Currency settlement

Global Investor explores some of the implications of the move to T+1 settlement from a foreign exchange perspective and how this could impact trading costs in Asia Pacific.

In an article published late last year, BoonHiong Chan, head of fund services and head of securities market & technology advocacy at Deutsche Bank and Britta Woernle, head of market advocacy Europe securities services, Deutsche Bank discussed how the global trend towards accelerated settlement cycles was playing out in Asia Pacific.

China Interbank Market’s government bonds operate on settlement cycles of T+0, T+1 and T+2. T+3 and a special service where settlement on the trade date plus four or more days, where four days is the minimum ((T+n (n >=4)), were subsequently rolled out to allow sufficient funding time for global investors, especially those unable to settle due to local holidays.

In 2021, India made a determined push for a T+1 settlement cycle for listed equities, which has been live since February 2022. The initiative has been heralded as a positive development from a domestic and regulatory perspective. Accelerated settlement cycles have also being discussed in the Philippines (to move from T+3 to T+2).

In June 2022, the ASEAN+3 Bond Market Forum and the Cross-Border Settlement Infrastructure Forum organised a webinar outlining accelerated securities settlement and emphasised the need for industry-wide engagement, collaboration and support.

BBH’s European custody product manager, Derek Coyle, has suggested that Asia is likely to be the most impacted by the move to T+1 in the US market due to time zone differences on the basis that all post-trade activity would need to be completed in two hours.

While the Indian market adapts processes to T+1 on a specific fund/client basis, elements of optimisation might be possible to set up in terms of process design, he said, referring to the importance of reviewing which operational tasks can be done on T+0 - such as matching and confirmations - so that no further action is needed when Asian markets wake up on T+1.

In February, the SEC adopted rule changes to shorten the standard settlement cycle for most broker-dealer transactions in securities from two business days after the trade date (T+2) to one (T+1). The compliance date for the final rules is 28 May 2024.

FX exposure

The global FX division of the Global Financial Markets Association (GFMA) subsequently suggested that accelerating securities settlement to T+1 raises the risk that transaction funding dependent on FX settlement may not occur in time, with trade matching, confirmation, and payment all having to be completed within local currency cut-off times.

Alex Dunegan, CEO Lumint Currency Management observes that T+1 FX settlement is challenging for multiple reasons with many regulatory and operational considerations governing the FX settlement process, much of which comes down to the brokers and banks involved.

“For example, I purchase Australian equities from New York for T+1 settlement,” he says. “The bank I traded with may have already missed its Australian dollar cut-off time for payment since it is already T+1 in Australia when I am in New York - and that assumes I have done the FX trade alongside the equity purchase.”

Firms that do not execute their corresponding FX trades until T+1 (or later) would also be severely impacted. These firms may prefer to wait for confirmations or maximise FX netting opportunities if their equity purchases and sales occur in the same market and by definition, they would encounter settlement risk here.

Joe Hoffman, CEO of Mesirow Currency Management agrees that FX is a concern for investors that operate in an Australian or Asian base currency and trade frequently at the US close. By the time these investors receive their equity trade with confirmed FX requirements, the trade date for FX would have flipped - which happens at 5pm NY time. This means the FX trade will become a same day settled trade.

“Suppose an investor executes the equity trades early in the US trading day and subsequently instructs the FX trade,” he says. “In that case, the trade will be considered T+1, allowing the custodian time to process the trade.”

PVP services

For most currency pairs the standard settlement period is T+2. Principle 35 (settlement risk) of the Global Code of FX Conduct states ‘market participants should reduce their settlement risk as much as practicable, including by settling FX transactions through services that provide PVP settlement where available’.

The mechanism for settling PVP or paymentversus-payment (a settlement mechanism that ensures that the final transfer of a payment in one currency occurs if and only if the final transfer of a payment in another currency is to accept that the settlement FX will need to be executed on T+0, in the Asian morning

Chris

takes place) has been continuous linked settlement or CLS, which has set cut-off times where trades need to be matched in order to settle in this framework. Unfortunately, with the new T+1 equity settlement cycle, investors will have difficulty posting trades ahead of the CLS cut-off.

