In February, the Securities and Exchange Commission (SEC) adopted rule changes to shorten the standard settlement cycle for most broker-dealer transactions in securities from two business days after the trade date (T+2) to one (T+1). The compliance date for the final rules is May 28, 2024.
While the merits of this move have been widely debated, one aspect that has received relatively little attention is currency conversion. BBH’s European custody product manager, Derek Coyle, has previously pointed out that a shorter settlement cycle impacts cross-currency transactions which have an FX component, with FX trades either needing to be booked on the same day or pre-funded.
Executing late in the US day creates potential market liquidity implications
Chris Gothard, BBH
“With a shorter settlement window there is less time to remediate breaks,” says Alex Knight, head of sales and EMEA at Baton Systems. “Those trading in US securities from outside the US need to factor in time for FX settlement to ensure they have the cash to settle their transactions.”
The global FX division of the Global Financial Markets Association has suggested that accelerating securities settlement to T+1 raises the risk that transaction funding dependent on FX settlement may not occur in time, with trade matching, confirmation and payment all having to be completed within local currency cut-off times.
Alex Dunegan, CEO of Lumint Currency Management, uses the example of purchasing Australian equities from New York for T+1 settlement. “The bank I traded with may have already missed its Australian dollar cut-off time for payment since it is already T+1 in Australia when I am in New York,” he explains. “And that assumes I have done the FX trade alongside the equity purchase.”
Establishing new teams in the US may not be efficient or feasible for European and Asian managers without local trading and settlement capabilities, suggests Chris Gothard, partner and head of global markets at BBH.
“Executing late in the US day creates potential market liquidity implications,” he says. “Another option is to accept that the settlement FX will need to be executed on T+0, in the Asian or European morning. This opens other risks such as potentially not being able to rely on risk mitigation market infrastructure such as continuous linked settlement.”
Challenge
Assessing the challenge of simultaneously executing equity and currency trades, Nathan Vurgest, head of trading at Record Financial Group, says the first question is who would be managing this joint transaction.
“Would it be an equity specialist or a custodian?” he asks. “It is notoriously costly to have custodians or non-FX specialists execute FX. If the FX transaction is merely tagged onto the equity transaction, the cost of execution would likely increase because operational process is likely to be prioritized over cost reduction.”
Vurgest reckons it would be possible to align equity and FX requirements efficiently if there were less focus on matching equity benchmarks. “In this scenario, more consideration could be given to trading during the day when there is better FX liquidity,” he adds.
Challenges of mixing stocks and currencies include differences in market dynamics, liquidity, execution speed, technology requirements and risk management, adds Dardan Abazi, senior institutional sales at Cornerstone FS. “Successful cross-asset trading requires careful planning, reliable data and technology, and expertise in both markets,” he says.
Executing FX trades on unconfirmed or unmatched equity trades can introduce additional settlement risk.
“The key risk here is currency rate changes between the time of striking the FX trade and the final settlement of the associated trade, resulting in errors or failed trades which in turn attract failure penalties,” says Gerard Walsh, global head of capital markets client solutions at Northern Trust. “One way to mitigate this is to create a full trade-related FX execution lifecycle that completes both elements as close in time as possible.”
An investor is better off trading the FX and having that transaction settle in a timely fashion instead of risking an overdraft waiting for the equity trade to match, suggests Joe Hoffman, CEO of Mesirow Currency Management.
The key risk here is currency rate changes between the time of striking the FX trade and the final settlement… resulting in errors or failed trades
Gerard Walsh, Northern Trust
“For example, if an investor buys 10,000 shares at $95.25 and the fees and commissions are one basis point, the net amount that needs to be purchased is $9,525,952.50,” he explains. “Suppose the broker changes the execution price to $95.23 before confirming and matching the trade. The net amount on the revised trade would be $9,523,952.30 – a difference of just over $2,000, which is immaterial in the grand scheme of things.”
According to Vikas Srivastava, chief revenue officer at Integral, automation of the trading process is needed, with very tight integration between the equity order management and execution management systems, the back office, and the FX execution management system.
Where FX execution is based on unmatched and unconfirmed equity trade information, the FX trade is essentially an estimate.
“Given the new deadlines it is plausible that this could be an approach some managers without the right infrastructure or solutions have to put in place, but it creates additional risk of large errors, potential for cash management breaks, and at the very least will increase the work around settlement FX flows from a trading and operational perspective,” concludes Gothard.
