What it is
We analyze the impact of the new rule that cuts down the amount of time to settle trades in North America to one day from two.
Why it matters
The change could increase trading costs and create operational headaches for investors if not managed well.
Where it's going
We believe our diligent portfolio management teams, technology and sophisticated global equity trade desk position us well to manage this change.
Q&A: What the New SEC T +1 Rule Means for Investors
In May, the U.S. Securities and Exchange Commission implemented new rules to shorten the standard settlement cycle for most securities transactions in the U.S. to one day (T +1) from two days (T+2). Since 2017, the time between the transaction date and the settlement date (when payments and deliveries of assets are finalized) has been two business days. Under T+1, all applicable securities transactions from U.S. financial institutions will settle in one business day from the transaction date. Canada and Mexico also transitioned to a T+1 settlement cycle at the same time, though outside North America T+2 remains. The SEC changed the rule after volatility created by the pandemic and “meme” stocks" highlighted potential market risks that shorter settlement times could help mitigate.
Quinn Whitaker, CFA, portfolio manager for our tax-advantaged equity team, answered some questions about the nuances and potential challenges this can present.
Q: Why is this change important to investors?
A: The change could create higher costs and operational headaches for investors. We expect asset managers with scale and experience managing different settlement cycles to hold an advantage in this environment.
Q: Which types of investment strategies are affected?
A: For strategies that don’t hold North American securities, nothing has changed because settlement times remain at T+2 outside of North America. Similarly, strategies investing in only North American securities won’t experience issues because all settlements are T+1. The major impact occurs to global investment strategies with a mix of North American, European and Asia-Pacific investments because of the mismatch between settlement times.
With global strategies, if a portfolio is selling more North American assets than what it is buying in Europe or Asia-Pacific, then no issues arise. This is because proceeds will be available a day earlier under T+1 in North America to fund purchases in Europe or Asia-Pacific the following day under T+2. However, issues can arise if a portfolio needs to buy more securities in North America than it will sell in Europe or Asia-Pacific. In this situation, the portfolio must pay for securities in North America in a day under the new T+1 rule, but proceeds from sales outside North America won’t be available until the next day under T+2. This creates a funding shortfall that the portfolio manager must manage.
Q: Under T+2, how did NTAM normally execute trades?
A: Our tax-advantaged equity team has 25 years of experience managing local share global portfolios. In our standard trading process under T+2, a portfolio manager built trade baskets “T-1” — or the day before trade execution. The portfolio manager sent the trade orders to the global equity trading desks in London and Hong Kong for execution as each local market opens. The following morning in the U.S., the portfolio manager worked with the trade desk to construct and execute the foreign exchange currency orders in order to fund purchases in local currencies. In the prior T+2 settlement environment, each piece of this process typically lined up smoothly — all equity and foreign currency trades settled two days after the transaction, so all currencies became available just as they were needed to fund equity settlements. The exception here is when certain markets had holidays which shifted back the settlement cycle. These holidays created mismatches similar to those created under the new T+1 rule in North America and caused potential funding shortfalls as well.
Q: Under T+1, how can portfolio managers address these potential funding shortfalls?
A: In these cases, our portfolio managers leverage trade optimization technology to determine the funding shortfall and work with our global trading desk to instruct broker-dealers to “short-settle” a portion of sales outside North America. This allows the portfolio to receive proceeds from sales in Europe or Asia-Pacific a day earlier to fund purchases in North America within a day. In some cases, we also “long-settle” purchase trades, where the seller accepts payment a day later under certain terms. It is important to note that the entire trade does not need to be short- or long-settled, only the amount needed to cover the funding shortfall. For example, we consider a portfolio with total net purchases of $100,000 with T+1 settlement ($2,100,000 gross purchases with $2,000,000 of gross sales) and total net sales of $100,000 with T+2 settlement ($1,000,000 gross purchases with $1,100,000 of gross sales). In this case, the portfolio would need to short-settle to fund the $100,000 of purchases on T+1.
Q: Will the change to T+1 increase costs?
A: Executing off-cycle settlements will typically incur additional transaction costs from commissions paid to the broker-dealers, which tend to be minimal versus the market value of the portfolio. These commission costs for short or long settlements are essentially a financing charge to cover borrowing cash before or after the standard settlement. The tax-advantaged equity team has been managing off-cycle settlements for decades, as global holidays frequently impact the settlement schedule between different markets. The scale and sophistication of our equity trading desk enables favorable terms for these transactions that may not be available to all market participants. These costs are very likely cheaper than the margin interest rate, charged within a brokerage account.
Q: Can portfolios just hold more cash to fund shortfalls?
A: Some managers may maintain larger cash balances to fund the shortfalls. One potential issue with this method is cash drag on portfolio performance. For example, assume an annual equity return premium of 5% over cash. If the portfolio reduces its equity allocation by 1% to increase its cash allocation by 1%, the portfolio would suffer a loss on annual return of 0.05% (5% times 1%) because of the lower allocation to equities. This is well above the costs we’ve seen using other techniques described earlier.
Q: What are the keys to managing the shorter cycle successfully?
A: Investment managers are dealing with these new challenges in various ways, and some firms have needed to make major operational changes to the way global portfolios are held at custody. With diligent portfolio management teams, technology and a sophisticated global equity trade desk, we believe we are positioned well to manage these challenges smoothly and efficiently using strategies that have been effective for decades. We would not expect our clients to have any change to the standard operating procedure we have used for the past 25 years.
