The big trading shake-up that is about to hit fund managers

The writer is global head of capital markets client solutions at Northern Trust

For fund and investment managers around the world, every sliver of a percentage point of return matters. That is why they need to be ready for what is known as T+1 — an imminent US, Canadian and Mexican rule change on trade processing that risks adding unwelcome costs and a drag on performance.

In the smartphone era, buying and selling financial instruments is a superficially simple act. A few taps and you can be the proud owner of an exchange traded fund or shares in a far-off country.

But behind that process is a complicated chain of events requiring multiple actors co-ordinating a string of trade executions, trade settlement and trade-related currency movements, completed to strict timelines, making sure legal ownership changes hands. 

In May, North American markets will shorten their settlement cycles to trade date (“T”) plus one day (“T+1”). It is a seemingly arcane regulatory change intended to protect consumers from market stresses. But it introduces the risk of a potential cost surprise for managers everywhere. Any rise in costs would be especially unwelcome in the UK, where managers need to comply with the transparency requirements of the new Consumer Duty rule changes from July this year that ask fund managers “to deliver good outcomes for retail customers”.

The largest and most impactful move for global investors is the US, with the trade settlement cycle for thousands of financial instruments listed on US exchanges shortened by a day. US equities, ETFs, American depositary receipts and several other instruments are included in this change. For the first time, successful completion of elements of that process will be subject to a Securities and Exchange Commission rule and, in time, scrutiny of performance against that rule.

Like most regulatory change, it involves a great deal of inspection, verification and renovation of practices in the industry’s “middle and back office”. Portfolio management processes and investment management decision-making need clear attention too. The T+1 shift is not just something for the “processing people” to fix. 

Managers will need to understand how likely it is that the trade they want to place will be traded and processed, along with any related foreign exchange trades, especially as they approach the end of the working week outside the US. In particular, careful attention will need to be paid to settlement cycle mismatches and complicated basket trades involving multiple securities and programme trading.

The reasons costs may go up for managers are linked. Access to liquidity — cash, overdrafts or another cash-like instrument to settle trades comes at a cost. Industrial-scale overdrafts are not free and they cost more now than they have for over a decade. Some fund ranges do not permit managers to carry excess cash overnight, let alone over a weekend.

Another potential trap is trades placed in the US needing a currency transfer at scale late in the week for settlement. Foreign exchange liquidity dries up on a Friday afternoon New York time, stopping completely at 5pm. If a manager has missed the deadline for trade-related currency transactions, they could be exposed to higher funding costs via other means for the weekend. That is exacerbated by the frequency of market closures on Mondays that coincide with US holidays.

The cost issue is real. Managers could potentially be exposed to higher costs for as much as 72 hours. Some managers in the UK grew so concerned about this foreign exchange risk they moved trading staff to New York or set up specific Treasury teams to manage their US dollar needs late in the week.

Not all managers are big enough to do that. Another less costly solution? Good planning and good portfolio management aligned with an efficient middle and back office. Portfolio managers need to be sure their trading decisions are supported by a simple, efficient trade settlement and trade-related foreign exchange process with as much automation as possible.

This is especially true late in the working week in the major Asian markets, where there is little time overlap with the Big Apple. It is no less true in Europe and London. In the competitive fund management market, driving performance for investors is difficult enough. Anything that adds costs to make a fund less competitive against its peers needs avoiding. So clear focus of minds on T+1 is needed.