Are You Ready? T+1 Trade Settlement Begins Next Week

On May 21, 2024, Securities and Exchange Commission Chair Gary Gensler formally announced the U.S. securities market’s switch to a T+1 standard settlement cycle. “T+1” means all trades in all U.S. markets will be settled the day after execution. The change will become effective on Tuesday, May 28. Gensler explained briefly:

For everyday investors who sell their stock on a Monday, shortening the settlement cycle will allow them to get their money on Tuesday. Shortening the settlement cycle also will help the markets because time is money and time is risk. It will make our market plumbing more resilient, timely, and orderly. Further, it addresses one of the four areas the staff recommended the Commission address in response to the GameStop stock events of 2021.

Over the past hundred or so years, trade settlement times have moved back and, on some exchanges, forward several times. Surprisingly, in the 1920s, the New York Stock Exchange settled trades on T+1 but gradually lengthened the settlement time to T+5.  The American Stock Exchange settled trades on T+2 before 1953, then on T+3 in 1964, and moved to T+5 only in 1968. By the 1950s, the number of investors had increased, as did the number and kind of issuers and the volume of transactions. Increasingly complex infrastructure was required to execute and settle trades, so by the ‘70s and ‘80s, T+5 was seen as the best to manage. 

However, after the Black Monday stock market crash in October 1987, the authorities began to give thought to making securities transactions less risky by speeding up trade settlement. Treasury Secretary Nicholas Brady saw the clearance and settlement process as the “weakest link” in the nation’s financial system. Gerald Corrigan, President of the Federal Reserve Bank of New York, noted: 

“[T]he greatest threat to the stability of the financial system as a whole [during the 1987 market break] was the danger of a major default in one of these clearing and settlement systems.” Government and industry studies were undertaken, the most important of which was the Bachmann Task Force on Clearance and Settlement Reform in U.S. Securities Markets, Submitted to the Chairman of the U.S. Securities and Exchange Commission in May 1992. It recommended that the Commission should shorten the settlement cycle from five days to three. The report’s authors reasoned that “time equals risk,” and so if it took less time for a transaction to settle, risk would be reduced. They stated further that a “shorter settlement cycle will also uncover potential problems sooner, before they mushroom or begin to cascade throughout the industry.”

And so, a proposal for a three-day settlement was adopted in November 1993. It became effective in June 1995. In 2017, a new proposal was made, shortening T+3 to T+2. It became effective in September of that year. More than 20 years had passed since what was considered an urgent problem in 1993. Although the Bachmann Report had made clear that “[t]he system and legal initiatives necessary to accomplish the T+3 settlement for corporate and municipal securities should serve as a stepping stone to further reductions in settlement periods over time as technology and systems permit,” initiatives to speed up settlement were moved to the back burner. It was a busy and tumultuous time: 9/11 was followed by the dot.com crash in 2001-2002 and then by what some called the Great Recession in 2008. 

The Transition to T+1

The Commission clearly didn’t want to let another two decades pass before making its next reduction. On February 9, 2022, it published a proposed rule that would:

shorten the standard settlement cycle for most broker-dealer transactions from two business days after the trade date (“T+2”) to one business day after the trade date (“T+1”). To facilitate a T+1 standard settlement cycle, the Commission also proposes new requirements for the processing of institutional trades by broker-dealers, investment advisers, and certain clearing agencies. These requirements are designed to protect investors, reduce risk, and increase operational efficiency.

Interestingly, the Commission also solicited comment on “how best to advance beyond T+1.” Most early commenters urged the SEC to switch to T+1 as expeditiously as possible. They felt that a compliance date two years in the future was unnecessarily distant. Others brought up short selling, which they uniformly regarded as evil. Many cited the story of the “meme stocks” in connection with their complaints about shorting, though many had, in fact, profited when GME and others squeezed. Most, however, understood the benefits shorter settlement time would provide to ordinary investors; they looked forward to T+1 and hoped T+0 would follow not long after. 

Nearly all the commenters were retail investors, not finance professionals. Their wishes were simple and made sense. Greg Englebert probably spoke for many of his fellows when he said, “I believe trades should be real-time. Settlements should be real-time. Money comes out of my account in real-time, as should everything else.”

One of the few letters written by industry bigwigs was from Hope Jarkowski, then General Counsel of the NYSE (she recently became Chief Legal Officer of Broadridge Financial Solutions). She praised the adoption of a T+1 settlement cycle but did not believe a T+0 cycle would be practicable in the near term. Why not? She noted that the transition from T+3 to T+2 in 2017 required several years of preparation and coordination between market participants and regulators. The SEC was planning on two years from a proposed rule for T+1 settlement to a hard compliance date. T+0 would be even more difficult, she believed, because it would eliminate the enormous advantage of multilateral net settlement, which we will learn more about later.

