Is T+2 the right direction at the right time for Europe?

“T+2 is not an issue for European cross border settlement,” asserts Tim Reucroft, director at Thomas Murray, and indeed it is not. When settling on a single currency, on a very similar time zone, two days is more than sufficient to complete all of the processes required to settle a trade. So, too, from a technology perspective, T+2 poses no challenge whatsoever. Where agreed, trades can be and currently are being, settled on T+0, or in real time. So why is there agitation, to a certain degree, amongst market participants about the move in Europe from T+3, which is well established in the majority of markets, to T+2?

“We have been happy with T+3 for years now,” commented one market participant at the recent Global Custody Forum in London. “It feels like a good idea, but we could have done with a couple more years. It is not impossible, but it will be a struggle for some and, if there is a ‘big bang’ and all of the European settlement cycles move on the same day, there will certainly be a lot of failed trades. This is an irritation and does not contribute much to reducing risk at the moment.”

The desire for more time arises out of the fact that CSD (central securities depository) regulation is arriving on the same wave as extensive regulation overhaul in the post-trade environment in response to the financial crises that set in globally post-2007. T+2 is one of the regulations outlined in the CSDR (Central Securities Depository Regulation), so it is unavoidable. CSDR recommends that all European settlement cycles be moved to T+2 before 1 January 2015. The success of the move to T+2 is central to the success of another European CSD initiative, T2S that is set to be implemented in June 2015. Set this against a regulatory backdrop of trade reporting and mandatory clearing, each arriving hot on the heels of the other, and market participants have a lot to adjust to in the derivatives space.

T2S is a separate discussion altogether here, but it has come too far not to be made a reality and a harmonised T+2 settlement cycle is a central tenet. Expensive, delayed, forcing competition into an always stable (there is no record of failure), largely uncompetitive landscape; seemingly the only benefit of T2S is the shakeup that it will bring in the collateral management landscape at a time when serious questions are being raised as to the amount of eligible, high quality collateral available in the market to satisfy the demand for it with the impending clearing obligation that will require initial and variation margin to be posted at CCPs (central counterparties) to cover default losses.

In line with T2S, T+2 will reduce the need for collateral and this is unmistakeably a positive, at least for those who don’t have much in the way of high quality collateral but need access to it. It has been estimated that the harmonised move to T+2 in Europe will reduce collateral demand and so result in net savings to the system of around €700m per year as the result of reduced counterparty risk exposure. If the risk is reduced by a day, the need for collateral to margin that position is reduced accordingly.

With everyone in the cash equities markets in Europe on a DVP (delivery versus payment) model, whereby equities are not delivered until payment is received and vice versa, just how much counterparty risk exposure is there, though? “The radical re-engineering of the settlement cycle in Europe to reduce counterparty risk seems off targets,” says Jim Micklethwaite, director of capital markets at Thomas Murray Data Services.

The harmonised T+2 settlement cycle, however, fits in with the goal of creating a level playing field in the newly competitive CSD landscape. It achieves this by reducing the possibility of national monopolies, since everyone will be on the same settlement cycle as imposed across Europe. No one CSD will be able to settle solely for its market on the basis that its settlement cycle is out of kilter with the rest of Europe, thereby increasing the scope for competition in line with the goals set out in T2S.

“We are supportive of the move to T+2 and it has been under discussion for many years now,” says Soraya Belghazi, secretary general of ECSDA. “It will soon be mandated in regulation and the question has now changed from, ‘should we do T+2’ to, ‘how are we going to implement T+2?’ It is interesting in Europe that a number of markets have chosen the same date of 6 October 2014 to make the switch to T+2.

“This raises its own question as to whether or not it is a good idea to have a number of markets moving at the same time, thereby by creating a big bang. Would it have been preferable to have managed the change in two or three waves?”

There is no obvious answer to this. The big bang approach carries risk, since if things go wrong, there can be no backward step. If a few markets move in a co-ordinated phased approach, however, there will be a period of instability in that some markets will still be settling on T+3. The big bang approach, however, is very sink-or-swim and will inevitably result in an increase in the number of failed trades as market participants struggle to realign their own internal mechanisms.

