SEC Requires T+1 Settlement Cycle

SEC efforts to shorten the US securities settlement cycle come as no surprise, yet these changes will have profound implications for the industry, US and global financial markets, and financial services generally. The push to move to T+1 essentially began the day after the industry moved to T+2 in September 2017. Nevertheless, various intervening events have caused delays in the timeline, while at the same time making it increasingly clear that T+1 is necessary. In particular, heightened volatility at the onset of the COVID-19 pandemic and the January 2021 “meme stock” events highlighted vulnerabilities in the settlement timeline that a shortened cycle should help mitigate.

The T+1 transition and implementation deadline is currently set for May 28, 2024. SEC Chairman Gary Gensler noted his view that the amendments will “make our market plumbing more resilient, timely, orderly, and efficient.” Commissioners Hester Peirce and Mark Uyeda both seemed supportive of the substance of the rulemaking, yet did not support adoption due to the implementation date. Commissioner Hester Peirce called for a September 3, 2024 implementation date (the first business day after Labor Day 2024) to allow for more time for industry coordination and testing and because Canada is moving to T+1 and also recognizes that weekend as a holiday.

T+1

Amended Exchange Act Rule 15c6-1(a) would prohibit broker-dealers from effecting or entering into contracts for the purchase or sale of a security (other than exempted securities and security-based swaps) that provide for payment of funds and delivery of securities later than T+1, unless the parties expressly agree to a different settlement date at the time of the transaction.

The SEC staff noted in their October 2021 Report on Equity and Options Market Structure Conditions the integral role clearing firms play in risk management for equity trading, and noted one method to mitigate the systemic risk posed by clearinghouses would be to shorten the settlement cycle. For its part, the Commission has noted that liquidity demands (i.e., margin calls) imposed by clearing firms on their participants during times of stress have procyclical effects that reduce overall liquidity and have the potential to exacerbate volatility. In addition to a potential reduction in this acute systemic risk, an added benefit of a shorter settlement cycle should be a reduction in overall margin that clearing firms require broker-dealers to post.

The Commission discussed a few interesting related points in the adoption:

• The existing exemptive orders issued pursuant to Exchange Act Rule 15c6-1(b) for certain insurance products and for foreign securities that do not have facilities for transfer or delivery in the US will remain in effect without modification. The goal here seems to be to avoid any “product misalignments.” 
• Interestingly, however, the Commission believes that ADRs should continue to be subject to the new T+1 requirement. The Commission noted that exempting ADRs from Rule 15c6-1(a) would diminish the benefits associated with moving to T+1. 
• Similarly, the Commission chose not to exempt from T+1 settlement US-listed ETFs with baskets that contain foreign securities and ADRs. The Commission acknowledged that settling these trades may become more costly for certain APs in a T+1 environment as result of the “prospective misalignment” between the settlement cycle for the trades themselves and the underlying foreign securities.

Same-Day Affirmations

New Exchange Act Rule 15c6-2 covers transactions that require completion of the allocation, confirmation, or affirmation process.^[1] A broker-dealer generally will be prohibited from effecting or entering into a contract for the purchase or sale of a security on behalf of a customer unless the broker-dealer has either:

• Entered into written agreements with the relevant parties (such as investment managers and bank custodians, as agents of a broker-dealer’s customer) to ensure completion of allocations, confirmations, and affirmations as soon as technologically practicable and no later than the end of the day on trade date; or
• Established, maintained, and enforced written policies and procedures reasonably designed to ensure completion of allocations, confirmations, and affirmations as soon as technologically practicable and no later than the end of the day on trade date.

Policies and procedures of broker-dealers that choose that path must:

• Identify and describe any technology systems, operations, and processes used to coordinate with other relevant parties, including investment advisers and custodians, to ensure completion of the allocation, confirmation, or affirmation process for the transaction;
• Set target time frames on trade date for completing the allocation, confirmation, and affirmation for the transaction;
• Describe procedures for communicating trade information promptly, investigating any discrepancies in trade information, and adjusting trade information to help ensure that the allocation, confirmation, and affirmation can be completed by the target time frames on trade date;
• Describe how the broker-dealer plans to identify and address delays if another party, including an investment adviser or a custodian, is not promptly completing the allocation or affirmation for the transaction or if the broker-dealer experiences delays in promptly completing the confirmation; and
• Measure, monitor, and document the rates of allocations, confirmations, and affirmations completed as soon as technologically practicable and no later than the end of the day on trade date.

The Commission seems to be providing the optional paths as a way to provide flexibility, while at the same time striving for the same goals — affirming trades as soon as possible to avoid settlement fails. The Commission also thinks this may help brokers and the other parties to an institutional transaction develop innovations that improve the allocation, confirmation, and affirmation process.

