Shortening the Settlement Cycle: A European View

Shortening the Settlement Cycle: A European View

On the 5th of October 2023, the European Securities and Markets Authority (ESMA) issued a call for an evidence on shortening the settlement cycle in Europe.1 ESMA invited various participants, such as market infrastructures (i.e., central securities depositories, central clearing parties, and trading venues), their members and participants, investment firms, issuers, fund managers, and retail and wholesale investors, to submit their response to 27 key questions concerning a reduction of the settlement cycle in the European market in a coordinated manner.

This effectively means that the day after tomorrow may vanish from the European securities settlement cycle, and market participants will be left with only today (i.e., trading date) and tomorrow (i.e., settlement date) to achieve settlement.

Settlement Cycle misalignment across markets will create liquidity mismatches.

This has already become a reality in markets such as India that moved to T+1, and soon with the U.S. and Canada that will move in May 2024. Following the North American market's move, there will be a misalignment within the EU and the UK market that will create liquidity mismatches and, potentially, make the North American market more efficient. Multiple task forces have been set up in the EU and UK to analyse the cost-benefit and impact of moving to a shorter settlement cycle, resulting in this call to action from ESMA.

The aim of ESMA's approach is to assist market participants in analysing, reviewing, and considering the impact of this misalignment in a holistic manner. The questions are primarily grouped into four main categories:

• Impact
• Benefit and cost
• How and when to implement
• Impact on EU market vis -a- vis international developments.

Considering options.

ESMA is asking participants to provide tangible reasoning, along with quantitative data, that supports and highlights the risks of moving to T+1 or T+0 and if the move could be based on factors such as asset class, instrument type, and transaction type. However, the big underlying question is whether Europe should start preparing for a shorter settlement cycle or augment the Central Securities Depositories Regulation (CSDR) settlement discipline first to address settlement efficiency, with the potential threat of mandatory buy-ins, before moving to a shorter settlement cycle.

Critical issues need to be addressed.

The following issues, if not addressed, could be fatal in moving to a shorter settlement cycle:

• Post-trade processes, such as allocation, confirmation, error handling, and pre- settlement matching, will need to be completed by T+0 before the nighttime settlement cycle batch begins. This will get exacerbated for trades executed close to the market cut off.
• FX will need to be initiated first for the trade to be settled by T+1 to avoid the risk of settlement failure or the need to prefund the trade. Continuous Linked Settlement (CLS) does offer Payment versus Payment (PVP) FX settlement, eliminating counterparty risk and providing settlement in T+1. However, the FX trade must be submitted to CLS before the cut-off time.
• Cross-border transactions (due to a mismatch in settlement cycle), multi-listed instruments, American Depository Receipts/Global Depository Receipts, Exchange Traded Fund transactions (where cash is received on T+2, but the funds need to purchase a U.S. security on T+1) will see much higher impacts and might result in liquidity mismatch if the settlement cycle is not aligned between the markets.

A five-point plan to overcome inefficiencies.

If this is to move forward and a shorter settlement cycle is proposed, the approach should be phased depending on the asset class or transaction type, rather than a big-bang approach. It should also include an end-to-end integrated testing cycle, rather than silos. It is possible that firms may experience difficulties with respect to timelines and increases in settlement failures/cash penalties, funding, and more, but incorporating the following five-point plan can help overcome inefficiencies.

• Phase out manual processes and increase automation.
• Move towards market standard communication protocols instead of Excel/CSV/e-mail.
• Review the entire IT infrastructure and ecosystem and move away from legacy technology, removing dependency on end-of-day batches while embracing the usage of Application Programming Interfaces (APIs), cloud hosting, and more.
• Adopt a follow-the-sun model to handle operational workflow.
• Encourage the use of market standards, such as Unique Transaction Identifiers, partial release/settlement, and hold and release.

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[1] "ESMA consults on the potential impact of shortening the standard settlement cycle", ESMA, May 1, 2023.

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This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.