On March 22, 2017, the Securities and Exchange Commission (SEC) adopted an amendment to Rule 15c6-1(a) under the Securities Exchange Act of 1934 (“Exchange Act”) to shorten the standard settlement cycle for most broker-dealer transactions from three business days after the trade date (T+3) to two business days after the trade date (T+2). Specifically, Paragraph (a) of Rule 15c6-1, as amended, will prohibit broker-dealers from effecting or entering into a contract for the purchase or sale of a security (other than certain exempted securities) that provides for payment of funds and delivery of securities later than the second business day after the date of the contract, unless otherwise expressly agreed to by the parties at the time of the transaction. According to the Adopting Release, broker-dealers must begin complying with the amended rule no later than September 5, 2017.
According to the Adopting Release, the SEC believes that shortening the standard settlement cycle to T+2 will lead to a number of benefits that will be distributed across the financial system, some of which are discussed below.
Reduction in Risk to Central Counterparties (CCPs) in the Clearance and Settlement Process
As explained in the Adopting Release, a CCP is a clearing agency that interposes itself between the counterparties to securities transactions, acting functionally as the buyer to every seller and the seller to every buyer. According to the SEC, shortening the settlement cycle should reduce a CCP’s credit, market and liquidity risk exposure to its members because a T+2 settlement cycle would, assuming that current levels of trading activity remain constant, result in fewer unsettled trades at any given point in time and a reduced time period of exposure to such trades. According to the SEC, the amount and period of risk to which the CCP is exposed is a function of the length of the settlement cycle. Therefore, the SEC believes that shortening the settlement cycle should reduce the CCP’s overall exposure to the credit, market and liquidity risks discussed below.
- Reduction of Credit Risk—CCPs assume credit risk of original counterparties through novating and guaranteeing trades so that it effectively acts as the counterparty to its members. As a result, CCPs face credit risk because they are exposed to the possibility that (a) a clearing member acting on behalf of purchasers of securities may fail to deliver the payment and (b) a clearing member acting on behalf of sellers of securities may fail to deliver the securities. In each case, the CCP assumes credit risk because it is required to meet its obligation to its members to deliver securities and to deliver cash.
- Reduction of Market Risk—During the settlement cycle, CCPs also face market risk. For instance, if a member defaults during the settlement cycle, the CCP may be forced to liquidate open positions of the defaulting member and any collateral or other financial resources of the member that the CCP may hold to cover losses and expenses in adverse market circumstances. This is particularly problematic if the market value of the unsettled securities has increased after the trade date. In the case of a seller default, the CCP would be forced to obtain the replacement securities in the market at a higher price. In the case of a buyer default, the CCP may be forced to obtain cash to purchase the securities at a higher price, which could involve liquidation of its members’ collateral.
- Reduction of Liquidity Risk—CCPs face liquidity risks during the settlement cycle if a member defaults, because the CCP may be forced to deploy financial resources to meet its end-of-day settlement obligations.
Reduction in Risk to CCP Members
A CCP takes a number of measures to manage the risks to which its members expose it. These measures may include collecting collateral and other financial resources and netting down the total outstanding exposure of a particular member. The extent to which a CCP applies these risk mitigation tools is controlled by the amount of unsettled trades that remain outstanding and the amount of time during which the CCP remains exposed to these risks. Accordingly, the SEC believes that reducing the amount of unsettled trades and the period of time during which a CCP is exposed to such trades will result in liquidity risk reductions for broker-dealers that are CCP members because a CCP will impose less resource obligations on its members.
Benefits to Other Market Participants
According to the Adopting Release, the SEC believes that shortening the standard settlement cycle will also lead to benefits to other market participants, including introducing broker-dealers, institutional investors and retail investors. For example, a shortened settlement cycle should allow these participants to have quicker access to funds and securities after executing the trade, which should further reduce liquidity risks and financing costs faced by market participants who use those proceeds to transact in other markets already operating on a T+2 settlement cycle. Other anticipated benefits for these other market participants include reduced margin charges and other fees that clearing broker-dealers may pass down, which, in turn, would reduce transaction costs generally and free up capital for deployment elsewhere in the markets by those participants.
The move to a T+2 settlement cycle is also expected to harmonize the settlement cycle in the U.S. with many non-U.S. markets that have already moved to a T+2 settlement cycle. This, according to the SEC, will reduce the degree to, and time during, which market participants are exposed to credit, market and liquidity risk arising from unsettled transactions. Furthermore, harmonizing the U.S. settlement cycle with non-U.S. markets will reduce the need for some market participants to hedge risks stemming from mismatched settlement cycles and reduce financing/borrowing costs for market participants engaging in cross-border transactions in both U.S. and non-U.S. markets.
Reduction in Systemic Risk
Reducing the period of time during which a CCP is exposed to credit, market and liquidity risk is also expected to enhance the overall ability of a CCP to serve as a source of stability and efficiency in the national clearance and settlement system. This reduces the likelihood that disruptions in the clearance and settlement process will trigger disruptions that extend beyond the cleared market. As discussed in the Adopting Release, clearing members are often members of larger financial networks, and the ability of a covered clearing agency to meet payment obligations to its members can directly affect its members’ ability to meet payment obligations outside of the cleared market. Accordingly, management of liquidity risk, such as that intended by the shorter settlement cycle, may mitigate the risk of contagion between asset markets.
Promotion of Technological Innovation and Changes in Market Infrastructures and Operations
Finally, according to the SEC, the move to the T+2 settlement cycle should promote technological innovation and changes in market infrastructures and operations. The SEC believes that this will incentive market participants to further pursue more operationally and technologically efficient processes, which may lead to further shortening of the standard settlement cycle.