Developments in the capital markets are often an indicator of where the funds market might go next. This is why we’re watching the shift in securities settlement times from T+2 to T+1 so closely. After all, there is a precedent here. Back in 2014, securities settlements in the UK and EU transitioned from T+3 to T+2, with the US market joining them shortly after. The funds industry quickly followed suit, reducing their own settlement times to T+3 from T+4. We believe the funds industry should seize this opportunity to speed up its own settlement times once again and make the move to T+2.
A number of major securities markets have either moved to or are considering moving to T+1 settlements. This was kickstarted by India in January of this year, while the SEC has committed US securities to T+1 settlements by May 2024, with the EU and UK also exploring a potential move.
But what’s driving the change? Primarily, a demonstrable increase in liquidity in the market and a serious reduction of counterparty default risk. On the former, shorter settlement cycles mean investors can access their funds more quickly following the sale of a security. This increased speed allows them to reinvest or utilise capital sooner, contributing to overall market liquidity. And, in regards to the latter, models run by the Depository Trust and Clearing Corporation (DTCC) show that a move to T+1 settlements on its National Securities Clearing Corporation (NSCC) could potentially reduce the volatility component of its margin by 41%. As that materialises and investors start to feel the benefits, it’s a matter of time until fund investors start to demand the same from their managers.
Benefits are there for fund managers too. It is no secret that most face increasing margin pressure due to fee compression driven by fierce competition, something that was recently confirmed in a survey from Fitch. Yet, if firms slash the time it takes to settle trades through automation, then costs are easily reduced along with errors. Such savings can help to reduce a funds’ total expense ratio and make it more appealing to investors thereby helping them to becoming more competitive.
Our hope is that the fund industry takes note of the benefits on offer as we believe that faster settlements will not only improve liquidity and reduce risk, but can act as a catalyst for further innovation and operational efficiency. As we found in Calastone’s recent survey on fund automation, despite some huge digital advancements, parts of the fund industry remain painfully manual. It feels somewhat premature to be talking about atomic settlements, or instantaneous and simultaneous exchange of cash for fund units, when almost 70% of mutual funds still rely on fax machines.
Even for securities, the move to T+1 is going to be complex. Where moving to T+2 was mainly about doing the same things more quickly, T+1 requires new processes. The three-day clearing period for BACS transactions, for example, presents a known operational constraint, potentially limiting the development of a scalable model for a shorter fund settlement cycle.
Similarly, it creates challenges for FX. In conversations we held with the Investment Association, this was a particularly big concern among members – and understandably so. For example, if a US investor buys an Indian security, the time needed for banks in both countries to open, process the FX trade, and subsequently handle the securities transaction may extend beyond a single business day. It could be costly too. The move has been driven, in part, by intraday liquidity which will put further pressure on funds to have sufficient cash reserves.
Despite these challenges, the fundamental changes a move by the capital markets to T+1 dictates means the investment industry as a whole should see a positive and progressive impact, with T+0 the ultimate goal. After all, the technology that can facilitate atomic settlements already exists. Through tokenisation, the process of representing assets as tokens on a blockchain, trades can be executed, cleared and settled instantly. Indeed, our settlement solution already enables funds to trade at T+0. We view the capital markets’ shift to T+1 as the necessary impetus to modernise operational infrastructure and improve processes and market practices.
For forward thinking and proactive fund managers, the starting point should be calling for the industry to follow in the capital markets’ footsteps with haste. Following that, the focus must be up-levelling their own systems to put them in pole position for when T+2 arrives and to lead the way when atomic settlements eventually and inevitably become the norm.