European fund managers are in talks with regulators over fears they will breach cash holding rules when the US shortens its settlement cycle.
Both Europe and the US currently settle trades two days after execution, a system known as T+2.
But on 28 May, US equities will move to T+1. That is creating headaches for European traders of US stocks.
“We’ve asked for regulatory reprieve until Europe is ready to move to T+1 and the settlement cycles align,” said Susan Yavari, senior regulatory policy advisor at the European Fund and Asset Management Association.
The mismatch in settlement cycles could cause funds to breach EU UCITS regulations that limit borrowing to 10% of assets and cash holdings to 20%.
Funds will be short cash when they buy US stocks at T+1, since the money to purchase those shares will arrive the following day. They will be long cash when the fund sells US securities.
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Yavari said European fund exposure to US securities is significant; US stocks make up around 42% of European portfolios, compared to 35% for European equities.
She said two key jurisdictions, Luxembourg and Ireland, differ in how they treat cash breaches. In Luxembourg, the situation would be considered an “active” breach requiring remedial action. In Ireland a breach would be “inadvertent”, requiring firms to report it, but not necessarily take action.
“We don’t think it should be considered an active breach,” said Yavari.
European regulators say they are closely watching the impact of the US transition.
“If you look at how we can overall support greater effectiveness and efficiency of markets, one of the areas that we clearly need to look at is shortening of settlement cycles,” said European Securities and Markets Authority chair Verena Ross.
“We will work also on the basis of the US experience in May and what we see comes out of that and we will provide some targeted recommendations to the Commission by the end of the year.”
Shifting sands
Some asset managers have already overhauled their equity trading to reduce risks.
Jim Goldie, head of Emea ETF capital markets at Invesco, said the fund house has decided to move all US only and global basket ETFs to a T+1 cycle, so the fund will be long cash on sales.
“What we’re trying to do is avoid the funds going short cash, because if the fund goes short cash and it goes overdrawn, we get charged by the custodian,” he said.
Adam Watson, head of custody commercial product at BNY Mellon, said he and his team had done “more than 10,000 hours worth of external engagement” over the past six months.
Citigroup has set up a war room, and is also running so-called “hypercare” exercises for T+1. These will run in advance of 28 May and for four to six weeks afterward, said Michele Pitts, head of North America custody product strategic initiatives at Citi.
“It’s working through fails in advance to bring them to as low a rate as possible. Post go-live, it’s about having the appropriate teams mobilised to provide support,” she said.
Europe falls behind
When the move to a shorter settlement cycle was announced in February 2023, there was an expectation that Asia, with its 12+ hour time difference with New York, would have the most difficulty in adapting. But with the go-live date approaching, Europe isn’t faring much better.
“Europe is struggling a little more than we expected,” said Watson.
With the halving of settlement time, the deadline for affirmation — a key milestone in completing a trade — shifts from 11.30am EST the day after to 9.00pm EST on the day of trade, a loss of 14.5 hours.
The time difference has a silver lining for Asia: traders are so far ahead that there is time in their early morning to work through the post-trade process during the New York night.
“Europe is probably the largest pain point and it’s squarely because it’s the middle of the night,” said Pitts.
For European traders without US operations, an evening or early morning shift is becoming a must, said John Oleon, head of operations at prime brokerage Clear Street.
“There’s no way around it,” said Oleon. “Even if they’re fully automated, they’re still going to need someone there to monitor what’s going on.”
The FX spillover
Most international fund managers do not hold dollar accounts to purchase US equities; they trade for dollars as and when needed.
A report from the European Fund and Asset Management Association found that 40% of FX transactions wouldn’t be able to settle on time through FX clearing house CLS to fund a T+1 equity trade. On an average day, this could be between $50bn to $70bn that would need to be transacted bilaterally, leading to more counterparty risk.
Funding Friday trading is also problematic. The FX market becomes very illiquid after 5pm eastern time, said Natsumi Matsuba, head of FX trading and portfolio management at Russell Investments.
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In a test, she requested quotes for a pound/dollar trade late one Friday afternoon. Matsuba said she received only two quotes, one of which was priced manually.
“I think banks will start to make a market but I don’t think the bid/ask spread will be tight because they’ll be holding it over the weekend,” she said.
Non-US holidays could pose an even larger challenge, Matsuba added.
“Unless you want to pay an overdraft charge, a fund manager will need to pre-fund, which creates a cash drag.”
A $31 billion price tag
The ultimate price tag of moving to T+1 could be enormous. A Bloomberg Intelligence report estimated the cost to investors could be as high as $31bn.
FX problems could cost investors $6.2bn. But the bulk of the loss, $17bn, could come from information leakage, or from loss of fees due to early recalls in securities lending.
“Though securities lending primarily settles same or next day, there could be cases where securities could be recalled before a trade is even executed,” said Larry Tabb, director of market structure research at Bloomberg Intelligence.
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“The recall is going to someone who is short the security. I’m tipping off a borrower — who’s already short — that there’s going to be more selling pressure,” said Tabb.
Is everyone ready?
With around two months to go, the market remains cautiously optimistic though, since most banks, large trading firms and asset managers have made preparations.
Many still expect settlement fails to rise come 28 May though.
“We’re anticipating that there’ll be an increase,” said Pitts. “But it’s hard to say what that level will be.”
Tabb expects 25% of securities lending will fail and 30% of trades will not meet the allocation deadline.
“You’re going to see a lot more fails,” he said.
Additional reporting by Justin Cash
To contact the author of this story with feedback or news, email Jeremy Chan
