United States: Twenty-Three Years Later, One Day Shorter: SEC Proposes T+2 Rule Amendment

Twenty-three years after adopting Rule 15c6-1 under the Securities Exchange Act of 1934 ("Exchange Act") to establish T+3 as the standard settlement cycle for broker-dealer transactions, on September 28, 2016, the SEC proposed amendments to Rule 15c6-1(a) 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 (T+2).

Shortening the standard settlement time to T+2, the SEC says, would reduce a number of risks, including credit risk, market risk, liquidity risk, and overall systemic U.S. market participant risk that may arise in the settlement process. T+2, the SEC says, would enhance the resilience and efficiency of the national clearance and settlement systems to the benefit of market participants.

Rule 15c6-1(a)

Rule 15c6-1(a) generally prohibits broker-dealers from effecting or entering into a contract for the purchase or sale of a security (other than certain exempt securities) that provides for payment of funds and delivery of securities later than the third business day after the date of the contract unless otherwise expressly agreed to by the parties at the time of the transaction.

General Overview of Trade Settlement

The trade settlement and clearance process for so-called retail investors and institutional investors (such as a fund) differ.

Retail investor trades, according to the SEC, are often smaller and less complex. On the trade date, and after the broker-dealer counterparties agree on the terms and lock the trade in, the trade details are sent to the National Securities Clearing Corporation ("NSCC"), then the NSCC validates the trade data received and sends communications to NSCC members that are counterparties to the trade committing them to its completion. On T+1, the NSCC novates the trade and becomes buyer to the selling broker-dealer and seller to the buying broker-dealer. On T+2, the NSCC issues a trade summary report to its members with a summary of all securities transactions and cash to be settled on the following day, in addition to sending electronic settlement instructions to The Depository Trust Company ("DTC") detailing net positions and cash that must be settled for each member/participant. On T+3, DTC transfers the securities, electronically, between the buying and selling broker-dealer accounts at DTC. Cash movement instructions are sent to DTC by settlement banks, and the trade is complete once the securities and cash are received by the various trading parties.

Institutional trade clearance and settlement processes generally start when an institutional customer places an order to buy or sell securities with its broker-dealer. The broker-dealer advises the institutional customer of the trade details, and the institutional customer may advise the broker-dealer as to how the total trade is to be allocated across its various accounts. Confirmation of the trade is generally completed automatically through matching/electronic trade confirmation ("ETC") providers. Once confirmed, and now referred to as an "affirmed confirmation," the affirmed confirmation is submitted to DTC on T+2. On T+3, DTC transfers the securities, electronically, between the buying and selling broker-dealer accounts at DTC. The participating broker-dealers instruct their settlement banks to send money to, or receive money from, DTC and the trade is completed.

The Settlement Cycle

During the three business days following the trade, a lot happens and a lot can happen. An entity's exposure to credit may change, market and liquidity risks may arise and defaults may occur. In a world where information travels at near instant speeds, three days seems like an eternity. By reducing the uncertainties that one day may entail, some degree of risk may be mitigated. In addition, costs could be reduced and accurate information could make its way to investors more quickly.

Conclusion

While generally viewed with welcomed acceptance by industry participants, many unanswered questions remain as to the implementation and possible unintended consequences of the move towards T+2, such as the effect on exchange-traded funds and the creation/redemption of units process, securities lending programs, and how small and mid-tier investment management firms, with potentially less automation of trade clearing and settlement, will implement the change.

Our Take

Costs, savings, and implementation aside, questions remain as to what, if any, impact the proposed change could have on the proposal to require mutual funds to establish liquidity risk management programs. The current proposal would require a fund to determine a minimum amount of its portfolio to be held in cash or instruments that could be converted to cash within three days. This is the so-called "three-day liquid asset minimum," and fund boards would be required to approve the liquidity risk management programs and the three-day liquid asset minimum.

Comments to the proposal are due 60 days after the date of publication in the Federal Register.

For additional insights on T+2 as applied to structured notes, our Structured Thoughts article is available here.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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