The clearing and settlement of equity trades may not sound like the most exciting subject, but it is an important one. And this year something big is happening. The US equity market is moving to a shorter settlement cycle.
Beginning May 28, trades in US stocks will settle the day after the trade date (T+1). Currently, the settlement cycle is two days after the trade date (T+2). Trades in US corporate bonds and unit investment trusts will also move to the shorter cycle, as will the national equity markets of Canada and Mexico.
This will place the US equity market on a shorter settlement cycle than most other developed markets, which operate on a T+2 or T+3 cycle.
Faster settlement protects market participants by reducing systemic risks, operational risks, liquidity needs, and counterparty risks. It also helps to reduce margin requirements and allows investors quicker access to the proceeds from a sale trade.
Faster exchange of securities for cash is in line with technological advances and may have further to go. If we can send money instantaneously — as most of us now can via faster payments systems — why can’t we move the cash associated with our equity trades in real time as well?
The answer is that money and securities move on different settlement “rails” with different operating procedures. Beyond that, we still operate in a world of national currencies and national securities markets. Moving money between them is not always seamless.
Why Does This Matter to a Global Index Provider?
FTSE Russell’s role as a global index provider is to offer an objective view of markets’ behaviour. This means creating and managing a wide range of indices, data, and analytical solutions to meet clients’ needs across asset classes, styles, and strategies.
It also means looking behind the daily headlines of market movements and into the way those markets operate. Settlement cycles matter to us because we can’t look at any particular equity market in a vacuum — from the perspective of local traders and investors.
In fact, a US trader or investor buying and selling Amazon or Microsoft shares probably won’t notice that much has changed at the end of May. But the new T+1 settlement cycle for US equities creates complexities for non-domestic investors in US shares.
For anyone outside the US buying or selling US shares, there likely will be an associated foreign exchange (FX) transaction. A foreign buyer of US shares may need to sell his or her currency to buy US dollars to acquire the shares. Equally, a seller of US shares will probably want to convert the dollars received into another currency.
The FX market’s convention is T+2 settlement. After May 28, there will be a mismatch between FX and equity settlement periods.
Knock-on Effects
The shortening of the US equity settlement cycle may have various knock-on effects for other financial market participants around the world. This may be exacerbated, depending on the time zone in which an investor operates.
Among those affected could be index fund managers. The replicability of regional or global benchmarks may be tested, for example, if the new settlement cut-off times are unattainable for a typical index-tracking portfolio. Importantly, US shares currently represent more than 60% of global equity indices by weight.
Keeping an Eye on Equity Market Structure
Changes to equity markets’ operating procedures are inevitable and ongoing. They are something FTSE Russell monitors closely via our equity country classification process. The quality of regulation, the dealing landscape, and custody and settlement procedures within individual equity markets impact that process.
We conduct a formal annual review of country classification within the FTSE global equity indices each September using a comprehensive, transparent, and consistent methodology, and an interim country classification review each March. We publish the results of each review shortly afterward.
In the last three decades, we have witnessed a welcome shift toward more seamless post-trade procedures and a shortening of settlement times. But the changes to market practices resulting from the impending contraction of the US equity settlement cycle is one area we will be following closely.
Two resources to help bring you up to speed on this topic are the market and index impact of the shorter US equity settlement cycle and The challenges and opportunities for FX from the US and Canada shift to T+1.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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