The calculus for shortening the settlement cycle in Middle East capital markets
Back in 2015, the United States Securities and Exchange Commission posed this question in a post on the benefits of shortening the settlement cycle of securities: "Why is it, some have asked, that trades can now be executed in less than a millisecond, yet it still takes three full days for those trades to settle?"
The post went on to praise the industry for working towards a two-day settlement cycle. We have come a long way since then with approximately 40% of the global volume of securities now settling on a T+1 cycle. In the Middle East, a panel at an event organised by the Arab Federation of Capital Markets briefly broached the topic only to signal that there were no imminent plans to make that switch just yet.
However, with the region witnessing an influx of foreign capital, this would be an appropriate moment to take a closer look at whether markets in the Middle East should transition to a shorter settlement cycle.
Current state of play
To better appreciate the relevance of this issue to the Middle East now and the challenges involved, it’d be helpful to understand the known impacts of recent settlement cycle changes on cross-border post-trade activities.
In January 2023, India mandated T+1 settlement for equities, becoming the first country in the world to do so. Following the transition to T+1, the Securities and Exchange Board of India (SEBI), the country's market regulator, recently also addressed investors’ issues around expeditiously moving their funds out of the country by facilitating same-day repatriation through quicker tax certificate issuances by tax consultants. Now, SEBI is beginning to phase in a T+0 cycle by the end of 2024 as it seeks to introduce instant settlements thereafter.
China provides T+0 settlement for A shares while most other emerging markets in Asia continue to operate on the T+2 system for now. Canada, Mexico, Jamaica and Peru transitioned to T+1 settlement in May 2024 while the UK and EU have announced plans to switch to T+1 in 2027 and Australia is exploring implementing it in 2030.
The US also moved to a T+1 settlement system in May 2024 and given that 20% of investments in the US originate from other countries, a significant proportion of foreign investors globally face a number of issues related to operating across disparate time zones and mismatched settlement cycles.
Key risks and challenges
Understandably, regulators, investors and intermediaries around the world are paying close attention to the challenges, inefficiencies, and risks that operating across mismatched time zones can bring. These include:
In today’s globalised financial markets, among the most obvious challenges posed to the transition is the time difference between various markets. For example, Dubai and New York City are eight to nine hours apart (depending on the time of the year), and trading and settlement practices between these centres will need to be adjusted to manage that time difference now that the settlement cycle in New York has been reduced significantly.
Foreign investors with exposure to securities in other countries will need to align their liquidity management practices to the settlement cycles of those markets.
This is a major hurdle because the FX market is the largest financial market in the world and is operated by a different industry segment, with its own trading and settlement conventions and market infrastructure that processes the vast majority of FX transactions. There is no corresponding initiative by the global FX market to shift spot market settlements to T+1, which presents significant obstacles to international investors, causing them to significantly overhaul their approach to funding their cross-border securities transactions, and may cause their transaction costs to rise significantly.
Standard Chartered’s first-hand experience of settlement acceleration – as a custodian in India – informs us that cross-border activity that requires FX transactions to fund local securities settlement presents the most intricate challenges. We have addressed them by supporting our clients’ continued ability to invest in a T+1 market through special FX arrangements, including overnight FX desk availability and standing instructions to sweep funds to settlement accounts. However, such services require significant investments in people and system changes, respectively.
ISSA estimates that a migration to T+1 reduces the available post-trade processing time by approximately 83%, with settlements teams having only two core business hours between the end of the trading window and the start of the settlement window, compared to 12 core business hours in a T+2 environment. This will impact the timely exchange of information between regions, especially in connection with open transactions. There will be less time to get executed trades allocated, confirmed, affirmed, and instructed to custodians; address exceptions by settlement close; for stock loan returns; and any other corporate actions.
Other challenges include addressing issues such as netting efficiency, cross border settlements and fails management. Furthermore, these issues will impact all global products with components from markets moving to T+1, such as ETFs and depositary receipts.
Is settlement acceleration really necessary?
This is a pertinent question for any market looking to shorten settlement cycles. It is especially so for the Middle East, where certain markets – like Saudi Arabia between 2000 and 2017 – used to operate on a T+0 basis before shifting to longer settlement cycles to align with global standards, comply with eligibility requirements mandated by global market indices and attract international investment.
It’s no surprise then that capital market leaders and policy makers in the region are adopting a measured approach to the matter. In the US, the sense of urgency behind the move to T+1 really stemmed from tremendous market volatility sustained over several years and the need to mitigate market and counterparty risk, reduce margin requirements and free up capital for clearing house members. The case for taking urgent measures to address these issues in the Middle East are not as compelling.
We live in a world where settlement cycles are misaligned and market participants have found ways to handle this disparity. With that in mind, we must ask how much dislocation risk will be involved between T+1 markets and T+3 markets in the event of a transition. We must also assess the extent of problems we will face on multiple fronts like the risks we have already outlined.
Additionally, it is crucial to evaluate the experience of Middle East investors – given their history with this transition – to determine if there is a strong enough justification for the region’s markets to switch yet again to support domestic outbound portfolio investment flows. Indeed, stakeholders across the Middle East would be well-advised to carefully examine these issues before they decide to pull the trigger.
The bottom line, in our view, is that if the burden of margin requirements and excessive market volatility are deemed not urgent or significant enough concerns for markets in the Middle East, then it must be concluded that the challenges, complexities and risks of settlement acceleration are likely to exceed the benefits the transition will bring.
