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The writer is Global Head of Capital Markets Client Solutions at Northern Trust
For fund and investment managers around the world, every percentage point slice of return matters. For that reason, it must be prepared for what is known as “T+1” — an impending change to the rules governing business operations in the United States, Canada and Mexico, which would add unwelcome costs and hinder performance.
In the age of smartphones, buying and selling financial instruments is a seemingly simple act. A few clicks and you can become the proud owner of a fund or exchange-traded stock in a faraway country.
But behind this process lies a complex chain of events that requires multiple actors to coordinate a series of trade executions, trade settlements and trade-related currency movements, which are completed according to strict timelines, ensuring that legal ownership is transferred.
In May, North American markets will shorten their settlement cycles to the trade date (“T”) plus one day (“T+1”). It's a seemingly vague regulatory change aimed at protecting consumers from market pressures. But it risks a potential cost surprise for managers everywhere. Any rise in costs would be particularly unwelcome in the UK, where managers need to comply with transparency requirements of new consumer duties rule changes from July this year, which require fund managers to “deliver good results for retail clients”.
The biggest and most impactful move for global investors is in the United States, where the trade settlement cycle for thousands of financial instruments listed on US exchanges has been shortened by one day. US stocks, ETFs, American Depositary Receipts and many other instruments are included in this change. For the first time, successful completion of elements of this process will be subject to an SEC rule, and over time, performance under that rule will be examined.
Like most regulatory changes, it involves a great deal of inspection, verification and revamping of practices in the “middle and back office” of the industry. Portfolio management and investment management decision-making processes also need explicit attention. The T+1 shift isn't just something the “healer people” have to fix.
Managers will need to understand the likelihood of trading and processing the trade they want to make, along with any related foreign exchange trades, especially as they approach the end of the business week outside the US. In particular, careful attention must be paid to settlement cycle mismatches, complex basket trades involving multiple securities, and software trading.
The reasons for the high costs for managers are related. Access to liquidity – cash, overdraft or other cash-like instrument to settle trades comes at a cost. Industrial-scale overdrafts are not free, and they cost more now than they did more than a decade ago. Some fund ranges do not allow managers to carry excess cash overnight, let alone over the weekend.
Another potential trap is that trades made in the US need a large-scale currency conversion late in the week for settlement. FX liquidity dries up on Friday afternoon New York time, and stops completely at 5 p.m. If a manager misses a trade-related currency transaction deadline, he or she may be exposed to higher funding costs via other means over the weekend. This is exacerbated by the frequent closure of markets on Mondays, which coincide with holidays in the United States.
The cost issue is real. Managers are likely to experience higher costs for up to 72 hours. Some UK managers became so concerned about foreign exchange risks that they moved trading staff to New York or set up specific treasury teams to manage their late-week US dollar needs.
Not all managers are senior enough to do this. Another less expensive solution? Good planning and good portfolio management go hand in hand with an effective middle and back office. Portfolio managers need to ensure that their trading decisions are supported by a simple and efficient trade settlement and trade-related foreign exchange process with as much automation as possible.
This is especially true late in the business week in major Asian markets, where there is little time overlap with the Big Apple. This is no less true in Europe and London. In a competitive fund management market, driving performance for investors is difficult enough. Anything that adds costs to make the fund less competitive against its peers should be avoided. So it requires a clear focus of minds on T+1.
