By Vivek Shankar

Measuring the impact of the move to T+1 settlement

January 2024 in Regulatory Issues & Conduct

The Global Foreign Exchange Committee (GFXC) and its Code have played an integral part in standardising FX market practices. Adopting the Code’s 55 principles is voluntary and has prompted significant cooperation between private and public sectors. The latest of the GFXC’s periodic reviews closed late last year, with the results due for publishing in January 2024. What are some of the concerns in this latest iteration, and will Code changes address the T+1 elephant in the room?

A brief overview of Code adoption

“In the six years since it was established, the Code has expanded its reach across the FX industry,” Anna Nordstrom, Head of the Domestic and International Markets Functions at the New York Federal Reserve Bank (The Fed,) said in October last year at FX Markets USA.

She explained that over 1,000 market participants worldwide have adopted the Code, with the adopters’ nature changing. “Whereas the initial adopters were bank dealers, platforms, and technology providers, we have seen greater adoption by the asset management community more recently,” she said.

Currently, 11 of the top 15 asset management firms in the US adhere to the code, representing $36 trillion of assets under management. While these numbers paint a positive picture, is the Code adoption having any significant effects on FX market practices?

Nordstrom’s comments suggest it is. “Many trading venues have reduced the maximum length of their “last look window,” a significant number of large bank dealers have announced an end to additional hold times, and several electronic trading platforms now offer trading venues from which non-Code-compliant liquidity providers are excluded,” she said in her speech.

Nordstrom also noted the Chartered Financial Analyst program’s decision to reference the Code in its Level 1 certification materials, lending further credibility. Past Code reviews have highlighted the importance of standardising Last Look and Pre-Hedging procedures.

Recent modifications to the Code addressed settlement risk concerns. Lisa Danino-Lewis, Chief Growth Officer, CLS, explains. “The FX Global Code includes key principles concerning settlement risk (principles 35 and 50) that emphasise the use of payment-versus-payment (PvP) settlement mechanisms where available,” she says. 

“It recommends the use of bilateral netting in cases where PvP settlement is not [available.] We continue to see growth in adoption of our products, CLSSettlement, Cross Currency Swaps, and CLSNet, that support market participants’ adherence to these principles.”

And what do volumes look like? “CLSSettlement volumes have grown steadily with average daily values settled exceeding USD6.5 trillion across 18 currencies”, she says, “which accounts for a large proportion of FX trades in the market.”

“In parallel, the adoption of CLSNet, CLS’s standardised bilateral netting calculation service, has continued to grow with the average daily notional value of net calculations consistently exceeding USD115 billion in the last 12 months.”

FX settlement risk will likely feature heavily in the GFXC’s latest Code review. While market participants will have to wait till January to understand how the GFXC will approach changes, the committee’s history of recent Code changes offers plenty of hints.

In addition to the changes Danino-Lewis highlights, the GFXC also concluded that more frequent collection of FX settlement data through semi-annual surveys distributed by regional FX committees was wise.

The committee also launched a working group led by the Bank of England to review and enhance existing FX settlement data collection templates. All this talk of settlement risk is leading to the issue of US T+1 settlement, as the reader can guess.

While the switch to T+1 was aimed at US equities, the FX impact is significant.

Looming T+1 implications for FX settlement

The Global Financial Markets Association notes that the foreign holding of US equities stood at USD 12.1 Trillion in May 2023. Europe accounts for 48% of those holdings with Asia coming in second place at 22%. The move to T+1 doesn’t necessarily complicate the settlement picture as much as accelerates processes within it.

CLS’s Danino-Lewis explains that a trade’s FX component will need settling before the equity portion. “To understand the potential impact of the move to T+1 for asset managers and funds accessing CLSSettlement through third-party service providers, CLS analysed its transaction data,” she says.

“This analysis concluded that a value equivalent to approximately 1% of CLSSettlement’s average daily settlement value (USD6.5 trillion) is executed on a T+1 basis, comprising volumes where one side is USD, and a fund is a party to the trade.”

