Foreign exchange market participants shouldn’t lose sight of the challenges raised by incoming changes to the settlement process for US securities, an FX specialist told ISDA’s annual legal forum in London on Tuesday.
The settlement deadline for US securities is due to be slashed in May from two business days after a trade takes place to just one – a practice known as T+1 – forcing many market participants to overhaul how they manage the currency trades used to pay for US equities and bonds.
Halving the settlement timeframe will cause a major headache for many foreign investors, which held about US$25trn in US securities as of mid-2022. That's because it will materially reduce the leeway these firms have to complete currency trades – and identify any issues with them – requiring many to make significant operational changes to reduce the risk of settlement failures.
“[T+1] may inadvertently transfer some of the risks to the FX market – and that's really where our concern lies,” Gaynor Wood, general counsel at CLS, told the ISDA conference. CLS has become a central part of FX market infrastructure over the past two decades, settling more than US$6.5trn in daily FX volume.
"There's a compressed timeline potentially to perform those post-trade processes," Wood said. "One of the main priorities from our perspective is to try to preserve the stability of the FX ecosystem."
The Securities and Exchange Commission said last February that the settlement cycle for US securities would move to T+1 in May 2024 to reduce the credit, market and liquidity risks within transactions.
Non-US firms own roughly 20% of the US securities market, according to the Global Financial Markets Association. While most of these firms secure the US dollars they need to make their purchases the day after the trade, the shift to T+1 will change that – forcing the exchange of currencies to occur the same day an investor buys stocks or bonds.
Timezone differences provide an obvious stumbling block in the new regime, narrowing the window for investors to match their equity positions and then execute the accompanying currency transaction.
The overall effect of the rule change will see post-trade processing times reduce by 83%, according to analysis by the Association of Financial Markets in Europe. About US$39bn in daily FX volumes – 0.6% of the total – from non-US firms will be affected by the shift, CLS estimates.
The tighter timeline also means investors may miss their window to settle FX trades via CLS. Designed to reduce settlement risk within the FX market, CLS went live in 2002 and now settles currency transactions each day by netting positions on a multilateral basis.
Investors may instead have to settle their FX trades bilaterally. That increases the risk of settlement failure – a phenomenon that came to prominence half a century ago when several counterparties of Germany's Herstatt Bank didn't receive FX payments they were owed following the lender's sudden collapse.
“Because of those timezone differences, European and Asian investors that manage funds might have a lot less time to mobilise currency through a T+1 securities trade in the US,” said Wood. “In an extreme scenario, you could end up only having two hours available for that [FX trade] submission to CLS to be arranged and organised.”
Wood said that more than 35,000 third parties settle FX transactions through CLS, in some cases using custodians to handle payments and funding. These firms will have their own internal cutoff times to meet CLS’s deadlines, creating “incredibly tight, if not impossible” timelines for the clients looking to settle their FX trades, she said.
Even if FX settlement failures don't trigger a crisis, they can still be costly for those involved. For trades unable to be settled within CLS – and so benefit from netting – investors will end up having to settle trades on a gross notional basis instead. This will mean investors need more funds to settle their FX trades.
“There’s no easy answer to [these challenges] but we mustn’t lose sight of the importance of coordination between [US] securities and FX settlements – and the challenges that might come with T+1 implementation,” said Wood.