The Securities and Exchange Commission (the “SEC”) adopted changes to Rule 15c6-1 under the Securities Exchange Act of 1934, as amended on February 15, 2023, to shorten the standard settlement cycle from T+2 to T+1. See 17 CFR Parts 232, 240, and 275 (February 15, 2023) (the “Final Rules”).

The new Final Rules that implement T+1 became effective on May 5, 2023, with a compliance date set for May 28, 2024 that is fast approaching. This development represents a significant step forward in reducing risk in clearance and settlement processes in the stock market.

When stock exchanges were first established, the standard settlement cycle was a lengthy 14 days, which allowed enough time for a horseback rider and ship to deliver a stock certificate before the trade was considered final. With technological advancements, settlement cycles began to shrink. The New York Stock Exchange, for instance, was able to reduce its settlement cycle to just one day after the trade date (“T+1”) in the 1920s.

Despite this progress, settlement cycles increased over time, reaching T+5 in 1968, before dropping back to T+3 in the 1990s. The SEC made a significant change in 2017 when it required the current T+2 timing, meaning that the time between the trade execution and the settlement date was reduced to just two days.

T+1 Standard Settlement Cycle

Amended Rule 15c6-1(a) prohibits broker-dealers from entering into contracts for the sale of a security (as defined in Section 3(a)(10) of the Exchange Act) (other than the exempted transactions discussed below) that provide for payment of funds and delivery of securities later than T+1, unless the parties expressly agree to a different settlement date at the time of the agreement to the transaction.

Exceptions to the T+1 Standard Settlement Cycle

Prior to Amended Rule 15c6-1(b), only transactions involving government bonds, municipal securities, banker’s acceptances, commercial paper, and certain limited partnership interests were exempted from the standard settlement cycle. Under the Final Rules, the SEC added an additional exemption for transactions involving security-based swaps. In the SEC’s view, the characteristics of security-based swaps, which include many terms that the parties agree to fulfil at later dates, are inconsistent with the purpose of the Final Rules to provide a “default” contract term for the timing of such obligations. Moreover, swaps are already subject to a comprehensive regulatory regime – the Dodd-Frank Act – that addresses the credit, market and liquidity risks that the Final Rules aim to address. Unlike other changes to the Final Rules, the exemption for transactions involving security-based swaps became effective on May 5, 2023, rather than the general compliance date.

In addition to the exempted transactions, the Final Rules also retained the so-called “override provision,” which provides some flexibility by permitting parties to a trade to agree to a settlement date other than T+1, provided that the parties expressly agree to such date at the time of the agreement for the transaction. This provision provides welcome and continued flexibility for many debt offerings and other offerings involving complex documentation that would cause T+1 settlement to be impractical.

Important Additional Changes

Firm Commitment Underwritings.

Prior to Amended Rule 15c6-1(c), a separate settlement cycle of T+4 was promulgated by the SEC in 1995 for firm commitment offerings, including initial public offerings, priced after 4:30 pm ET because such transactions could not settle on a T+3 basis in light of the extensive documentation associated with such offerings (i.e., prospectuses could not be printed prior to the trade date when pricing occurred).

During the rulemaking process, the SEC proposed moving to T+1 for these transactions, as well. However, it ultimately opted to reduce the settlement period for these transactions from T+4 to T+2 instead. The SEC acknowledged that it was persuaded by commenters on the proposed rule that a T+1 settlement cycle is not long enough for such transactions to settle on time when circumstances unforeseen at the time of pricing arise (e.g., issues relating to transfer agents, legend removal, local law matters, medallion guarantees or non-U.S. parties). This change accounts for the fact that delays in the process that previously made delivery of the prospectus challenging have been mitigated by the “access equals delivery” standard, but also, acknowledges that unanticipated issues with respect to such transactions could lead to a greater likelihood of failures to settle trades on a T+1 basis than in other transactions.

Same-day Affirmations.

Prior to amended Rule 15c6-2 (“Amended Rule 15c6-2”), “same-day affirmation” was solely an industry best practice. “Affirmation” refers to the verification of trade details between the broker-dealers, investors and custodial banks prior to settlement. Further, “trade allocation” refers to the process by which an investor allocates a large trade among client accounts or determines how to apportion securities trades ordered simultaneously on behalf of multiple clients. Allocation and affirmation processes can identify and resolve any potential errors that delay settlement. Yet, today only an estimated 68% of trades achieve affirmation on the trade date because market participants do not have substantial incentive to achieve same day affirmation.

