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Accelerated Settlement Cycle Enforced by SEC

The Securities and Exchange Commission (SEC) made an impactful regulatory change on February 15, 2023, trimming down the standard settlement cycle to one business day (T+1) from the previous two business days (T+2). This move is intended to curtail credit, market, and liquidity risks tied to securities transactions. This isn't the first time SEC has shortened the standard cycle; back in 2017, they moved from a T+3 to a T+2 cycle. The move towards T+1 had been hinted at through various speeches and regulatory agenda updates.

Moreover, the newly instated regulations have also reduced the standard settlement cycle for firm commitment offerings, if they're priced post 4:30 p.m., from four business days (T+4) to two (T+2). However, it should be noted that the new rules do allow issuers and underwriters to agree on an alternate settlement date to accommodate the complex processes of document closing and processing between the pricing and closing stages of deals.

These rules aim to enhance the processing of institutional trades. Broker-dealers must now either formalize written agreements or establish and adhere to written policies and procedures, aiming to guarantee the swift completion of allocations, confirmations, and affirmations as soon as feasible and no later than the end of the trade date. These rules also mandate registered investment advisers to maintain records of the allocations, confirmations, and affirmations for specific securities transactions. Additionally, the new regulations impose a requirement aimed at facilitating straight-through processing, applying to certain kinds of clearing agencies that offer central matching services.

The effective date for these regulations is May 28, 2024, the first working day following the Memorial Day weekend.

Every securities trade encapsulates a legally binding contract. The act of "clearing" these trades involves the realization of the contractual terms, ensuring accurate processing to the rightful buyer and seller, in the correct amounts, at the right price and date. This process is carried out electronically.

"Settlement" pertains to fulfilling the contract through the exchange of funds and delivery of securities. The Exchange Act Rule 15c6-1, established in 1993, necessitated that settlement occur three business days after the trade date (T+3). Deliveries are made electronically through adjusting book entries concerning entitlement. One brokerage account gets debited, another credited at the Depository Trust Company (DTC) level, with corresponding entries made at every brokerage firm involved in the transaction.

Brokerage firms can act as "clearing brokers" if they are direct members with DTC. Many brokerage firms enter agreements with these DTC members (clearing brokers) to clear the securities on their behalf and are known as "introducing brokers". Technology plays a significant role in this process and facilitates the efficient management of settlements.

Under the Dodd-Frank Act, "financial market utility" or FMU was defined, and associated responsibilities were clarified. Clearing brokers are FMUs and manage the actual functions related to clearing trades through the DTC system. The National Securities Clearing Corporation (NSCC), a DTC division, takes the role of buyer and seller for each contract, settling all brokerage transactions daily with a single adjusting entry.

The rules adopted by the SEC have thus shortened this cycle to one business day. They have also shortened the settlement cycle for firm commitment offerings for securities that are priced after 4:30 p.m. ET to T+2.

Moreover, the SEC has added Rule 15c6-2 that requires brokers or dealers to have entered into a written agreement with relevant parties to ensure allocation, confirmation, affirmation, or any combination thereof, be completed as soon as practically possible and no later than the end of the trade date to comply with Rule 15c6-1(a).

Compliance with this requirement can be achieved by formulating, maintaining, and enforcing written policies and procedures which are suitably designed to complete the allocation, confirmation, affirmation, or any combination thereof, for the transaction as quickly as possible and no later than the end of the trade date. These policies and procedures should ideally include clear descriptions of any technology systems, operational processes, and target timelines for completing the aforementioned steps.

The SEC has also implemented new Rule 17Ad-27 to establish additional requirements for certain clearing agencies acting as central matching service providers (CMSPs). Under this new rule, a clearing agency providing central matching services for transactions involving broker-dealers and their customers (i.e., CMSPs) must set up, implement, maintain and enforce policies and procedures that facilitate Straight Through Processing (STP) for transactions involving broker-dealers and their customers, and they are required to submit certain reports to the SEC every twelve months.

These reports must describe the CMSP’s current policies and procedures for facilitating straight-through processing, the CMSP’s progress in facilitating straight-through processing during the preceding twelve-month period, and the steps the CMSP intends to take to facilitate and promote STP during the following twelve-month period.

In summary, the SEC's recent move to a T+1 settlement cycle, among other changes, is a significant step forward in reducing the credit, market, and liquidity risks associated with securities transactions. As technology continues to advance, it is clear that the SEC is committed to making the securities trading and settlement processes as efficient and risk-averse as possible. These changes are bound to have a substantial impact on the landscape of securities trading, and it will be interesting to see how the market adapts to these new norms.