Opinion
Wall Street is changing its trade clocks. Here’s how it could cost you
Stephen Bartholomeusz
Senior business columnistWhen Wall Street reopens after Monday’s Memorial Day holiday, trading will resume as normal. Yet when it comes to settling those trades, the process will be anything but normal.
The US, along with Canada, Mexico and Argentina, is halving the time allowed to settle trades in its stocks, bonds, exchange-traded funds and mutual funds from two days to one day – or, in the jargon of market participants and their regulators, from T+2 to T+1.
Wall Street is halving the time for settling trades from two days to one, creating headaches for international investors.Credit: Bloomberg
The move to T+1 is designed to lower trading costs and the amounts of capital required to support trades, while making the settlement process more efficient and reliable. It should lower the overall risk in the US system, but could – at least in the short term – increase the “fail rate” of trades.
It could also lead to mismatches between the US and other markets, most of which – including the ASX – operate within T+2 settlement regimes.
If a fund manager, for instance, wants to sell shares in Hong Kong or London, which have T+2 settlement, to buy shares in New York, they may have to settle the US transaction before they have received the funds from the sale of the shares in their home market.
They’ll also have to acquire the US dollars needed to buy the US shares before receiving funds from the shares they’ve sold, with a significant risk that equity and currency markets may have moved against them in the interim.
They may also have to staff their offices at unusual and difficult times. The mismatches in settlement periods and time zones mean that traders or fund managers in the Asia Pacific and Europe may have small windows at very inconvenient times (such as the wee hours of the morning) to execute and settle their trades.
In London, which usually has a five-hour time difference with New York, the processes involved in ensuring trades are being allocated to the correct accounts and properly verified by the participants had up to 14.5 hours to be completed with a T+2 US settlement period. The UK firms had up to 18.5 hours to recall securities they might have lent out, and up to 24 hours to organise the foreign exchange.
Under T+1, those same firms have only three hours to complete most of those processes, and they have to complete them by midnight in London.
The ASX is in a somewhat different position. While it is considering whether to move to T+1 (it issued a white paper on the topic last month), for many US and European investors, that would effectively mean moving them into a T+0 regime.
About 29 per cent of the funds flowing into Australia’s cash equities markets come from offshore, with about 14 per cent of investment in Australian equities coming from the US and about 8 per cent from the UK and Europe.
Australian Eastern Standard Time is generally 14 hours ahead of the US Eastern Standard Time (16 hours during daylight saving), and 8 to 9 hours ahead of Europe and the UK (10 to 11 hours during daylight saving).
In effect, the ASX says, once its 11.30am settlement cycle cut-off time is taken into account, those UK and US east coast investors already experience a T+1 environment.
In the US, the decision to truncate the settlement was prompted by the 2021 meme stock debacle, when the fee-free trading platform favoured by the retail investors driving the buying frenzy of stocks like GameStop and AMC Entertainment halted trading because it didn’t have the capital to provide the collateral to cover the deluge of trades for the two days until they settled.
Investors were left with uncompleted trades and with their cash – whether for purchases of shares or from sales – frozen within broking firms until Robinhood was able to raise more than $US1 billion ($1.5 billion) of new capital.
With time equalling both money and risk, the halving of the settlement period ought to mean less collateral needed to support trades and therefore less capital for the firms executing the trades. It might also mean more liquidity in markets, because the cash should be turning over more quickly.
It does, however, also mean a lot more automation for the firms involved, which means more costs that will probably be recovered from buyers and sellers – costs that will be even greater for foreign investors in the US because of the repercussions of the mismatches within the settlements periods for the different equities markets and the foreign exchange implications of those mismatches.
There is an expectation that the shortened timetable will, at least initially, lead to more failures of transactions, given the reduced time to sort out issues with the funding of a transaction or mistakes somewhere within the processes between acquiring/selling a security and settlement of the deal.
The halving of settlement times should lower the overall risk in the US system but could increase the “fail rate” of trades.Credit: Bloomberg
If the shares involved have been lent out (to enable short-selling), it may also take more than 24 hours to recover them, which might reduce the willingness of fund managers to lend the securities they hold.
The fail rate in the US stock market is already quite high, at around 4 per cent of transaction volumes, and it’s even higher in Europe. The ASX, despite all the issues it has had trying to replace its ageing CHESS clearing and settlements platform, has a fail rate of only 0.3 per cent.
At least initially, that rate – which brings with it its own costs and penalties – is likely to rise in a T+1 environment.
While there will clearly be some significant issues and costs for investors outside the US who want to buy or sell within the US securities markets, there’s likely to be some less daunting issues for some US investors trading offshore too, as they sell into the T+1 environment and buy into T+2 environments. The mismatch in settlements means a longer exposure to currency market risks than there is today.
For US exchange-traded funds investing offshore, where transactions in their own securities will settle within a day but trades in the underlying assets they hold offshore could take two days or more to settle, there will be a funding mismatch – and potentially, in the event of significant outflows during a period of volatility in markets, a substantial one. It is possible that the buy/sell spreads for US ETFs will widen to cover the increased costs and risks.
For the US, the increased costs of T+1 relative to T+2 are justified by the reduced risks and lower capital requirements within its system, as well as by the increased sophistication and efficiencies that the need to automate more processes will produce.
For the rest of the world, it generates only the increased costs, probably increases risks, and will make cross-border trades with the US a lot more complex and clunky than they have been.
The larger banks and brokers with a lot of cross-border trading experience ought to be able to cope, but there will be an anxious period for some less well-equipped firms as they work through the effects of the various timing mismatches and logistical challenges that the new environment creates.
Read more:
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