Features & Departments Thinking the Unthinkable: The Case for T + 1

Thinking the Unthinkable: The Case for T+1

September 11, 2001 made us rethink probabilities and the extent of impacts once thought of as unthinkable. With devastating clarity, September 11 highlights the need to plan for "worst-case" scenarios.

What effect did the September 11th events in the U. S. have on T+1?
Clear demonstration of the need for STP
Delay in the timing of T+1 by one year to June 2005


by Barbara Amsden

Risk is measured by analyzing probabilities and impacts. Where risk is unavoidable or accepted for business reasons, it is managed to an appropriate level by the application of policies, processes, controls and oversight. The residual risk is financed or transferred.

The market volatility of the past few years and the increase in securities transaction volumes over the past decade underscore the need to address counterparty settlement, market and operational risks. Two years before the September 2001 terrorist attacks on the U.S., concerns with such risks and the system's capacity to handle growing volumes led to proposals in Canada and the U.S. to reduce the securities settlement cycle from T+3 to T+1 by moving to straight-through processing (STP).

What are T+1 and STP and what are the exposures in the current T+3 environment? What financial and operational gains will flow from a shortened settlement cycle and what does this mean for the Canadian securities industry? For investors and for your firm?


Many confuse T+1 and STP. T+1 is shorthand for reducing the securities clearing and settlement cycle from the current standard of three days after trade date (T+3) to one day (T+1). STP occurs when securities transactions are processed electronically from seller through intermediaries through buyer, with no manual intervention. STP is possible--desirable, even--without T+1, but its true benefits arise only when it is adopted market-wide. T+1 is a rallying point for moving to STP across the industry to reduce risk, improve efficiency, lower costs and sustain market competitiveness.

In the wake of the October 1987 market crash, the Group of 30 (G-30), an international consultative body, questioned whether securities firms and investors affected by huge losses could cover their obligations. A key recommendation in the ensuing G-30 report was to shorten the settlement cycle. This led to the 1995 move in North America from settlement on the fifth day after trade date (T+5) to T+3. Canadian and U.S. G-30 Working Committees agreed that differing settlement conventions in the two countries would risk disruptions, distortions and a dislocation of business, likely increasing costs and risks for investors.1 The significant increases in securities volumes, values and market volatility that exist today are similar to the conditions that led to the G-30 recommendations and the implementation of T+3 (see Chart 1).


Annual Canadian Exchange Trading Volume and Value Growth, 1990-2000


A number of other trends exist today that have increased risk exposures in the market. For example, the consolidation of market participants and the institutionalization of investment activity can lead to an increase in risk. This is due to a decrease in participants in the settlement system and greater concentration of trading volumes and values among fewer principals.

Another factor is the globalization of investment management. Fifteen per cent of Toronto Stock Exchange (TSE) listings are now interlisted, accounting for 40 per cent of TSE trading value. The trend to global access and trading is attractive to issuers and investors, but less so to regulators as they see potentially greater exposures to the capital base of intermediaries, including those that may not be subject to their direct oversight. When clients buy securities in a market outside their home country, steps involved in a trade multiply, contractual obligations of market participants and laws governing ownership rights vary, and operational complexity is added by differences in time zones, practices and languages.

New entrants also increase risk. New participants may be good for competition, but they are not always as well-capitalized or able to withstand significant trading losses. Stretched systems and processes are also a risk. The current systems in use were designed to handle fewer transactions and the processes are often still paper-based and manual. U.S. experts predicted in 1999 that cross-border trades would triple by 2002, increasing risks and strains in the system. Even with the market slowdown, volumes are up significantly from the beginning of the decade.

The result of these trends is the increased likelihood that a transaction may not be completed or that one of the parties to a transaction may fail. For example, as cross-border transactions have increased, so too have transaction fail rates. The number of cross-border securities trades that fail to be completed may be as high as one in five and one international body estimates that over 40 per cent of securities operations time is spent dealing with such failed trades. These trends have several associated risks:

Settlement risk: The risk that settlement will not take place as expected, comprised of credit risk - the risk that a counterparty will not settle an obligation for full value (a combination of principal and replacement cost risk) and liquidity risk - the risk that an obligation will not settle when due.

Market risk: The risk of losses due to movements in market rates.

Operational risk: The risk that a breakdown in information systems, internal controls or human error may cause unexpected losses.

The convention of settling securities transactions over an extended period of time also exacerbates systemic risk - the risk that the failure of one institution will trigger failures of others, threatening the stability of financial markets. Systemic risk rises with increased volumes and volatility and is more concentrated as intermediary numbers fall.

