The international nature of US securities trading means market participants cannot afford to ignore the currency exchange implications of faster settlement. Finding the most appropriate solution is far from straightforward.
The potential implications of faster securities settlement in the US have been widely reported. However, one aspect that has been underplayed is that foreign investors in US securities – which are denominated in US dollars – will have to execute FX trades to fund purchases or sales from their local currency. According to Treasury International Capital, around 30 percent of US treasury securities are held by foreign investors.
T+1 scheduled for 28 May
On 15 February 2023, the US Securities and Exchange Commission (SEC) adopted amendments to Rule 15c6-1 that shorten the standard settlement cycle for most broker-dealer transactions from the second business day after the trade date (T+2) to the first business day (T+1).
From the expected compliance date of 28 May, the settlement cycle for broker-dealer transactions in the US will therefore experience its biggest change since 2017 when the cycle was shortened from T+3.
In May 2023, the global FX division of the Global Financial Markets Association (GFMA) issued a report stating that moving US securities settlement to T+1 raised the risk that transaction funding dependent on FX settlement might not occur in time given the need for trade matching, confirmation and payment to be completed within local currency cut-off times.
Each country has its own cut-off times for same day currency payments based on a combination of central bank and commercial banks’ operating hours. In addition, some currencies in emerging and frontier markets are subject to capital controls and trading restrictions that make them difficult to settle offshore.
Increased settlement risk without CLS
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’.
PvP or payment versus payment is 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 takes place.
CLS is the mechanism for settling PVP and has set cut-off times by which 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 this cut-off,” says Joe Hoffman, CEO of Mesirow Currency Management. “As a result, they will need to be settled outside of CLS, which increases the risk surrounding settlement. This is an unintended consequence of this change in the equity settlement cycle that regulators either missed or ignored.”
In November 2023, the Foreign Exchange Professionals Association (FXPA) published guidance recommending that traders should conduct a full review of the scale of the challenge of T+1, considering trading relationships, credit, operational processes, funding, and settlement.
Citi’s Securities Services Evolution 2023 report states that offshore portfolio managers will have to think about how to book, fund and settle any required FX trades within one day when most FX markets settle on T+2, especially less liquid currency pairs.
Yet when the same report asked survey respondents to list the key areas of change required to facilitate the move to T+1, only 28 percent of respondents listed FX as one of their top three change areas.
Despite this lowly ranking, the GFMA’s view that the move to T+1 settlement poses a risk to the funding of securities settlements with a related FX trade is widely shared.
Since the US equity market closes at 4pm ET (9pm UK/10pm CET), this leaves very little time on T+1 to match equity trades and generate and execute the FX required to settle the trade. For European and Asian managers without US trading and settlement capabilities this poses a challenge, and establishing new teams in the US may not be efficient or feasible.
“Another option is to accept that the settlement FX will need to be executed on T+0 in the Asian or European morning,” explains Chris Gothard, partner and head of global markets at BBH. “This opens other risks such as potentially not being able to rely on risk mitigation market infrastructure such as continuous linked settlement (CLS). Other notable risks include executing and settling ahead of settlement cut-off times, which occur early in the global trading day for Asian currencies.”
Matching equity and FX trades is challenging
Simultaneous execution of equity and currency trades is one possible solution to the challenge of completing international trades in a shorter settlement cycle. However, when FX execution is based on unmatched and unconfirmed equity trade information the FX trade is essentially an estimate and will need to be adjusted subsequently.
“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 and the 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 BBH’s Chris Gothard.
Alex Dunegan, CEO of Lumint Currency Management, observes that there are many currency management and brokerage desks that support simultaneous execution of equity and currency trades, but adds that this is not necessarily easy to implement.
“A systematic and automated approach may still face the same issues around time zones and bank settlement cut-off times,” he says. “For example, 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.”
Challenges of mixing stock and currency trades include differences in market dynamics, liquidity, execution speed, technology requirements and risk management, adds Henry Hatton, sales director at Cornerstone FS. “Successful cross-asset trading requires careful planning, reliable data and technology, and expertise in both markets,” he says.
Simultaneous execution of equity and currency trades depends on workflow, technology, and internal trade execution and operation functions, suggests Tara Taylor, head of North America StreetFX pricing services, sales and trading.
“When evaluating current workflow, one needs to look at where equity and FX executions are taking place, how they are being executed, the number of internal systems, and whether these systems are aligned to adjust a spot FX value date to a shortened security settlement date,” she says.
“An automated solution with consistent workflow for all activity allows managers to choose their execution times to allow better alignment with security execution. Because the spread is pre-negotiated there is consistency in pricing and cost transparency.”
Does the answer lie in technology?
Alex Knight, head of sales and EMEA at Baton Systems also advocates a technology-based approach and says distributed ledger technology or DLT is ready to play a greater role in the settlement process. Baton Systems itself utilises the new technology in post-trade processing solutions that it develops.
“Automated and scalable settlement utilising DLT is 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.”
Automation of the trading process is required with very tight integration between the equity order and execution management systems at the front end, and confirmation of the equity trade to flow into the FX execution management system at the back end, agrees Vikas Srivastava, chief revenue officer Integral.
“With automated trading capabilities in place for the equity and FX trades, near simultaneous execution should ensure that firms are meeting the shorter settlement time while not exposing themselves to unwanted risk,” he adds.
Other considerations include who would be managing this joint transaction. Having custodians or non-FX specialists execute currency trades is expensive and if the FX transaction is merely ‘tagged on’ to the equity transaction, the cost of execution would likely increase due to the lack of attention paid to the former since the operational process is likely to be prioritised over cost reduction.
That is the view of Nathan Vurgest, director, head of trading at Record Financial Group, who says it would be possible to align equity and FX requirements efficiently if there were less focus on matching equity benchmarks.
“Thus, more consideration could be given to trading during the day when there is better FX liquidity,” he continues. “Using specialist currency managers and/or being able to access FX trading tools directly (such as online FX managers and bank portals) could help in this process.”
Executing FX trades on unconfirmed or unmatched equity trades can also introduce additional settlement risk. Where a trader purchases FX on an equity target purchase amount and the order is only partially filled, the resulting currency exchange (which settles the next day) will leave them with a surplus in the currency of the equity and possibly a shortfall in the funding currency.
Addressing this would require further trading – and therefore additional transaction costs – and take time to resolve.
“Over-trading could lead to increasing portfolio costs, incurring overdraft charges on accounts or opportunity cost if balances are held in different accounts and different currencies are needed to resolve mismatches in equity and FX trades,” says Vurgest.
Gerard Walsh, global head of capital markets client solutions at Northern Trust offers a more upbeat assessment, suggesting that T+1 FX settlement risk can be mitigated through greater use of straight-through-processing, as low a level of human intervention as possible, and a full rework of existing processes.
He also notes 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 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.”