“As a result, they will need to be settled

Vikas Srivastava, chief revenue officer at Integral

and establishing new teams in the US may not be efficient or feasible,” he says. “Executing late in the US day also creates potential market liquidity implications that need to be understood. Another option is to accept that the settlement FX will need to be executed on T+0, in the Asian morning.”

Additional issues

However, this opens other risks such as potentially not being able to rely on risk mitigation market infrastructure such as continuous linked settlement. Other notable risks include executing and settling ahead of settlement cut-off times, which occur early in the global trading day for Asian currencies.

When trading US assets, the standard process is often for asset managers to trade the representative FX trade T+1. Once transactions are matched, trade calculation takes place the next day.

“This would therefore imply that after the T+1 change, we would either require execution in illiquid periods of the day - likely late in the day after London market period ends - or move to T+0 execution, which results in a much smaller window of potential execution, matching, and settlement, not to mention the lack of infrastructure to assist with this” says Nathan Vurgest, director, head of trading at Record Financial Group.

outside of CLS, which increases the risk surrounding settlement,” says Hoffman. “This is an unintended consequence of this change in the equity settlement cycle that regulators either missed or ignored.”

Since the US equity market closes at 4pm ET (9pm UK/10pm CET), this will leave very little time on T+1 to match the equity trades and to then generate and execute the FX required to settle the equity trades agrees Chris Gothard, partner and head of global markets at BBH.

“For Asian managers without US trading and settlement capabilities this poses a challenge,

This could potentially lead to inefficiencies in terms of cash balances being held in different currencies and more transactions to true these balances up, if these are required.

Under T+2, firms had more time to figure out exactly how much would be needed in the local currency for the equity trade, plus commissions and other fees. Achieving this under T+1 is much more challenging as in APAC firms will have a matter of hours and not days to ensure they have the correct amount of dollars available from settlement of associated FX trade.

Trading automation

To make this a reality, automation of the trading process is needed with very tight integration between the equity order management system, equity execution management system, back office, and the FX execution management system.

That is the view of Vikas Srivastava, chief revenue officer at Integral, who notes that all this needs to happen very quickly and with no mistakes.

“Manual processes will not be able to handle this and will lead to higher trade fails,” he says. “The spectre of T+1 should be a wakeup call for market participants to work with their technology providers to install highly automated trading technology. Given the time pressure to deliver the infrastructure there are significant benefits of going with a cloud-based system which has a much faster time to market than in-house tech builds.”

According to Gerard Walsh, global head of capital markets client solutions at Northern Trust, Asia-Pacific markets will need particular attention. In 2022, the US Treasury recorded approximately 25% of all US foreign owned equities were held by APAC investors (data as of 30 June 2022 published by the US Treasury in April 2023 from the report on foreign holdings on US securities).

However, he also observes that T+1 isn’t the shortest settlement cycle in place around the world. “For example, Taiwan is a T+0 market and there are models already at work to satisfy that ultra-short cycle,” says Walsh. “T+0 markets are pre- funded and elements of that T+0 process may need to be adopted by managers who invest in US assets and are based in a time zone that has low levels of overlap with US trading hours.”

Risk mitigation

Walsh also suggests that FX risk can be mitigated through thorough preparation.

“Leaving aside human error in the US T+1 future state, more use of straight through processing, as low a level of human intervention as possible, and a full rework of existing processes will help mitigate such risk,” he adds.

Whilst the GFMA report identifies that advances in distributed ledger technology (DLT) are developing and could eventually provide alternative solutions to the challenges of T+1 US securities settlements outlined in the report, this is significantly underplaying its current role suggests Alex Knight, head of sales and EMEA at Baton Systems.

“Automated, safe, and scalable settlements utilising DLT are already in use by some tier 1 banks, helping them to address the roadblocks to efficient trading that will be thrown up by this monumental shift in market structure,” he says. “DLT is already proven as the means to accomplish risk-proof FX settlements for cross-border transactions.”

