because of the pre-hedging and then the actual hedging taking place twice. And again, we are talking about increased costs.”
There is also a possibility that, as investors are pushed towards the US close, global FX liquidity patterns shift. Xavier Porterfield, head of research at New Change FX, says that rather than having a distinct surge during European hours when US markets open, it is possible that a considerable portion of the flow migrates to the close.
“It might be that the US close becomes a big thing in FX, just like it is in equities, and the peak in liquidity we currently have around lunchtime in European hours flattens out as late evenings become busy,” he says. “If that ends up being the case, transaction costs could actually fall overall.”
