Starting next week, securities trading will continue evolving with the move to “T+1” settlement on May 28, 2024. For most, understanding the nuances between trade execution and settlement may seem unnecessary. Yet, it’s a fundamental aspect of how our financial system operates. With the impending change, our focus this week will be highlighting historical changes in settlement times, what the newest change will bring, and why it is essential.
What is Trade Execution?
Trade execution occurs when a buyer and seller agree to the price and quantity of a financial asset (stocks, bonds, ETFs, etc.). Thanks to modern trading platforms’ advanced technology and infrastructure, execution happens almost instantaneously. However, the actual exchange of money and asset ownership, known as settlement, occurs later.
What is Trade Settlement?
Trade settlement is the process that follows trade execution, where the buyer transfers money to the seller, and the seller transfers ownership of the asset to the buyer. This ensures that both parties fulfill their part of the transaction. The time between trade execution and settlement is called the settlement period.
The History of Settlement Periods: From T+5 to T+2
T+5 (Trade Date Plus Five Business Days)
Historically, settlements took longer. In the early days of stock trading, settlements were set at T+5, meaning five business days after a trade was executed. This period allowed for manual paperwork processing and the transfer of physical stock certificates and cash. The lengthy settlement period was necessary due to the lack of electronic systems and the slower pace of communication and logistics.
T+3 (Trade Date Plus Three Business Days)
As technology improved, the SEC shortened the settlement period to T+3 in 1993. This transition was facilitated by the advent of electronic trading systems and the digitization of records. T+3 reduced the risk of default and improved the efficiency of the trading process, allowing investors to have quicker access to their funds and securities.
T+2 (Trade Date Plus Two Business Days)
The 2008 financial crisis and ensuing regulatory reforms highlighted the need for further efficiency and risk reduction in the settlement process. In 2017, the industry moved to T+2. This shorter settlement period sought to reduce counterparty risk and enhance market liquidity. T+2 allowed for faster capital turnover, enabling investors to reinvest their funds more quickly.
The Move to T+1 Settlement
Why T+1?
The transition to T+1, which will be implemented next Tuesday, is driven by the same goals of efficiency, risk reduction, and market stability. A T+1 settlement period means exchanging money and assets occurs the business day after the trade is executed.
Two recent episodes of elevated market volatility — in March 2020 following the outbreak of COVID-19 and in January 2021 during the “meme” stock mania — highlighted potential vulnerabilities that a shorter settlement cycle could help mitigate. This change is particularly significant in an era when digital transactions and high-frequency trading dominate the market.
Benefits of T+1 Settlement
- Reduced Risk: A shorter settlement period minimizes parties’ exposure to counterparty risk, reducing the likelihood of a trade failing due to default.
- Increased Liquidity: Investors gain quicker access to their funds and securities, allowing for more rapid reinvestment and enhancing overall market liquidity.
- Operational Efficiency: Faster settlements streamline back-office operations, reducing financial institutions’ administrative burden and associated costs.
The evolution of settlement periods reflects the financial industry’s continuous efforts to enhance efficiency, reduce risk, and improve liquidity. While T+1 is a significant milestone, the future might hold even faster settlements, potentially reaching T+0. Understanding these concepts and their implications helps investors appreciate the mechanisms that ensure the smooth functioning of financial markets, ultimately contributing to greater market stability and investor confidence.
Economy
- Markets were mixed this week, buoyed by Nvidia earnings. The S&P 500 was flat, the Nasdaq was up 1.4%, and the small-cap Russell 2000 was down -1.2%.
- According to preliminary data, the S&P Global U.S. Composite PMI surged to 54.4 in May, up from 51.3 in April, marking the highest level since April 2022.
Stocks
- U.S. equities were in positive territory. Technology and Communication Services were the top performers, while Energy and Real Estate lagged. Growth stocks led value stocks, and large caps beat small caps.
- International equities closed lower for the week. Developed markets fared better than emerging markets.
Bonds
- The 10-year Treasury bond yield increased five basis points to 4.47% during the week.
- Global bond markets were in negative territory this week.
- High-yield bonds led for the week, followed by government bonds and corporate bonds.
