GFMA Highlights FX Challenges of US Move to T+1

A new paper published by the Global Financial Markets Association (GFMA) offers insight into what will no doubt be a challenge for financial markets participants – especially non-US investors – from the shift in the US securities settlement cycle from T+2 to T+1 in May 2024.

The paper also discusses the considerations that need to be taken into account by buy side investors in particular given the potentially heightened risks likely to emerge in the funding, settlement and operational areas.

The US move to T+1 has been confirmed by US regulators as occurring on 28 May 2024 and while some jurisdictions are already at T+1, GFMA observes that more are likely to follow in due course, thus making the FX hedging element more complex. On the US, it cites the 19.6% of US securities and 16% of US equities held by offshore investors, which amounts to close to $25 trillion and $12 trillion respectively.

The paper says the accelerated settlement window in the US will require a review of both the timing of the FX hedging transaction, as well as the full settlement process for both FX and security trades. “The acceleration of the US securities settlement cycle to T+1, raises the risk that security transaction-funding, dependent on FX settlement, may not occur in time,” the paper observes. “Closer coordination of the timing and settlement for both the security and FX trade is needed to ensure there is adequate time available for the settlement and payment of FX trade for the T+1 security transaction.

“The FX trade lifecycle is already established for T+1 settlement, and is a process that includes execution, allocation, confirmation, and payment within local currency operating hours – adding another layer of complexity for meeting T+1 security settlement,” it adds.

Within the major currencies, where liquidity is more freely available generally, trading at what would be T+1, or even T+0 for those executing US securities trades on a Market on Close (MOC) basis (i.e. 4pm EST), is manageable and settlement risk is mitigated by CLS where it is available.

When dealing in local markets, however, the challenges increase – not least because a PvP settlement mechanism may not be available. GFMA also points out that FX settlement for local currency is governed by the combination of operating hours of the local central banks and operating hours of the commercial banks. “This dictates local currency cut-off times and warrants a thorough understanding of the window of time available to execute the supporting FX trade for the corresponding securities transaction,” the paper states.

Prioritising the execution of the FX trade as close- in-time to the equity trade as possible can help to optimise the settlement process for US T+1 trades

It adds that cut-off times are often different for each currency and are mostly governed by local RTGS hours, but also need to include correspondent bank networks for both the currency and counter currency. “Awareness of any local (scheduled and unscheduled) holidays is also required, as local market closures could adversely affect the ability to settle T+1,” the paper reminds.

Some EM and frontier currencies include “restricted currencies” and may have the added complexity of capital controls and trading restrictions, it continues. These may adversely affect the ability to settle offshore and often need to be transacted through local trading exchanges. “Understanding the timing and nature of these nuances for each currency is critical, as they may also require pre-funding, i.e., on T-1, to settle a T+1 US security transaction,” GFMA says.

Looking more at the operational processes of investment managers in particular, the paper also observes that having US-based operations may help mitigate some of the issues faced by firms seeking timelier FX and security trading and settlement. The paper states, “Prioritising the execution of the FX trade as close- in-time to the equity trade as possible can help to optimise the settlement process for US T+1 trades.”

It acknowledges that this is not easily achieved by some buy side participants (although some UK and European asset managers are establishing operations in the US, GFMA reports), therefore the paper recommends these firms consider investment in technologies that focus on the increased automation of processes, as well as to assessing the viability of using third-party vendors. “Increased automation offers the advantages of operational efficiencies and could help to address the time-zone challenges,” it states.

The use of specialist outsourcing to specialist currency managers is also suggested as a potential avenue to increase efficiency in this area, especially if the outsource firm has trading and operations teams in all major time zones, can offer passive and active hedging strategies and have 24/5 market access.

The cost and complexity of upgrading existing systems is significant and need to be balanced with the long-term strategic benefits of developing improved capabilities to address accelerating settlement cycles

The paper also sees trading platforms having an increase in demand for multi-asset trading and settlement capabilities. “FX Trading may witness an increase in client activity towards the end of the New York day for 4p.m. MOC equity-related orders,” it states. “Historically, FX liquidity tends to be reduced into the NY close and before the Asian session opens, which should be taken into consideration when executing FX trades.

“Trading desks may also witness an increase in T0 FX trades – which may require added vigilance towards funding and settlement processes to ensure adequate funding is in place to support same-day settled trades,” the paper adds.

On those managers that use the 4p London FX fix, the paper observes the amount of FX to be transacted is dependent upon the confirmed and matched equity transaction, which may not occur in time for a benchmark trade for T+1 settlement. “The risk of executing FX trades against unconfirmed/unmatched equity trades needs to be weighed up against the operational risks of increased trade amendments or cancellations,” it points out.

Clearly a shortened settlement cycle represents an operational risk, a fact noted in the paper, which says compliance checks will also need to be executed in a compressed window. The challenge is even greater in block trading, something that will require “added pre-trade vigilance” for new account set ups. “T+1 will limit the ability for the sell-side to affect payments for T+1 or same-day account set-ups for new accounts,” the paper states. “Meeting currency cut-off and settlement times will be challenged if new accounts are not established, and the loading of standard settlement instructions (incl. CLS eligibility) are not loaded in a timely fashion. Adopting automated client onboarding solutions may help alleviate this problem and to accommodate the demands of meeting T+1 settlement cycles.”

Transaction Costs

While there is unlikely to be a significant change in the costs of execution – there will be some change, however – there are significant risks of higher costs around the transaction. GFMA observes that pre-finding may be required for certain transactions where there are time zone challenges, especially Asia. Pre-funding within the existing trade life cycle can add additional cost and call into question the economics of the investment in the underlying security.

There is also the potential for increased costs associated with any late payment and interest rate charges, amplified when in a higher interest rate environment. Additionally GFMA points out that in an EU context any adverse cost impact resulting from late settlement fees under Central Securities Depositories Regulation (CSDR) rules also need to be highlighted for European-based transactions.

Finally, adequate time and consideration needs be given to any modification to post-trade and trading support processes, and to promote the timing of the FX execution to occur earlier in the workflow. A review of the costs associated with revised processes and new systems (including new locations for operations and staffing), and any changes in policies and workflow procedures will all need to be well understood. “The cost and complexity of upgrading existing systems is significant and need to be balanced with the long-term strategic benefits of developing improved capabilities to address accelerating settlement cycles,” the paper states.

The paper concludes by observing the accelerated settlement cycle is “a theme that is growing in focus across global financial markets”, adding the number of jurisdictions adopting or reviewing a move to T+1 securities settlement is growing.

For FX, the development of digital currencies is taking this phenomenon one step further – towards T+0 where the development of central bank digital currencies (CBDC’s) and other forms of digital currency have the potential to settle continuously and instantaneously.

“The advances in technologies such as distributed ledger (DLT), machine learning (ML) and artificial intelligence (AI) are also developing and in the future could provide alternative solutions to the challenges of T+1 US securities settlements,” GFMA says.

The full paper can be accessed here