These observations beg the question ‘how challenging is simultaneous execution of equity and currency trades?’. Historically, currency trades on the back of equity trades were an afterthought and left to the operations team or the custodian (un-negotiated FX trades typically realise much higher costs). As a result, the investor would wait until the equity trades were confirmed and matched before the currency trades were instructed.

Challenges of mixing stocks and currencies include differences in market dynamics, liquidity, execution speed, technology requirements, and risk management explains Dardan Abazi, senior institutional sales at Cornerstone FS.

“Coordinating the timing of equity and currency trades can be complex due to these factors,” he says. “Successful cross-asset trading requires careful planning, reliable data and technology, and expertise in both markets.”

Service providers

There are currency management and brokerage desks which can provide this service, but that does not necessarily make it easy to implement. Service providers that can execute simultaneous FX deals are best poised to help - assuming they can provide systematic solutions – but even a systematic and automated approach will face the same issues of time zones and bank settlement cutoff times.

The fastest FX execution system in the world is only as fast as the input data it receives and if that data arrives on T+1 or later, the settlement risk remains.

Vurgest says traders need to ask who would be managing this joint transaction - an equity specialist or a custodian – adding that it is notoriously costly to have custodians or nonFX specialists execute FX.

“Related to the above, if the FX transaction is merely ‘tagged’ on to equity transactions, the costs of execution would likely increase due to the lack of attention paid to this aspect,” he says. “This is because operational process is likely to be prioritised over cost reduction.”

This could lead greater inefficiency as there would be more ‘out of hours’ FX transactions. For example, when equities are transacted at New York close it is likely to be more expensive to execute FX outside of London hours.

“Lastly, it would be possible to align equity and FX requirements efficiently if there were less focus on matching equity benchmarks,” he adds. “Thus, more consideration could be given to trading during the day when there is better FX liquidity.”

Estimated trade

While simultaneous execution of equity and currency trades can be done, the concern there is that the FX execution is based on unmatched and unconfirmed equity trade information – the FX trade on this basis is essentially an estimate.

“Given the new deadlines it is plausible that this could be an approach some managers without the right infrastructure or solutions have to put in place, but it creates additional risk of large errors, potential for cash management breaks, and at the very least will increase the work around settlement FX flows from a trading and operational perspective,” says Gothard.

Executing FX trades against unconfirmed or unmatched equity trades can lead to settlement mishaps, counterparty risk, pricing confusion, regulatory concerns, and operational risks.

“For example, if I purchased FX on an equity target purchase amount and the order was only partially filled the resulting exchange (which settles the next day) would leave me with a surplus in the equity’s FX and possibly a shortfall in my funding currency,” explains Dunegan. “I would likely need to reverse this, which would require further trading (more transaction costs) and take additional time to resolve - extending the cost of the settlement risk.”

According to Hoffman, an investor is better off trading the FX and having that transaction settle in a timely fashion instead of risking an overdraft waiting for the equity trade to match.

For example, if an investor buys 10,000 shares of equity ABC at $95.25 (£75.37) and the fees and commissions are one basis point, the net amount of USD that needs to be purchased is 9,525,952.50. If the broker changes the execution price to $95.23 before confirming and matching the trade the net amount on the revised trade would be $9,523,952.30.

“The difference between these two amounts is just over $2000, immaterial in the grand scheme of things,” says Hoffman. “If the investor waited for the equity trade to be confirmed and missed the cut-off for the FX trades, they could incur an overdraft on the $9.5mn. Assuming an overdraft rate of 7%, the investor would be assessed a charge by their custodian of approximately $1,850 for not executing the FX trade and in some jurisdictions there may also be a regulatory implication associated with an overdraft.”

Increased costs

Other risks of executing FX trades against unconfirmed or unmatched equity trades include over trading, which could lead to increased portfolio costs, incurring overdraft charges on accounts or an opportunity cost of investment. This is likely to happen if balances are held in different accounts and different currencies are needed to resolve mismatches in equity and FX trades.

One way to mitigate this risk would be to create a full trade and trade-related FX execution lifecycle that completes both elements as close in time as possible says Walsh, adding that such processes exist now from providers of joined-up global trading and FX solutions that address US T+1 for firms outside US time zones.