Amended Rule 15c6-2 will improve same-day affirmation rates through incentivizing broker-dealers to promote a more thoughtful and orderly settlement process, which will ultimately facilitate shortening the standard settlement cycle. Specifically, Amended Rule 15c6-2(a) will require a broker-dealer to either establish, maintain and enforce reasonably designed written policies for transactions covered by Rule 15c6-1(a), or alternatively, enter into written agreements that ensure prompt completion of applicable allocation, confirmation or affirmation processes for such transactions. To comply with Rule 15c6-2, such agreements or policies must ensure that allocation, confirmation or affirmation processes be completed as soon as technologically practicable but in no case later than end of day on the trade date.

Additionally, Rule 15c6-2(b) sets out the specific elements of compliant policies for those broker-dealers who determine that adopting policies rather than written agreements best suit their existing business practices, client relationships and resource levels. For example, paragraphs (b)(1) and (b)(2) of the rule require policies and procedures that categorize the broker-dealer’s range of transactions and customers, estimate the length of time to complete each of the related allocations, confirmations and affirmations, and set target time frames related thereto. Paragraph (b)(3) requires that policies set forth the steps which broker-dealers will take to timely communicate trade information and investigate discrepancies. Under paragraph (b)(4), procedures must describe how the broker-dealer identifies and resolves delays by a third party. Finally, paragraph (b)(5) requires policies to be reasonably designed to monitor affirmation rates.

In addition, Financial Industry Regulatory Authority, Inc. (“FINRA”), incorporated changes addressing the transition to T+1 in the recently adopted amendments to its rules that pertain to or reference the standard securities settlement period in order to account for the planned move to the T+1 settlement cycle. See FINRA Adopts Amendments to Conform its Rules to the T+1 Settlement Cycle, Regulatory Notice 24-04 (Published: Feb 26 2024).

In its notice, FINRA stated that the amendments will become operative on May 28, 2024, which is the compliance date the SEC announced for Amended Rule 15c6-1 (“Settlement cycle”) and Amended Rule 15c6-2 (“Same-day allocation, confirmation, and affirmation”). These amendments impact a wide array of FINRA rules related to transaction reporting, trade processing and other operational aspects of securities trading.

Record-Keeping for Investment Advisers.

In connection with the changes to Rule 15c-1, Rule 204-2 under the Investment Advisers Act of 1940 generally sets out the requirements for the retention of books and records relating to all written communications received and sent by an investment adviser. Pursuant to amended Rule 204-2(a)(7)(iii), the SEC added a requirement for advisers to make and keep records specifically with respect to any transaction that is subject to the requirements of Rule 15c6-2(a) of each confirmation received, and any allocation and each affirmation sent or received, with date and time stamps for each. To comply with this rule, advisers will be required to keep originals of written confirmations received, and copies of all allocations and affirmations sent or received, but advisers may maintain records electronically subject to certain conditions. In the SEC’s view, such record retention will be important to the monitoring of the transition from T+2 to T+1 and assessing pain points in the settlement process, as well as improve affirmation rates and timeliness overall in the settlement process.

Clearing Houses to Facilitate Straight-Through Processing.

Clearing agencies, such as The Depository Trust & Clearing Corporation, electronically facilitate communications between broker-dealers, investors or investment advisers, and the investor’s custodian to reach agreement upon the details of a securities trade, enabling the trade allocation, confirmation, affirmation or the “matching” of trades (such central matching service providers, individually “CMSP”, and collectively, “CMSPs”). After the trade details have been matched by the CMSP, it can complete settlement of the transaction. In the SEC’s view, CMSPs have become critical to the functioning of the securities market because of the increasing volume of transactions for which CMSPs provide matching and other services. Hence, the SEC sought to better position CMSPs to provide services that reduce risks and costs associated with the settlement process in order to promote an orderly transition to T+1.

Accordingly, the Final Rules also adopt new Rule 17Ad-27(a) under the Exchange Act to require CMSPs to establish and implement written policies and procedures reasonably designed to facilitate settlement through automated straight-through processing (“STP”). In the context of institutional trade processing under this rule, STP occurs when a market participate uses the CMSP to enter trade details and complete the trade allocation, confirmation, affirmation and/or matching processes automatically without human intervention. In the SEC’s view, the use of manual processing introduces errors that delay settlement and may result in a failure to settle the transaction. Thus, this rule will encourage clearing agencies to move away from manual input of trade details and use technological advances to reduce errors in the settlement process.

