17 January 2025

As the UK and Europe prepare for a shortening of the stock market settlement cycle from trade date plus two days (T+2) to trade date plus one (T+1) in 2027, Matt Pells, Product Manager, Funds Administration, examines how taxing the transition will be.

Fund managers and their providers had to adapt to meet the shortened settlement deadlines in North America in May 2024. But how much more will UK and European managers have to do for the planned transition to T+1 in their own backyard?  

To answer that, it is helpful to look at some of the lessons learned from the US implementation. Top of the list is the need for automation. Andrew Douglas, who chairs the technical group of the UK’s Accelerated Settlement Taskforce (AST), said in his report in October 2024: ‘Reviews of the US T+1 implementation suggest that insufficient focus was given to automation, leading to firms post implementation having to deal with increased volumes of manual processing and exception management.’ Higher headcount costs eroded any benefit gained elsewhere.

If firms are to avoid an increase in operational risk, processes need to be fully automated and scalable – all the way through the post-trade lifecycle to asset servicing. Areas highlighted in the AST’s report where manual operations frequently predominate today were stock lending recalls and corporate actions such as entitlement calculations, corporate action claims and tax reporting.

‘The big issues for funds during the US transition’, says Alex Chow, investment operations policy lead at the Investment Association, ‘were trade matching and affirmation, together with meeting FX cut-offs’. In its submission to the AST, the IA stressed that many firms across Europe with material US exposures have made system and process changes that should leave them well-placed to manage a UK transition to T+1. Those changes span trade matching and settlement, foreign exchange and funding.

Where there is more to do, there are fully automated third-party solutions available. Fund managers and distributors probably don’t need to worry too much provided their TAs are ready for the transition. Those with leading TA systems can automate how they accommodate changes to settlement time frames. They should flex as they need.

They should also have workflow automation tools to further improve the end-to-end service. All providers should be offering a fully digitalised service to help funds make the transition – and funds should insist on this.

Funding remains an issue

While the SEC can count the transition a success, it was doubly difficult for many non-US investors given the combination of time zone and currency issues. The most obvious impact was on funding. Mutual fund subscriptions and redemptions commonly take 3 days to settle in the UK and other popular EU fund jurisdictions, creating a two-day funding gap for the purchase of US securities which now occur on T+1. Funding challenges will be further exacerbated when the UK and Europe implement T+1 settlement.

For the US move, UK and European funds adopted a variety of measures to address this funding gap, the main ones being to leverage custodian overdrafts or look for extended settlement, says Mr Chow. In both cases, additional costs could be incurred and sometimes passed to investors. Some funds, he says, looked to make use of swing pricing in the case of large redemptions and subscriptions, to protect the fund’s existing investors.

The funding issue has particularly impacted trading in European ETFs with significant US weighting, such as global equity ETFs where the US will represent a 65-70% weighting of an index being tracked. Since the US transition, our member firm ETF issuers have not seen a material change in ETF trading spreads but have seen an impact on the ETF premium (the amount at which an ETF trades above the market value of its constituent securities). This is because authorised participants (APs) making markets in ETFs are costing in a funding gap between ETFs trading at T+2 in EMEA but needing to settle T+1 for the US weighting of their portfolio. This has meant that the ETF premiums are around 1.5 basis points higher than prior to the transition though this should be alleviated with a UK and EU transition to T+1 (including ETF primary market settlement), which will re-harmonise settlement cycles.

Funding is likely to be a major concern in the UK, too. The UK funds industry generally uses the BACS transfer system for redemption payments because it is the most cost-effective system. The downside is it takes up to three days to make a transfer – which effectively rules it out as an option in a faster settlement environment. There are other options, most notably Faster Payments, but all involve added cost.

In November the Treasury published its long-awaited National Payments Vision, which, among other things, promises ‘to clarify the upgrades required to the existing Faster Payments System’. A more detailed approach is to be published by the end of 2025. John Allan, the IA’s head of innovation and operations, says: ‘We are hopeful it will introduce some new options, or a bolstered version of what’s already there.’ 

He also points out there is also some movement in costs with Faster Payments and CHAPS where cheaper options are available to customers that can offer reasonable volumes. ‘The question is whether any new system can be delivered within the timeframe required’, he says.

Question marks over stock lending recall cut-off times

Not surprisingly, the US move to T+1 caused an increase in stock borrowing. The key issue has been the cut-off time for returning borrowed stock.  The original proposed cut-off time was 23.59 EST but after much discussion it was set an hour before close of trading. ‘For many, that is not seen as achievable given how much trading takes place in the run-up to the close,’ says Mr Chow: ‘It doesn’t leave enough time on big deals to get back to an agent lender and this can cause liquidity issues on less traded small and mid-cap stocks.’

There are unresolved issues around stock recalls for the UK ahead of the transition. The AST has suggested investment managers will need to instruct their lending intermediaries before they sell securities on loan. This raises confidentiality issues. The IA wants this changed – so the information is sent post-execution but before matching.

The other issue is what should be the appropriate cut-off time for recalls of stock – in many ways a re-run of the debate that occurred ahead of the transition in the US. The International Stock Lending Association has proposed an hour before close of dealings (15.30) while the AST has suggested 16.30 to coincide with the close. The IA wants it fixed at an hour after the close to give investment managers a chance to adhere to the cut-off time.

The AST has stressed the importance for both borrowers and intermediaries of automating the recall process to deliver speed and continuity of communications, a reduction in manual errors and the elimination of ‘false recalls’.

Shorter subscription and redemption cycle is key

Many of the above issues will be easier to manage once the funds industry as a whole shortens its own subscription and redemption cycle. The IA did give what it calls a ‘soft’ recommendation for the sizeable minority of fund groups that remain on T+3 or even T+4 cycles to move to T+2 ahead of the US transition, but few did so.

‘Many are clearly not going to make the change until we move to a T+1 markets settlement cycle here,’ says Mr Allan. Fund groups are loath to move just a few of their funds to T+2 while others remain on T+3. It creates misalignment within the range if customers want to switch funds and throws up client money issues. There is also the BACS problem to resolve. ‘It will be simpler to make the change when other markets than just the US move to T+1. That, we think, will be the trigger for a wholesale move’, he says.

The good news is that the European Union has now said it will also move to T+1 in October 2027, almost certainly aligning with the UK. Switzerland is expected to do the same. Without that, certain securities such as exchange-traded products and Eurobonds would have remained outside the scope of the UK T+1 migration, creating complications.

European firms and their providers may also need to heed the words of AST’s Andrew Douglas: ‘As firms in the US who have not automated seem now to be realising, the legacy of not automating is increased headcount costs to deal with manual processes and the higher levels of exception management that result from manual processing’.

While automation is not new advice, fund firms should make sure their TA can accommodate any settlement timeframe they need for their different funds. It should be a simple adjustment, but you do need to ask the question.