For transactions subject to Rule 15c6-2(a), the rulemaking amends the RIA recordkeeping rule (Advisers Act Rule 204-2) to require that RIAs make and keep records of each confirmation received, and of any allocation and each affirmation sent or received, with a date and time stamp for each indicating when it was sent or received. SEC staff will likely request these records during exams and use them to monitor the transition from T+2 to T+1. The Commission noted that RIAs must keep originals of written confirmations received, and copies of all allocations and affirmations sent or received, but may maintain records electronically if they satisfy certain conditions.

Straight-Through Processing

Straight through processing or “STP” essentially refers to a process that is entirely automated without manual intervention. In the institutional context, a market participant can use the facilities of a central matching service providers or “CMSP” (like DTCC) to enter trade details and complete the trade allocation, confirmation, affirmation, and/or matching processes without manual intervention. As the Commission noted, CMSPs facilitate communications among a broker-dealer, an institutional investor or its investment adviser, and the institutional investor’s custodian to reach agreement on the details of a securities transaction, enabling the trade allocation, confirmation, affirmation, and/or the matching of institutional trades.

The Commission designed new Rule 17Ad-27 to require CMSPs and their users to assess their processes and find solutions to reduce or eliminate reliance on manual or other inefficient processes or that otherwise do not facilitate STP in the institutional trade processing environment.  Specifically, a CMSP must establish, implement, maintain, and enforce reasonably designed written policies and procedures that facilitate STP. CMSPs will also need to submit an annual report to the Commission via EDGAR that provides:

• A summary of its current policies and procedures reasonably designed to facilitate STP;
• A qualitative description of its progress in facilitating STP during the 12-month period covered by the report; 
• A quantitative presentation of data that includes specified metrics and organized in a specified manner; and 
• A qualitative description of the actions it intends to take to facilitate STP during the 12-month period that follows the period covered by the report.

Firm Commitment Underwritings

Amended Rule 15c6-1(c) prohibits broker-dealers from entering into contracts for firm commitment offerings priced after 4:30 pm ET that provide for payment of funds and delivery of securities later than T+2 (currently T+4), unless the parties expressly agree to a different settlement date at the time of the transaction.

The Commission originally proposed going to T+1 in this area. However, it ultimately opted to reduce the settlement period from T+4 to T+2 instead. The Commission pointed to the difficulty in processes for delivery of the prospectus, despite being mitigated by the “access equals delivery” standard. The Commission acknowledged that it was persuaded by commenters that a T+1 settlement cycle is not long enough to prevent firm commitment offerings priced after 4:30 pm ET from failing to settle on time. The Commission acknowledged that unforeseen circumstances at the time of the pricing of the transaction could arise that would prevent settlement on T+1 (including unanticipated issues relating to transfer agents, legend removal, local law matters (including local court approval), medallion guarantees, or non-US parties to the transaction).

What’s Next?

The T+1 settlement transition is set to take effect on May 28, 2024.

Of course, the next question everyone has is when will same-day/T+0 settlement become the standard. Beyond the when is the question of what that will look like or how it will be implemented.  The SEC has referred to various “pathways to T+0,” including:

1. Netted settlement at the end of the trade day on a T+0 basis;
2. Real-time or near real-time settlement, presumably on a gross basis (i.e., without any netting applied to reduce the overall number of open positions); and 
3. “Rolling” settlement by netting and settling intraday on a periodic and recurring basis.

Significant technological, operational, compliance, and risk challenges lay ahead to get to T+1, but these will be closely coordinated among industry stakeholders. Market participants should also be mindful of the knock-on effects for complying with Regulation SHO, confirmation and prospectus delivery obligations, and broker-dealer financial responsibility obligations (including what it means to “promptly transmit” funds and “promptly deliver” securities).

 

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^[1] The Commission notes that it did not define the terms “allocation,” “confirmation,” or “affirmation,” but explained that trade allocation refers to the process by which an institutional investor (often an investment adviser) allocates a large trade among various client accounts or determines how to apportion securities trades ordered contemporaneously on behalf of multiple funds or non-fund clients. The T+1 proposal from 2022 explained that the terms “confirmation” and “affirmation” refer to the transmission of messages among broker-dealers, institutional investors, and custodian banks to confirm the terms of a trade executed for an institutional investor, a process necessary to ensure the accuracy of the trade being settled. In proposing Rule 15c6-2, the Commission used the term “confirmation” to refer to the operational message that includes trade details provided by the broker-dealer to the customer to verify trade information so that a trade can be prepared for settlement on the timeline established in Rule 15c6-1(a), in contrast to the confirmations required under Exchange Act Rule 10b-10. The Commission explained that the term “confirmation,” as used in Rule 15c6-2, should be understood to refer to the institutional trade processing message or verification and not the disclosure required under Exchange Act Rule 10b-10. The Commission also explained that the term “customer,” as used in Rule 15c6-2, includes any person or agent of such person who opens a brokerage account at a broker-dealer to effect an institutional trade or purchases or sells a security for which the broker-dealer receives or will receive compensation. The Commission stated that the term is intended to cover institutional investors and any and all agents acting on their behalf.