Why, then, this move to T+2? There is already a certain level of harmonisation across Europe in that most markets, the notable exception being Germany, currently settle on T+3. As the market participant quoted previously stated, the market has been happy with T+3 for years. It could be argued that, given the economic muscle flexed by Germany in recent years, there is a political element to the rest of Europe moving to the German settlement cycle, rather than Germany moving to the almost uniform European settlement cycle.

Any move to reduce counterparty risk should be welcomed, however, and the T+2 settlement cycle has worked perfectly well in Germany. Indeed, CCPs clearing German transactions have not encountered difficulties in doing so. The CCPs can instruct settlement of both sides of a transaction without the need for manual intervention in the process. With the clearing obligation impending, the fact that T+2 fits in well with this environment is a bonus. The fact that the CCPs will require less collateral posting to them, as discussed, is also a fillip to those possessing and with less access to, high quality collateral.

There is also the fact that the shift to T+2 has next to no impact on the CSDs. With minimal impact to market infrastructures, the move makes a lot of sense. “This isn’t so much of an issue on the CSD side, it is an issue on the trading side,” says Soraya. “From a pure CSD perspective, it is just a parameter; it is not very difficult to make the change and the technology already exists and the systems can already handle it – in fact, they can achieve shorter than T+2 with T+0, or real-time settlement. This is not a big deal for the CSDs themselves. It is far more important to co-ordinate the market and make sure that all participants are ready for the switch. The only potential issue for the CSDs is that, when the switch occurs, if the market is not ready, this could result in a temporary increase in the number of settlement fails that the CSDs will have to deal with. Other than that, it is really not a big issue for the CSDs.”

That might be underplaying the potential that T+2 will create some problems, at least in the short term. “It will be an issue for cross-time zone and cross-currency trades,” explains Tim. “It does not pose much of a challenge, or risk, to the clearer-brokers and CSDs themselves, but it is a challenge for the end investor. This is one issue with the big bang approach; if the move happens across Europe on one day, there will inevitably be a glut of failed trades.”

IT integration is another potential problem. There are new systems required for clearing, reporting and banking regulations that are being enforced, so the addition of new settlement requirements adds to the already challenging IT environment. This poses an entirely new level of risk to market participants, since there is always a risk that the new systems cannot be integrated smoothly. That’s without mentioning the cost. Having so much new IT arrive within such a short space of time is far from ideal, since there is not much time for systems testing and the conducting of any necessary repair work before the integration and implementation of another new system.

Another issue is raised by Soraya. “One issue that we at ECSDA are very concerned about is the timing of the entry into force of the new settlement discipline framework in the CSDR and T+2 settlement. CSDR provides for much tougher sanctions as regards failed trades, so the timing becomes potentially a very big problem. If CSDR provisions on penalties for late settlement come into effect on 1 January 2015, at the same time or just after the switch to T+2, then the market might not have time to adjust and this could cause problems. We are not sure that the policy makers have given full thought, or are fully aware of, the potential implications that this could have. This, of course, depends upon the final implementation timeline, which yet has to be confirmed, but the current proposal does not mitigate for this. There needs to be time for CSDs and market participants to adapt to T+2 before we implement a new settlement discipline framework with stringent penalties for failed and late transactions. We feel, therefore, that it would be best not to implement the switch to T+2 and a new penalty system very close together.”

There are very clear pros and cons to a Europe-wide shift to a T+2 settlement cycle. The pros of harmonised settlement are clear, not least in regards to the collateral benefits that it will bring. If the settlement cycle can be shortened, without much in the way of market disruption, as evidenced by the cycle in action in Germany, then it certainly makes a lot of sense.

It is, however, another regulatory burden at a time of intense regulatory burden. Could it not have waited for another couple of years whilst the glut of other regulations was implemented? Are the issues of clearing and reporting and banking not more important than knocking a day off settlement cycles in Europe?

The main driver for this comes from T2S, a solution that was designed for a pre-crises market. It has become a runaway project that was due for implementation in 2009. It now won’t arrive until 2015. At the earliest. T+2 is a by-product of this runaway project, whichever way you look at it. Hopefully the market will have fully adapted to T+2 by the time T2S finally arrives. There will surely be teething problems, especially if the market moves en masse, but there is evidence, not least in Germany and around the rest of the world in locations such as the U.S, that T+2 will be a success.

Tags: CSDCSDRECSDARegulationT+2T+3SettlementT+0CCPsDVP