ESMA feedback statement on shortening the EU settlement cycle reveals widespread industry concern

The European Securities and Markets Authority (ESMA) has released a feedback statement summarising comments received from market participants during its consultation on shortening the EU settlement cycle.

Under the EU Central Securities Depositories Regulation (CSDR), all transactions in transferable securities and other similar instruments executed on a trading venue must be completed no later than the second business day following the trade date. The CSDR also established a settlement discipline regime, which includes measures to prevent failed settlements.

Since its adoption, financial markets and technology have continued to evolve, and some jurisdictions outside the EU have adopted, or are planning to adopt, shorter settlement cycles, namely the first business day after the trade date.

Widespread concern

The call for evidence aimed to collect views from market participants to feed into an ESMA report to the European Commission on the potential impact of shortening the securities settlement cycle in the EU. ESMA invited participation from all stakeholders involved in financial markets. As expected, the feedback statement reveals a range of responses but with a common thread of widespread industry concern about the significant challenges involved.

The underlying message was that, although T+1 is technically possible, mandating a harmonised shift from T+2 to T+1 in the EU would have considerable operational impacts.

As expected, responses considered that securities borrowing and lending, repo, foreign exchange trading and cross-border activities were likely to be the most challenging aspects of the transition to T+1.

ESMA will further explore these areas in its final report. Several challenges were highlighted, including:

• 80% to 90% reduction of time available for post-trade processes.
• Lack of automation in relevant functions.
• Inventory management.
• Complex management of long chains of intermediaries and infrastructures for cross-border transactions.
• Net asset value calculations and cross-border distribution for certain types of funds and FX trading.
• Existing standards of corporate conduct.

Some feedback also requested that ESMA evaluate the adverse impacts that T+1 in the EU could have on investors in the Asia-Pacific region settling trades in EU securities. ESMA noted the request and will consider it in the final report, as well as arguments about how EU and UK transitions ought to align.

Balancing costs and benefits

Most feedback generally acknowledged the merits of a shorter settlement cycle, but some were unconvinced that such benefits would outweigh associated costs.

ESMA suggested this sentiment could be explained by the relative ease of identifying immediate costs (e.g., technology upgrades, standardisation and human resources) compared to the more nebulous, longer-term benefits (e.g., freeing up regulatory capital, innovation and competitiveness).

ESMA agreed that an eventual transition to a shorter settlement cycle would require intensive coordination between regulators and the industry. It also took note of feedback requesting coordination with UK and Swiss financial authorities, as well as consideration of lessons from the North America transition to T+1.

Regarding a start date, ESMA's preliminary feedback analysis suggests it could take no less than 32 months (just under three years) from when the industry is informed.

Two main concerns emerged from feedback on the consequences of adopting T+1 in other jurisdictions:

• Less time for post-trade processes: In North America, this challenge stems from significant time-zone differences and may not be solved even if the EU shortens its settlement cycle.
• Misaligned settlement cycles: Differences between EU and non-EU jurisdictions, such as the funding gap to be covered by EU funds invested in U.S. securities, which would persist without realigning settlement cycles.

Feedback also included numerous requests for regulatory action, including guidance about funds breaching UCITS limits for investments in deposits and temporary borrowing limits, as well as temporary suspension of the CSDR settlement discipline regime.

ESMA does not consider any of these to be material, based on its interpretation of UCITS requirements and its understanding of the operational impact from faster settlement of underlying securities held by a fund, but it will continue to monitor market developments.

Resistance and hesitancy

There remains notable resistance towards T+1 in the EU due in large part to the unique and fragmented nature of the bloc's capital market. Participants have expressed concerns, a few of which would be a surprise to ESMA.

When the EU implements T+1, sell- and buy-side firms will require significant effort to implement the shift, but the Commission and ESMA will need to ensure there is sufficient time and clear guidance about the impact on other regulatory requirements.

This article was first published by Thomson Reuters Regulatory Intelligence.