Jeffrey Davis, a Nasdaq senior vice president, concurred with other commenters on the transition to T+1. Like Jarkowski, he did not believe a move to T+0 should be ventured anytime soon. He, too, was concerned about losing the benefits of “netting.”

Representatives of DTCC and SIFMA had many meetings with SEC Commissioners, staff from the Division of Trading and Markets, and others at the SEC. Oddly, though, OTC Markets Group, which is usually eager to comment on SEC proposed rules, was not heard from and scheduled no meetings with SEC officials.

DTCC made a significant contribution to the proposed rule. The Commission notes:

In February 2021, DTCC published the DTCC White Paper stating that accelerating settlement beyond T+2 may bring significant benefits to market participants but requires careful consideration and a balanced approach so that settlement can be achieved as close to the trade as possible without creating capital inefficiencies or introducing new, unintended consequences–such as inadvertently reducing or eliminating the benefits and cost savings provided by multilateral netting… DTCC suggested that shortening the settlement cycle to T+1 could occur in the second half of 2023, and it estimated that a T+1 settlement cycle could reduce the volatility component of NSCC margin requirements by up to 41%. DTCC also contended that achieving T+1 could be largely supported by using existing systems and available tools and procedures.

DTCC, like the NYSE and the Nasdaq, did not believe a move to T+0 was feasible within the next few years. 

The final rule was issued on February 15, 2023. It is long and complex, mainly consisting of the SEC’s responses to comments it received from industry professionals. Much of it is highly technical. 

What Will T+1 Mean for Retail Investors?

The SEC and the Financial Industry Regulatory Authority have provided special guidance on T+1 for retail investors since the beginning of the year. In January, FINRA explained the upcoming changes in terms a bright five-year-old could understand. But it also brings up possibilities not many ordinary investors are likely to have considered:

Under the new T+1 settlement cycle, most securities transactions will settle on the next business day following their transaction date. Using the example from above, if you sell shares of a stock on Tuesday, the transaction will now settle on Wednesday.

You might not notice a change, as many brokerage firms currently require investors to have the needed funds in cash accounts before making a purchase. But if you normally initiate an Automated Clearing House (ACH) payment for your purchases the day after your trade is executed (e.g., you wait for trade confirmation before sending money from a linked bank account), you’ll likely need to make payments a day earlier under the T+1 cycle to ensure the payment has posted by settlement date. Simply initiating an ACH transaction doesn’t meet payment requirements; the funds must be deposited in your brokerage firm’s bank account.

FINRA also points out that if by some chance its hypothetical investor holds his stock in certificate form rather than in street name—which is increasingly rare nowadays—when he sells, he must make sure to get that cert to his broker by the next day. 

The move to a T+1 settlement won’t affect only stocks. It will also apply to transactions in bonds, exchange-traded funds, certain mutual funds, and limited partnerships that trade on an exchange. All of them will settle on T+1, as options and futures already do. 

On March 27, the SEC’s Office of Investor Education and Advocacy released an Investor Bulletin about the transition to T+1. It explains the basics and offers one bit of advice not touched on by any of the other authorities: if you have a margin account, its terms may be affected by the change. The SEC advises that you call your broker if you have any questions.

On the same day, the SEC also produced a FAQ that seems mainly directed to small broker-dealers and investment advisers. It addresses limited exemptions from the new rule; they are essentially the same as those applied when T+3 was introduced in 1995. See also the Risk Alert published by the regulator on the 27th.

On May 9, the SEC offered more explanatory material, “A Small Entity Compliance Guide.” The small entities in question are broker-dealers and investment advisers. The SEC wants to ensure that small brokers are aware that they may need to upgrade some of their technology and that they may have new recordkeeping responsibilities. The same will be true for investment advisers.

The best and most complete information about the transition is presented by DTCC at a website dedicated entirely to T+1. The site is intended for professionals, but it’s interesting to explore nonetheless. DTCC has been working with the Securities Industry and Financial Markets Association (SIFMA), the Investment Company Institute (ICI), Nasdaq, and a host of prominent investment banks to make sure all goes well on T+1’s big day.

The FAQ sets forth some information not found elsewhere. It starts off with a query about the benefits of accelerated settlement for the industry. The answer is bound to warm the hearts of the people who run the markets:

Today, an average of over $13.4 billion is held in margin every day to manage counterparty default risk in the system. Shortening the settlement cycle would help strike a balance between risk-based margining and reducing procyclical impacts. In one significant finding in the paper, our risk model simulations have shown that the Volatility component of NSCC’s margin could potentially be reduced by 41% by moving to T+1, assuming current processing and without any other changes in client or market behavior.

