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© Copyright 2000 Rogers Media. The following article first appeared in the January 2000 edition of
BENEFITS CANADA magazine.
The race to T+1
Next-day transaction completion is the next big challenge facing the securities industry. Here's
why T+1 matters to you.
BY DAVE MALONE
There are three words that many are using to describe the future of the financial services industry:
Faster. Faster. Faster. Just as technology has allowed us to do our personal financial transactions in
seconds, not surprisingly, this light-speed momentum has made its way into the stock exchanges of the
world.
While buy and sell transactions are presently executed and completed three days after the order is placed,
otherwise known as T+3, the push now is for a faster process: settling trades one day after the trade date,
or T+1.
Implementation of T+1 has profound ramifications for the industry and will require a significant commitment
of its collective resources. And, like the Y2K challenge, plan sponsors need to get involved to ensure its
agents are up to the challenge of operating effectively in an electronic trading environment.
Here's a primer on T+1--why it's happening, what's going to change and what the transition means for your
plan.
THE RISK FACTOR
The North American investment industry made the switch from T+5 to T+3 in 1995. Why move to T+1 now? The
answer lies in risk management. The shorter time between trade and settlement dates means a lower risk of
the counterparty walking away from the deal.
This was brought home to the industry during the 1987 market crash, when the value of trades dropped
precipitously before settlement, exposing sellers to significant credit risk.
In 1989, the Group of Thirty (G-30), a non-partisan, international consultative body issued a report that
called for all securities markets to move to a T+3 environment in order to:
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increase efficiency in clearing agency and broker/dealer operations;
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reduce liquidity risk and financial costs; and
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mitigate credit and market risks.
With worldwide pension assets expected to top US$15 trillion by 2005 and cross-border trade volumes
increasing over 50% per year, managing risk is taking on a whole new perspective. The shift to T+3 was the
initial response to this systemic risk. T+1 is the next step.
In the United States, the growth in cross-border investments, new entrants and emergence of electronic
trading systems have all caused dramatic increases in volumes. When combined with the upcoming events such
as decimalization and extended trading hours, volumes will be pushed even higher. The U.S. securities
infrastructure is starting to show signs of strain and this has regulators concerned. The U.S.-based
Securities Industry Association recently, for example, released a paper predicting that, without
substantive changes, on any given day in 2002, over 40% of institutional trades may still be awaiting final
settlement instructions on T+2.
The chairman of the Securities Exchange Commission has challenged the U.S. securities industry to move to
T+1 by July 2002 to deal with what is believed to be an unacceptable level of systemic risk.
If the U.S. is going to T+1, does that mean everyone has to do the same? Many countries are still
struggling with T+5 and the implementation of electronic settlement systems. The U.K., for example, has
recently announced its intention to move from T+5 to T+3 in 2001. T+1 is on the distant horizon. In Canada,
however, we must move with the U.S. because of the number of inter-listed stocks between the U.S. and
Canadian markets. As the Toronto Stock Exchange has found out to its detriment, trading flows to the most
efficient market--the one that settles first and provides greater liquidity. A two-day difference in
settlement dates would drive even more trading to the U.S. and provide tremendous arbitrage opportunities.
The move from T+5 to T+3 was accomplished by making existing settlement processes more efficient and/or by
adding additional staff. T+1 settlement, on the other hand, will require a complete redesign of the way
managers, brokers and custodians deal with each other, and will force all participants to embrace a
completely electronic environment.
The present systems used by brokers and the Canadian Depository for Securities (CDS) to settle equity
trades rely on daily overnight batch processing. The manually based processes that many investment managers
use to allocate trades to various client accounts resident at multiple custodians will not work in a T+1
environment. In short, the success of T+1 will be dependent on an absolute, unwavering commitment to
electronic straight through processing (STP).
While this sounds like a stretch, it's not beyond our grasp. The CDS and the broker community are already
re-allocating capital resources from Y2K to T+1. Since the U.S. securities industry is fully committed to
STP in order to cope with increasing volumes and systemic risk, Canada will follow suit.
FIRST STEPS
To start managing the transition to T+1, the Canadian securities industry has revived its G-30 organization
to move the industry forward. An industry-wide effort, much like the Y2K project, and fully supported by
Canadian securities regulators, will be required. To do otherwise will further jeopardize the
competitiveness of our financial marketplace.
For the custodian side of the equation, the move to T+1 poses business challenges as well as opportunities.
Most custodians' existing street side systems that deal with money managers and depositories are already in
real time and require only fine-tuning.
The bigger issue is how to electronically link the key participants involved throughout the full life cycle
of both domestic and international trades. Accurate data and standardized formats will be essential to this
transition.
One of the most promising solutions is an initiative endorsed by the Global Straight Through Processing
Association (GSTPA). The GSTPA, consisting of major global custodians, broker/dealers and money managers,
is working collaboratively to design a single system that will provide an STP-based solution to
cross-border trading. The members represent close to 40% of the world's securities industry trading
volumes.
If a common industry platform can be developed to handle worldwide cross-border trading, it's a simple leap
of technology to apply this process to domestic settlement systems. That's why both CDS and the U.S.
Depository Trust Company are involved in one of the four finalist vendor consortiums bidding on this key
initiative. The initial vendor selection is to be completed this month and development done by the end of
2001. While the dates are subject to debate, there is a huge potential for improving STP rates and reducing
systemic risk for all participants, including custodians. It's also a prerequisite for T+1.
By covering the full life cycle of a trade, GSTPA could provide common interfaces to all market
participants and a business architecture solution to the T+1 issue. Industry participants wouldn't have to
independently develop proprietary systems at great expense.
MOVING FORWARD
The challenge of the ever-increasing trade volumes and the issue of liquidity and systemic risk will never
go away. Having survived Y2K, however, T+1 represents the natural next step in the efforts to remove risk
and provide efficient and effective markets to last us through the next millennium.
The role of plan sponsors will be to think like Wayne Gretzky: never skate to where the puck is but where
the puck will be. In other words, start taking an active interest in supporting your agents' STP and T+1
initiatives.
Dave Malone is the T+1 project director at Royal Trust Global Securities Services in Toronto.
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A T+1 tutorial
Keep this list of questions handy to ask your
money managers and custodians.
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How will T+1 impact the manager's systems, business processes and electronic links with
brokers/custodians?
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How and when does the manager transmit trade data to brokers and custodians? If it's by fax or after
T+2, ask why.
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What is your custodian's overall straight through processing rate? What percentage of trades fail to
settle on time? What's the custodian doing to get itself and its partners ready for T+1?
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