Market Analysis

US Stock Settlement Transition Faces Initial Resilience Challenge

Amos Simanungkalit · 20 May 20242.2K Views

Participants in the United States' multitrillion-dollar securities markets are about to face a significant challenge in adapting to regulatory reforms aimed at speeding up trade settlements. The reforms mandate that starting May 28, U.S. stocks and corporate bonds must settle one business day after trading instead of the previous two-day standard. Markets in Canada and Mexico are also implementing these changes to reduce counterparty risk and improve market liquidity.

However, just three days after this new T+1 settlement standard goes into effect, a major index rebalance by MSCI is scheduled to occur. This quarterly event, which requires funds to readjust their holdings to track the index, is one of the largest trading days of the year and is raising concerns about its impact on the newly adjusted market.

"This really is the rubber hitting the road immediately after T+1 goes live," said Gerard Walsh, leader of Northern Trust's Global Capital Markets Client Solutions group. "The MSCI rebalance occurs across thousands of funds, ETFs, and portfolio structures. It's a big deal."

Walsh anticipates an immediate spike in failed settlements due to several "separate-but-related market events," including the rebalance. During the last rebalance, global trading volumes increased by an average of 120%, with the U.S. seeing a 199% rise, according to data from Northern Trust shared with Reuters.

"The concern is what hasn't been thought of rather than those things that have been solved for," said John Oleon, managing director of clearing and settlement operations at Clear Street. He expects the fail rate to increase in the first week after the switchover.

Failed trades occur when a counterparty cannot deliver the securities or funds to meet their settlement obligations, leading to financial losses, increased transaction costs, and potential reputational damage, as noted by financial tech firm Gresham Technologies. The U.S. Securities and Exchange Commission believes faster settlement will make markets more efficient, though it acknowledges that foreign investors will have less time to recall their U.S. securities and gather the necessary dollars to trade.

Market participants worry that an increase in transaction failures could hinder investors' efforts to adjust portfolios in line with MSCI benchmarks. The Depository Trust Company reported that in April, 83.5% of transactions from U.S. and non-U.S. firms were affirmed by the cut-off time of 2100 ET on the trade date. While affirmation is not required for settlement, it smooths the process and reduces the risk of failed settlements.

"DTCC is well prepared for the implementation of T+1, and we are confident in our ability to capture and process the additional volumes from the MSCI rebalance," said Brian Steele, president of clearing and securities services at DTCC. "We will continue to work across the industry and with key stakeholders to ensure a successful T+1 implementation."

Failed trades or delays in securities lending recalls can incur overdrafts or interest charges. Walsh noted that overdrafts needed to bridge the gap between trade and settlement can cost around 1.5 basis points per day. Daniel Takieddine, chief executive MENA at brokerage BDSwiss, pointed out that index rebalancing could increase trading costs and necessitate more attention to settlement operations.

Stephane Ritz, T+1 global lead at CapCo, mentioned that clients expect 3%-5% of trades to fail immediately after the switch, consistent with current fail rates. However, there is a concern that the fail rate might be higher in Asia, where the time frame is tighter.

MSCI has been closely monitoring global clearing and settlement equity cycles and has not altered its methodology or processes for markets adopting faster settlements. "The alignment of settlement systems is critical for maintaining the stability of securities markets and protecting investors' assets," MSCI stated.

Natsumi Matsuba, head of FX trading and portfolio management at Russell Investments, acknowledged a liquidity concern around the MSCI rebalance every quarter but emphasized that being aware of settlement cut-offs and peak liquidity times can minimize the impact.

RJ Rondini, director of securities operations at the Investment Company Institute, noted that the components of the rebalanced index are announced weeks in advance to prevent market surprises. "There's likely to be added trading volume on Friday, May 31," Rondini said. "But the industry participants are very well aware of the rebalance. We're hearing that it will add volume but not necessarily complexity."