That would be beneficial indeed for those required to put up the margin. The money they now spend on it could be used for additional investment. 

DTCC also explains what “multilateral netting” is and why it’s so important to NSCC and to the broker-dealers who do the trading:

One of NSCC’s primary roles in the industry is netting — the automatic process of offsetting a firm’s buy orders for a particular security against its sell orders for that security. Netting consolidates the amounts due from and owed to a firm across all the different securities it has traded to a single net debit or a net credit.

Allowing trades to “net” settle reduces the total amount of cash and securities that have to go back and forth throughout the day and eliminates a significant amount of operational and market risk. By netting down or reducing the total number of customer trading obligations that require the exchange of money for settlement, NSCC helps to minimize risk and free up trillions of dollars of capital each year. Every day, NSCC netting reduces the value of payments that need to be exchanged by an average of 98-99%.

That makes it easy to see why informed commenters on the SEC proposed rule were unenthusiastic about the introduction of T+0 in the foreseeable future. It would mean trades would settle as they were executed, and the advantages—the savings—of netting would be lost.

SIFMA has yet more helpful information on its own website, much of it in the form of webinars and podcasts, some of which were produced last week. The most recent communication is intended to assure the industry that everyone is ready for the implementation of T+1. Any participant who doubts that or feels nervous can get in touch with SIFMA’s Command Center for help with any issues that may pop up and for what SIFMA calls “socialization.” 

Will the T+1 Have Any Effect on the Meme Stocks?

Yes, that sounds like a dumb question, but we feel we need to say something about it. Gensler mentioned it in his recent statement, and many of the retail investors who commented on the proposed rule said they approved of it because it would, they believed, curb Shorty’s excesses. They believe that in 2020 and 2021, Shorty was shorting naked—without bothering to borrow stock—and is probably doing it again. They believe GameStop (GME) is ready for a second short squeeze. That is because an investor called Keith Gill, better known as “Raging Kitty,” returned to social media after three years of silence. He said nothing specific, but those still following GME interpreted his cryptic messages positively. The stock popped and then subsided.

One of the T+1 commenters is not, apparently, a social media enthusiast hooked on GME. Her name is Birgitta Siegel, and she’s an adjunct professor at the Cornell Securities Law Clinic. But she does reference the meme stock phenomenon. In a discussion of the Bachmann Report, she says:

The report noted that a “shorter settlement cycle will also uncover potential problems sooner, before they mushroom or begin to cascade throughout the industry.” These observations are as true today as they were when that report was written. For example, in early 2021, the fiasco involving GameStop, AMC, and other meme stocks was worsened by the two-day settlement cycle. This two-day delay contributed to wide price swings and extreme volatility not based on much more than speculation, which put retail investors at particular risk.

She is correct. Some of the GME players made money, even a lot of money. Many held on, hoping for greater profits, and lost out. But as the SEC staffers who investigated the meme stocks’, and particularly GME’s, incredible run discovered, naked shorting was not a problem because there were very few persistent fails to deliver. That is not to say there weren’t problems. At the end of the study, its authors point to four areas where improvements could be made, which might promote greater transparency and enhance investor protections in the future. The first addresses settlement:

Forces that may cause a brokerage to restrict trading. A number of clearing brokers experienced intraday margin calls from a clearinghouse. In reaction, some broker-dealers decided to restrict trading in a limited number of individual stocks in a way that some investors may not have anticipated. This episode highlights the integral role clearing plays in risk management for equity trading, but raises questions about the possible effects of acute margin calls on more thinly-capitalized broker-dealers and other means of reducing their risks. One method to mitigate the systemic risk posed by such entities to the clearinghouse and other participants is to shorten the settlement cycle.

[Emphasis ours.]

The other suggestion is that “improved reporting of short interest” would be desirable.

It’s certainly true that accelerated settlement will reduce volatility. Less volatility means less risk for everyone involved with a trade: the buyer, the seller, the market maker, and the clearing firm. It will also mean many fewer enormous runs like the one that GME and other meme stocks enjoyed in 2021. Though it may mean reduced liquidity, speeding up settlement was more beneficial than harmful to investors in 1995 and 2017. Chances are the transition to T+1 will have the same effect.

For further information about this securities law blog, please contact Brenda Hamilton, Securities Attorney, at 200 E. Palmetto Park Rd, Suite 103, Boca Raton, Florida, (561) 416-8956, or by email at [email protected]. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as and does not constitute legal advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.

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Brenda Hamilton, Securities Attorney
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