Impact on all stock, bond, and ETF trades! Understanding the new "T+1" settlement rules in the United States in one article

The U.S. stock market is about to witness a historic moment this week.

Starting from May 28th local time, the settlement cycle of U.S. stocks will be shortened from T+2 to T+1, meaning that investors can receive settlement funds for stocks sold on the same day within one working day after the transaction.

This also means that stocks will be in line with bonds, options, and ETFs, and the application of T+1 in the U.S. financial market is expanding.

What is T+1 settlement?

T+1 settlement refers to completing financial transactions within one working day. For example, if a trade occurs on Monday, it will settle on Tuesday, and traders will formally receive cash or securities and can freely exchange them without any penalties.

The trigger for the transition of U.S. stocks from T+2 to T+1 settlement was the 2021 GameStop incident.

At the beginning of 2021, the frenzy of retail investors driven by cheap "MEME stocks" represented by GameStop surged on social media, leading to increased trading volume and volatility. This caused trading platforms like Robinhood to face significant capital pressure as they needed to provide collateral for a large number of trades within the T+2 settlement period.

To ensure sufficient capital to cover collateral, Robinhood began restricting investors from buying these stocks. This action sparked strong dissatisfaction among retail investors and attracted scrutiny and questioning from regulatory agencies and members of Congress, prompting regulators to start implementing the T+1 settlement system.

Over the years, the U.S. securities market has been speeding up the settlement process. In 1993, the U.S. Securities and Exchange Commission (SEC) shortened the standard settlement period from the usual five days (T+5) to three working days (T+3). Subsequently, the SEC further shortened the settlement period to two days (T+2) in 2017 and will introduce the T+1 settlement period in 2024.

Why is T+1 important for the market?

The adoption of a T+1 settlement cycle in financial markets primarily serves two purposes: reducing risk and improving efficiency.

"There is a time-tested golden rule for clearing and settlement, that the sooner the better," said Brian Sussman, Senior Vice President of Global Operations at Interactive Brokers, to the media.

The longer the time for trade settlement, the greater the likelihood of issues with securities or funds. If the buyer's funds are insufficient or the seller's stock quantity is incorrect, it can lead to settlement failures. While brokerage firms and clearinghouses usually have safeguards, the longer the time between trading and settlement, the greater the risk. Shortening this cycle helps reduce market risk.

Securities like stocks can change hands multiple times a day, and the more trades there are, the greater the accounting workload for brokers, custodians, and clearinghouses. A delay between trading and settlement can cause accounting backlogs. Shortening to T+1 can improve settlement efficiency, promoting the adoption of more automated and efficient systems within the industry.

What are the benefits of T+1 for investors?

The transition from T+2 to T+1 may not have a direct impact on investors, but they will benefit from a safer and more efficient market environment Sifma's Director of Technology, Operations, and Business Continuity, Tom Price, stated that the biggest benefit of T+1 for retail investors is the reduction of investment risk.

"While the transition to T+1 is largely seamless for retail investors, they will benefit from the overall risk reduction brought by T+1 settlement. Reducing systemic risk is beneficial for a healthier market, which is always better for investors."

A shorter settlement period helps improve market efficiency, increase liquidity, and allows stocks to be traded more quickly. Proceeds from selling securities will be credited faster, enabling quicker reinvestment. Buying securities, on the other hand, requires having funds ready in advance, which may affect fund turnover in certain situations, such as involving foreign currency exchange.

Compared to T+2, T+1 also helps investors reduce trading costs.

"Longer settlement periods often require financial institutions to allocate more funds to risk management and back-office processes associated with the longer settlement cycle," said Jason Steeno, President of investment firms CoreCap Investments and CoreCap Advisors.

What are the risks of T+1?

A shortened settlement period may lead to more trade settlement failures.

The SEC stated that in the short term, the market may see an increase in the number of failed settlements, as broker-dealers and other market participants need an adjustment period to adapt to the faster pace and more efficient trading processes required by T+1 settlement.

For margin traders, T+1 means additional margin call notices may come faster, requiring them to raise funds in a shorter time to prevent broker-dealers from forcibly liquidating positions to meet margin call requirements.

For stock lending businesses, the time for lenders to identify and recall lent stocks is shortened. If borrowers fail to return stocks promptly, it may lead to settlement failures. Frequent settlement failures may result in fines from exchanges or regulatory authorities, increasing the operational complexity and potential default risks of stock lending businesses.

In a report last year, BNP Paribas wrote: "Due to the reduced time for identifying and recalling loans, settlement failures may increase, leading to higher penalty amounts."

A shortened settlement period means lower margin for error in trades.

Under a T+1 settlement cycle, the time for completing trades is halved compared to before, giving investors almost no time to correct any errors, especially in terms of costs. Once settlement is completed, errors are difficult to rectify.

Nathan Peterson, Director of Derivatives Analysis at Jiaxin Wealth Management Research Center, pointed out that once settlement is completed, an investor's cost basis—including the initial investment amount, paid commissions or fees, and the method of receiving dividends and distributions—is determined for tax purposes and not easily changed.

For the very few investors who still hold physical paper securities, if they want to sell securities, they need to deliver these certificates one day in advance, which is stricter than the previous T+2 requirement. However, the number of investors using paper certificates is now very small

T+1 has arrived, is T+0 far behind?

The settlement cycle of US stocks has gradually transitioned from T+5, T+3 to T+2, and has finally achieved the goal of T+1. The next question is, can US stocks further speed up to achieve same-day or real-time settlement?

According to the law in the financial industry that longer trading hours lead to higher risks, transitioning from T+1 to T+0 can eliminate the time risk factor.

Dave Lauer, CEO of Urvin Finance, told the media: "It eliminates all overnight risks in the system, which I think is a good thing. I think it will make abusive short selling more difficult, non-delivery of securities more difficult, and exploiting loopholes more difficult."

Lauer believes that T+0 can prevent certain forms of market manipulation, thereby avoiding harm to retail investors. In addition, he believes that this can also provide a more natural experience for investors, as investors expect to receive trading results on the same day they place orders.

From a technical perspective, achieving same-day real-time settlement at T+0 is not impossible, especially in blockchain and cryptocurrency trading, where this has already become a reality. In addition, earlier this year, the Indian stock market has already started adopting T+0, becoming one of the first countries to adopt same-day settlement.

However, there are still significant challenges to fully implement T+0 settlement in the US stock market. Some analysts believe that the main challenge lies not in technology, but in financing and efficiency.

The reason why cryptocurrency transactions can settle in real-time is because the buyer pre-deposits the full amount before the transaction. Given the scale and complexity of the US stock market, this would pose significant financial pressure on market participants, potentially affecting market liquidity.

T+1 is already a very tight settlement cycle. Speeding up to T+0 may introduce new risk points, and the impact of issues such as system failures and network delays could be magnified.

Furthermore, T+0 may conflict with certain aspects of the current market system, such as involving cross-border transactions, currency exchange, etc., requiring coordination at the institutional level.

Some analysts believe that T+1 has struck a good balance between reducing risks and improving efficiency - higher efficiency than T+2 and lower risk than T+0. In comparison, while T+0 is tempting, it may still be premature to implement it at this stage, as it may bring more problems than benefits.