A new law affecting practically every trade of stocks, bonds, and exchange-traded funds (ETFs) in U.S. markets will take effect on May 28. Will it impact your investing, though?
Yes and no, then.
The “T+1” settlement cycle is established by this new rule, which has to do with how long it takes for securities transactions to “settle.”
Settlement: What is it?
Suppose you use your broker to purchase or sell stocks. Although you typically receive a confirmation of the trade immediately, this does not imply that the transaction has settled. In order for it to occur, the money must be taken out of the buyer’s account and delivered to the seller, and the stock must be moved from the seller’s portfolio to the buyer’s portfolio. Therefore, the formal handover of securities and funds between the two parties is referred to as “settlement.”
The day a trade is placed, or the transaction date, is not always the day that settlement takes place. As of right now, U.S. financial institutions have two business days to settle any applicable security transactions under the “T+2” settlement cycle. Institutions will now have one business day after the new regulation takes effect to settle.
The requirement that securities deals settle within one business day of the transaction date is hence referred to as “T+1.”
The following securities will be subject to the T+1 settlement cycle:
- Stocks
- Corporate Debt Securities
- ETFs
- local securities
- A few mutual funds
- Restricted alliances that engage in exchange trading
All assets that were traded on a T+2 settlement cycle will switch to a T+1 settlement cycle as of May 28. Other assets, such as government securities like Treasurys and options, will match up with the aforementioned securities since they are already on a next-day settlement schedule.
Why does T+1 settlement matter?
There are two main reasons why financial industry groups have been pushing for the T+1 settlement cycle: risk reduction and efficiency.
“There is a time-tested golden rule of clearing and settlement, which is the sooner you can get it done the better,” Brian Sussman, senior vice president of global operations at Interactive Brokers, told MarketWatch.
That’s because the longer it takes for a trade to settle, the higher the chance of the security or money not being there. Let’s say there’s an issue with the buy side and it turns out the account isn’t properly funded, or there’s some accounting error and the seller doesn’t own the correct number of shares. This is called a failure to deliver (FTD). Brokerages and clearinghouses generally have protections in place to prevent this from happening, but FTDs can happen, and the longer the period between the transaction and settlement, the greater the risk.
Reducing that risk is one of the reasons that industry players have been pushing to get to a T+1 settlement cycle since the 1990s, when the settlement cycle was still at T+5. Over the years, the U.S. has moved to a T+3 settlement cycle, then T+2 and now finally T+1.
During that time, the financial industry has evolved and introduced new forms of technology and automation. This leads to the second major reason: efficiency.
Securities like stocks can exchange hands multiple times a day. The more transactions in a day, the more accounting work that has to be done by the brokers, the DTC and clearinghouses. When multiple days pass between transaction and settlement, it can effectively create an accounting backlog. So shortening that time makes the settlement process more efficient, and promotes the adoption of more automated and efficient systems across the industry.
How does T+1 settlement affect me as an investor?
Best-case scenario, investors might not notice the transition to T+1, but they still stand to benefit from it.
“While the change to T+1 will be largely seamless for retail investors, they will benefit from the overall reduction in risk created by the move to T+1 settlement,” Tom Price, managing director and head of technology, operations and business continuity at Sifma, told MarketWatch. “Reducing risk in the system makes for healthier markets, and that is always better for investors.”
Even if the change is largely invisible for investors, there are a few things they might notice. For example, proceeds from selling a security should hit investors’ accounts faster, which also means that money can be reinvested faster. The flip side is true too, meaning investors have to have their funds ready sooner before they buy securities, which may affect things like currency exchange when an investor wants to buy a security in a foreign market.
However, as Price says, the main takeaway for retail investors is the reduction of risk.
Besides that, most of the changes brought by T+1 will be felt by brokers, clearinghouses and other institutions, since they’re the ones who have to process trades and settlement on the back end. But many of these institutions have spent years preparing for the new settlement cycle and have put in the work for everyone to be prepared for the transition.
Will we ever see a T+0 settlement cycle?
With T+1 settlement being something years in the making, a logical next question is, can we move even faster and do same-day or real-time settlement cycles? After all, cryptocurrencies settle in real time thanks to the blockchain. But for other securities, this may create more problems than it solves.
“The challenge with T+0 is not whether or not the NSCC’s platform can do it, or whether [brokerages] could change the code for our systems. The challenge is largely around financing and efficiency,” Sussman of Interactive Brokers told MarketWatch.
Crypto trades can happen in real time because they are prefunded, but prefunding the entire U.S. stock market is an entirely different beast due to the sheer volume and complexity of the market. On top of that, getting the U.S. stock market to trade at T+1 already involves many tight, same-day turnarounds. Getting things to move even faster may introduce additional risks that aren’t present with a T+1 cycle.
So with T+0 potentially creating more issues than it’s worth, the T+1 settlement cycle may be the sweet spot. To many of the financial professionals who have spent years working to get T+1 adopted, it represents a Goldilocks settlement cycle—less risky than T+2, less risky T+0, just right. And for investors, hopefully it represents a big step toward more efficient markets.