Additionally, Rule 17Ad-27(b) will require such CMSPs to submit to the SEC via EDGAR an annual report regarding STP implementation describing current policies related to and progress in facilitating STP and the steps the CMSP plans to take to further promote STP during the upcoming year. The reporting requirement will help the SEC assess the progress made by CMSPs to further the use of STP and evaluate the need for additional regulation, as well as enable the public to better understand the operations of CMSPs. CMSPs will be required to file their first annual report with the SEC no later than March 1, 2025.

The Rationale Behind the Rule Changes

The Final Rules were designed to benefit investors by increasing efficiency and reducing the credit, market, and liquidity risks in securities transactions, such as a potential drop in price of a purchased security between trade execution and settlement. Recent episodes of high volatility and stressed market conditions, such as those seen during the COVID-19 pandemic and the “meme stock craze” of 2021 (e.g., GameStop), highlighted the risks that exist between trade execution and settlement, as well as raised concerns about the methods used to manage those risks. In the SEC’s view, shortening the standard settlement cycle could help mitigate some of these risks.

In particular, the shortened settlement cycle will lower each of the number, trading volume and total value of unsettled trades, which is expected to reduce the time of exposure to credit and market risks that arise from securities trades. Reducing the time span between the trade and settlement will also diminish the likelihood of a major unforeseen event disrupting the settlement process (such as force majeure events like war or pandemic, or unexpected accidents like the proverbial “CEO gets hit by a bus”). The SEC also anticipates shorter settlement cycles will promote coordinated and expeditious transitions by securities clearing agencies and other market participants, and enable investors to enjoy faster access to their funds or securities, as well as lower margin requirements.

Shortening the settlement cycle will reduce the cost of risk management, which, in turn, may flow through to investors. For example, investors may be less at risk of internalizing the cost of failures in the settlement process through higher transaction fees charged by broker-dealers. These savings may then allow investors to take advantage of more investment opportunities than they could in T+2 settlement.

SEC Commissioner Jaime Lizárraga supported the adoption of new rules, opining that it “helps mitigate some of the risks that drove stock price volatility and significant margin calls.” SEC Chair Gary Gensler also supported the rule amendments, stating: “Cosmo might say this adoption will take our plumbing from bronze to copper. I say that, taken together, these amendments will make our market plumbing more resilient, timely, orderly, and efficient.”

Key Impacts Across the Trade Process

The move to a T+1 settlement cycle will have significant implications for the industry, including financial markets and services. Broker-dealers, clearing agencies and investors will all need to adjust their current operational practices and technology and update any obsolete or outdated processes to prepare for shorter timelines.

What’s Next?

After the bold move to a T+1 settlement cycle, the next advancement would be a transition to real-time settlement. During the rulemaking process, comment letters supporting the SEC’s proposal to shorten the settlement cycle to T+1 already expressed support for further shortening the settlement cycle to “T+0” or simultaneous settlement. By contrast, certain commenters expressed concern that T+0 is either not achievable or not practical in the near future, arguing that such a change would “require a ‘rewrite’ of not only the current clearing and settlement infrastructure, but also the associated banking, securities custodian and money market systems that are critical components of the clearing and settlement ecosystem.” While the SEC is assessing the feasibility of a move to T+0, the SEC believes that overcoming the wide ranging infrastructure and procedural challenges that a successful move to T+0 requires would take longer to design and implement than a successful move to T+1. For now, the shift to T+1 may be a useful step on a potential pathway to T+0.

In the short-term, pressure is mounting on markets in Europe and Asia to follow suit with respect to T+1. One operational challenge that may follow a move to T+1 in the United States relates to the misalignment of securities settlement cycles, such as increased costs and complex logistics related to U.S. transactions that settle on T+1 from proceeds of foreign exchange transactions that settle on T+2. The SEC is working with international regulators through its participation with the Financial Stability Board and the International Organization of Securities Commissions to minimize any adverse impact of the settlement cycle transition, and, if possible, to coordinate a move to T+1 on a global basis. Canada has already announced that it will adopt the T+1 settlement cycle to align with the U.S., making it clear that the world is moving towards faster and more efficient securities trading.

Upcoming Compliance Date: The T+1 Settlement Cycle