“Therefore, the maximum value that may need to move to T+0 after May 2024 by this community, is approximately USD 65 billion, assuming there are no trading and operational process changes by industry participants.”

Walking through a sample scenario facing international asset managers is instructive in understanding T+1’s impact. A fund manager based in the EU must sell EUR and buy USD when purchasing US equity. The amount of USD they need will only be known when the equity transaction occurs.

“The FX Global Code includes key principles concerning settlement risk that emphasise the use of payment-versus-payment (PvP) settlement mechanisms where available”

Lisa Danino-Lewis

Assuming the equity trade occurs at the New York market close (9 PM GMT,) the fund manager must settle their trade the following day, making it a T0 settlement. The manager can settle through CLS, since EURUSD is CLS-enabled, mitigating any settlement risks.

However, the trade remediation window reduces significantly. The picture is even more complex for Asia-based asset managers. With markets closing before New York opens, T0 transactions are a given. However, the lack of CLS enablement in several Asian emerging currencies increases settlement risk.

Fund managers will have to settle outside CLS while dealing with local market controls. One way of mitigating local control risks is to pre-fund the transaction, but this results in increased trading costs.

Danino-Lewis explains CLS has been working with market stakeholders to understand these risks better. “Asset managers access CLSSettlement indirectly through custodian banks that manage all payment instructions and funding relating to their clients’ FX trades,” she says.

“As part of this process, these custodian banks set their own cut-off times for CLS-related settlement to ensure adherence to CLS’s deadlines. CLS is also exploring how its services can assist in this issue and has conducted feasibility studies with both the buy side and sell side on adjusting CLSSettlement processes to accommodate later submission of instructions for settlement.”

Automation will play a role here, Danino-Lewis says. “For instructions that do not meet CLS’s 00:00 CET deadline, CLSNet, can enhance post-trade efficiencies and mitigate risk.”

“The service helps buy- and sell-side participants reduce funding requirements and the number of payments required by calculating net payment obligations that facilitate payment netting. CLSNet also enhances operational efficiencies through full automation, removing manual interventions from the netting calculation process.”

Neill Penney, Group Head of FX, LSEG, expands on the technology theme. “There are aspects of the workflow change that are universal, especially when it comes to technology,” he says. “Without greater automation, firms will face a struggle with both their FX funding and hedging operations.” 

“The key to a successful transition to the new environment will be the efficient transmission of data to both internal and external systems – and here advances in artificial intelligence (AI) and robotic processing automation (RPA) offer great potential.”

Penney reckons the FX market must evolve and embrace new products to overcome market structure challenges. “The good news is that FX is largely an automated industry and as such error rates are very low,” he says.

“Equally, as automation increases amongst investment managers,” he continues, “the error rates generated from failed trades in securities markets will also drop significantly. Investment managers will have an increased need for cash liquidity, which could be fulfilled through new products, while credit and pricing mechanisms may need to be adjusted to a shorter time horizon.”

In her speech at FX Markets USA last year, the New York Fed’s Nordstrom outlined a few considerations market participants will have to tackle. “FX market participants will need to carefully analyse their operational and liquidity management practices to avoid disrupting market functioning,” she said.

“Stakeholders may also need to make substantial improvements to their existing operational systems and reconfigure FX settlement processes. An additional consideration is how T+1 will affect the values and volumes that currently settle through payment-versus-payment arrangements.”

Nordstrom pointed out that while CLS can support this change, the volume of bilateral trade settlement outside CLS will increase, pushing settlement risk up. So, what are some of these considerations and how must stakeholders evaluate their processes?

Key considerations for a smooth T+1 move

The first consideration that springs to mind is local currency cut-off times and holidays. Local central and commercial banks dictate currency settlement hours that affect settlement time windows.

