T+2, T2S and CSDs - the impact on European settlement

With the advent of CSDR (Central Securities Depository Regulation) and Target2 Securities (T2S) arriving in Wave 1 on 22 June 2015, one fundamental change is occurring in the European settlement cycle this October with the switch from a general T+3 settlement cycle to settlement on T+2. This means that trades that are to be settled in Europe will have one less day to settle than they did previously.

This will not affect everyone, notably those active in the German market, which already settles on a T+2 basis, but the majority of markets are moving to T+2 in October ahead of the first Wave of T2S migrations as European settlement cycles harmonise. This will have a big impact in Europe, with people used to settling on T+3, and has raised fears from some industry observers as to a ‘big bang’ of everyone moving on the same day and a subsequent sharp increase in the number of failed trades. Given the German market is already on T+2 and the rest of Europe will be bringing itself in line with this, there have also been opinions raised as to the real motives behind the switch.

This move in European settlement will also have implications upon regulations, initiatives and directives away from just CSDs. It will impact areas such as country and custody risk, and market infrastructure monitoring and reporting under AIFMD and UCITS V, particularly the latter, since depositary banks will be directly liable for CSDs under UCITS V. It will also impact upon the timings that reports will need to be made to trade repositories under EMIR.

Away from the questions around T+2, there are undoubtedly a lot of positives to take from it, too, though. A reduced settlement cycle reduces counterparty risk exposure and, therefore, collateral requirements posted against trades. “I think the market is largely happy that T+2 is coming,” says Scott Coey, head of Broker-Dealer Services EMEA at BNY Mellon-Pershing. “I think a lot of participants wish it was coming a lot quicker. I do not think that is to say that our clients are happy with the increased costs of T+2, but they can see the benefits and efficiencies of it. Taking the trade cycle down by one day reduces risk, the cost of carry of capital is reduced by one third and anything that harmonises the European landscape and makes European markets more accessible to investment banks and broker-dealers is going to be beneficial. The move to T2S will help in this regard, too.”

With all moves of this magnitude, however, there is always an element of taking each challenge as it comes. “The biggest thing that I see coming up with T+2 this year is the question of understanding what is actually going to happen on 8 October, which is the double funding day,” explains Scott of one of the initial hurdles in moving to T+2. “On that day, trades happening on 2 October settling on T+3 and trades happening on 6 October settling on T+2 will create a double settlement day. The capital and credit requirements linked to both trades settling on T+3 and T+2 will meet, but also the settlement rates may fluctuate more strongly – possibly out of the compliance levels required by CSDR. Some investment banks may have 20 or 30 systems looking after one market, with settlement efficiencies in the mid-80% region. CSDR looks to having settlement efficiencies in the high 90s, with the threat of penalties looming over the failure to achieve these rates. A shortened settlement cycle will only make this a bigger concern for firms.

“There will be a grace period, but for firms running lots of systems, it is not a straightforward six month project to correct any problems that are revealed. Again, there will be a lot of cost involved. Our clients appreciate the benefits of T+2 going forward, but the general outlook is that there is going to be a lot of short-term pain for a long-term gain.”

The IT challenges of the somewhat dramatic changes taking place in the post-trade world are huge. From the perspective of the central securities depositaries (CSDs) actually performing the settlement function in the case of T+2, this is not such a huge challenge since they already have the technology solutions in place to settle on a T+0 basis and they are only concerned with settlement functionality. The challenge is for the market participants themselves in navigating the new, post-crises, post-trade environment and settling trades within two days.

“The fact that there is a grace period in place prior to the handing out of punishments for failure rates shows that there is a bit of uncertainty as to how long it will take for firms to get within the required settlement ratios,” continues Scott. “The regulators are still discussing the length of this period, considering somewhere from six to 12 months, so they seem somewhat unsure, too. On the part of the firms, they just want a grace period long enough to get their systems in order. It is unclear at this moment how long that should be.”

Different markets have their own nuances. Being efficient in settlement in Germany, already on T+2, will not mean that you are automatically going to achieve similar efficiencies in Italy when that market moves to T+2. You can have the system in place, but it is the adaptability of that system to other markets that is key. This is where outsourcing becomes an attractive option. “We already have a long-standing presence in European markets and we can, therefore, pass on those efficiencies,” explains Scott of Pershing’s involvement. Outsourcing of the settlement process is an increasingly attractive proposition to market participants, since they do not need to build out their IT infrastructure around the new cycle and platform of T+2 and T2S.

With everything that has happened, is the move from T+3 to T+2 the right one, or a necessary one, for Europe? “The biggest change that comes about as a result of the move is the reduction in the risk in the European settlement cycle," answers Scott. "As a third of the settlement time is removed, so the capital requirement to cover the trade cycle is reduced as well. Anything reducing the risk and the overnight funding is good for the market and makes it faster and more efficient.”

For more on T2S and the competitive landscape that it will introduce European CSDs to, please read: Competition at CSDs, for better or worse

Tags: T+2T+3T2SSettlementRegulationCSDRCSDAIFMDUCITS VDirectivePershing