Shortening the cycle: ESMA Call for Evidence on shortening the EU settlement cycle

Background

On 5 October 2023, the European Securities and Markets Authority (“ESMA”) launched a Call for Evidence on the shortening of the settlement cycle in the EU (the “Call for Evidence”).

Under the EU Central Securities Depositories Regulation (“CSDR”), all transactions in transferable securities and certain other similar instruments which are executed on a trading venue must complete by no later than the second business day after the trade date (i.e. on “T+2”). This requirement was originally introduced in 2014, with the aim of increasing the safety and efficiency of securities settlement in the EU and reducing cross-border risks through a harmonised, EU-wide approach. The CSDR also established a settlement discipline regime, which included measures to prevent settlement fails, such as requirements on the automation of settlement instructions and the imposition of cash penalties.

However, since the adoption of CSDR, financial markets and technology have continued to evolve, and some jurisdictions outside the EU have moved, or are planning to move, to shorter settlement cycles, such as T+1 (the first business day after the trade date) or even T+0 (the same day as the trade date). We summarise the Call for Evidence and discuss the key considerations and initial feedback from the industry below.

The Call for Evidence

The aim of the Call for Evidence is to collect views from market participants to feed into an ESMA report to the European Commission (“EC”) on the potential impact of reducing the securities settlement cycle in the EU. In summary, ESMA is seeking feedback on the impact of a shortened securities settlement cycle, the benefits and costs, how and when a transition could be achieved and the impact of international developments on EU capital markets. ESMA has indicated that it will consider all possibilities for a shortened settlement cycle, including moving to T+1 and T+0.

ESMA invites input from all stakeholders involved in financial markets including market infrastructures (central securities depositories, central counterparties, trading venues), their members and participants, other investment firms, issuers, fund managers, retail and wholesale investors, and their representatives. ESMA encourages all interested stakeholders to provide their feedback by 15 December 2023. Further detail is available on ESMA’s website and information on next steps is set out below.

Key considerations

An uneven picture. ESMA has already received some feedback from industry experts on how the shortening of the settlement cycle would impact the operations of different market players. This initial feedback revealed that the readiness for a settlement cycle shorter than T+2 is uneven. ESMA’s view is that market players who are closer to settlement may be less affected, whereas those further down the settlement chain may face more challenges. Certainly fund managers and institutional investors will be reliant upon smooth and efficient processing by custodians and brokers, and in relation to securities lending arrangements, for example. The asset management industry has separately highlighted that a key pain point will be ensuring that there is access to sufficient, well-priced liquidity in the FX markets within a shorter window to enable settlement of securities transactions in other currencies. There could be an impact on trade costs, if firms are required to execute in tighter timeframes. 

Further investments are required. ESMA acknowledges that EU market players have already invested in systems and processes to comply with the settlement discipline regime set out in the CSDR. Further shortening of the settlement cycle could pose significant additional challenges and costs, including phasing out manual processes, investing in more automation, and facing more frequent settlement fails and penalties. Moreover, the EU post-trade landscape is complex and diverse, including a high number of market infrastructures and several currencies as well as inconsistent national securities laws. As a result, shortening the settlement cycle in the EU may prove to be more challenging than in jurisdictions with centralised post-trade financial markets infrastructure and harmonised securities laws (such as the UK).

Potential benefits. However, shortening the settlement cycle could bring several advantages, including increasing efficiency and reducing counterparty risk (and thus collateral requirements) and reducing the risks linked to excessive volatility between trade and settlement. This would also enhance the competitiveness and attractiveness of EU financial markets, as well as negating any potential impacts of misalignment with shorter settlement cycles in other jurisdictions. 

Developments in other markets, including the UK

Key markets around the world have already moved or are planning to move to shorter settlement cycles, which could have considerable implications for the competitiveness of the EU's capital markets.

In January 2023, India completed its phased transition to a T+1 settlement cycle in equity markets, with completion of the transition of the final batch of securities. China has transitioned to T+0 for interbank market government bonds and the US and Canada are expected to move to T+1 by the end of May 2024 for a broader range of financial instruments.

Other jurisdictions, including the UK, are also exploring a transition to T+1 or T+0. The UK’s Accelerated Settlement Taskforce is due to publish its initial recommendations in December 2023, with a full report and recommendations published by December 2024 at the latest.

These developments could create pressure on the EU to align. Without action, the EU could face challenges and risks associated with fragmentation and inefficiencies in cross-border settlement. A shorter settlement cycle in the EU may increase its integration and attractiveness for global investors.

Commentary

There has so far been some notable resistance and hesitancy to a mandate for T+1 in the EU, due in large part to the unique and fragmented nature of the EU capital market. Should it proceed, market participants will no doubt be keen to feed back that any transition to T+1 or T+0 in the EU should be managed so that it takes account of implementation programmes in other jurisdictions, results in minimal negative impacts on costs and liquidity, and that sufficient time is given to implement necessary systems changes. Service providers are already offering new solutions to firms, to enable them to meet their obligations as global markets move towards T+1 and T+0.

Next steps

ESMA will consider the feedback it receives from this consultation in Q1 2024 and intends to submit to the European Commission and publish a final report by Q4 2024 at the latest.

Co-authored by Tom Callaby and Rachel Smart