With each country adhering to different RTGS hours that govern currency cut-off times,) the challenge is one of coordination for asset managers. Correspondent bank hours and cut-offs also impact the settlement window.

“Without greater automation, firms will face a struggle with both their FX funding and hedging operations.”

Neill Penney

Technology and automated scheduling are obvious solutions to this puzzle and settlement risk. As Danino-Lewis explained, CLS has solutions, for trades that miss the 00:00 CET deadline, such as CLSNet which covers more than 120 currencies. 

Asset managers trading EM currencies, for instance, must account for additional credit lines and increased costs. Sticking with the EM theme, some of those currencies come with capital controls and trading restrictions.

With trade remediation windows squeezed due to T+1, participants will have to plan execution avenues ahead of time. For instance, some currencies will need to be transacted through local exchanges that bring unique nuances to the picture.

If the picture is too opaque, a prefunded mechanism to settle a T+1 transaction might be the solution. Of course, this increases costs. The GFMA notes that some fund managers are establishing US-based operation hubs to smooth settlement, but this option might be excessive for smaller fund managers.

FX market participants will need to carefully analyse their operational and liquidity management practices

The body notes in its report, “Consideration should also be given to the benefits of improving operational efficiencies, including investment in technologies that focus on the increased automation of processes, and 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.”

“Trading platforms could also see an increase in demand for multi-asset trading and settlement capabilities,” it continues. “Simultaneous execution and increased process automation of equity and currency trades in tandem will assist in expediting the confirmation and settlement process required to meet the T+1 deadline.”

The GFMA also notes that FX trading activity may increase towards the end of the New York day, a period where liquidity historically drops off. T0 FX trades may also spike, needing trading desks to pay special attention to funding needs.

“Fund managers also aim to offer “best execution” and price transparency for their clients, often using the WMR 11am NY/4pm London benchmark to execute FX trades for international equity transactions,” GFMA’s report notes. “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.”

Risk and cost impact

Given the shorter timeframe T+1 creates, automation will prove critical for firms looking to mitigate risk. For instance, Standard Settlement Instruction (SSI) loading and verification will come under stress in a T+1 environment. Sell-side firms will face limited timeframes to execute same-day account setups for new clients.

“An additional consideration is how T+1 will affect the values and volumes that currently settle through payment-versus-payment arrangements.”

Anna Nordstrom

Automating onboarding is one solution to this challenge. Automation can also solve issues in pre- and post-trade processing from KYC/AML checks and loading SSIs to matching and confirmation.

In contrast, the buy side might find currency management challenging and could consider adopting passive currency strategies. Leveraging external providers with local market experience and access is another option.

Most stakeholders will be keeping an eye on costs, given current market conditions. Pre-funding involving EM Asian currencies will increase costs. However, as interest rates rise, interest costs on late payments will likely have a significant impact. 

EU-based entities will have to contend with Central Securities Depositories Regulations (CSDR) that obligate them to disclose the adverse impact of late settlement fees. Infrastructure and workforce changes will also likely create a significant cost impact.

Technology is poised to help solve many of the challenges firms face due to T+1 settlement

With accelerated timelines in place, firms must consider augmenting existing roles with more personnel or introducing automation to the mix. Integrating these new roles with existing processes will need time, something that is a hidden cost.

In some cases, shifting operations to a US-based location might make sense, despite high costs. If the impact of a smoother settlement reduces risk, firms could justify higher operational costs.

The role of technology and automation

Speaking of technology, Distributed Ledger Technology (DLT) offers a curious peek into what could be the future. DLT promises a T0 settlement, given the blockchain’s immutability. However, it isn’t in any usable shape for the institutional market and it lacks large scale industry adoption, as well as any proven track record, unlike existing solutions. 

Despite the current limitations of new technologies, such as DLT, one fact is for certain: greater automation of post trade practices using existing technology will help to solve any challenges firms face due to T+1 settlement. How comprehensively firms automate their post trade services will prove critical in preparing successfully for T+1.