In January 2001, the Bank for International Settlements (BIS) published a consultative report2 identifying risks in securities settlement systems and recommending ways to reduce or eliminate these exposures, including shortening the settlement cycle. As the report noted, the G-30 recognized that "to minimize counterparty risk and market exposure associated with securities transactions, same-day settlement is the final goal." In September 2001, the BIS issued its Working Paper on Regulatory Treatment of Operational Risk. This contains proposals for calculating the capital levels to be maintained against inherent operational risks in eight business lines, including payment and settlement, asset management, trading and sales, agency services and custody, and retail brokerage.


Aside from risk reduction, the benefits from the move to STP and from T+3 to T+1 will be seen in several areas:

The Canadian Capital Markets
In Canadian markets, an average of 135,000 equity, debt and money market trades are made daily. In the T+3 settlement cycle, the value of trades awaiting settlement at the end of each day ranges from $100 to $150 billion. Given the three days it takes to settle trades, the total dollar amount outstanding on any business day is three times this, a daily credit/settlement risk of $300 billion to nearly half a trillion dollars. Shortening the settlement cycle to T+1 will reduce the overall daily risk associated with unsettled trades by two-thirds. This will strengthen our financial markets and maintain Canada's competitiveness with the U.S. and globally, while keeping business and the related tax revenues in Canada. As well, the proposed BIS capital accord may lead to a reduction in regulatory capital requirements for firms that demonstrate lower operational risk.

Securities Market Firms
Increasing the automation of trade processing will reduce credit exposure and operational risks associated with securities trades, while improving productivity and liquidity. Cost savings from a shortened settlement cycle are derived from improved operational efficiency and retention of revenues. The original G-30 report assessed this risk of revenue loss as 10% of settlement and trading revenues, a percentage viewed as conser-vative as it excluded estimates of revenues from debt trades, custody, securities lending, deposit balances and cash management/foreign exchange.

T+1 and greater automation of the system will reduce risk, improve service and increase liquidity. The move to STP required for T+1 implementation will support round-the-clock trading demanded by a growing number of investors. Also, by improving settlement efficiency, we can expect to see lower risk and transaction costs that should translate into improved trade prices for investors.


The U.S. T+1 business case shows that the move will generate tremendous benefits for the American securities industry. The U.S. Securities Industry Association (SIA) claims that the increased efficiencies resulting from T+1 are expected to generate US$2.7 billion in pre-tax annual net benefits for a one-time investment of US$8 billion. Consequently, the U.S. remains committed to implementing T+1 despite and because of the events of September 11.

Although both the investment and benefits for the Canadian market are expected to be proportional to those in the U.S., the Canadian securities industry has not undertaken a comparable analysis. This is because Canada's very capital markets industry and the preservation (if not expansion) of its securities business are at stake. In an increasingly global market, Canada's processing systems must be in harmony to support cross-border securities activities.

The disadvantages of not moving to T+1 at the same time as the U.S. are that Canadian investors would almost certainly see higher settlement costs and higher risks than in the U.S.3 With North American securities markets so highly integrated, different settlement periods between Canada and the States could result in the movement of some trading activity south, given the natural convergence of transactions to the marketplace with narrower bid-ask spreads.





Fundamental systems and technology changes to allow automated matching to handle growing trade volumes
Seamless communication through agreement on interconnectivity, data messaging and other standards and best practices, including adoption of a mechanism to report adherence to, and enforce, standards
Changes to operational procedures and conventions
Electronic rather than physical securities holdings, handling and payments
Resolution of legal issues.

The costs associated with the change from T+5 to T+3 were mostly process- and education-related. In the move to T+1, a major cost to participants will be investment in new information and processing technology. Hard costs aside, a key challenge will be the cultural and organizational transformation that must accompany technology changes.


With such a broad scope to the changes required, the move to T+1 and STP will have a dramatic effect on all participants in the securities markets.

Custodians will benefit from lower costs due to reduction in time spent obtaining missing information, correcting errors and matching trade instructions. They may gain new business opportunities providing outsourcing services.

Brokers have already faced the reality of lower commissions and spreads falling while trade processing costs have remained flat and therefore require the long-run savings possible from STP.

They will also benefit by having more time available for "real" business as less time is spent dealing with errors, etc.

Investors and investment managers will have faster access and may save considerably on cash management. They may be able to rationalize their data architecture and receive securities data from fewer vendors. However, as with Y2K worldwide, decimalization in the U.S. and the move to the Euro in Europe to address identified risks, there may be large costs involved in moving to STP and T+1.

The SIA estimated a US$1.7 billion investment for the asset management industry in the United States. This is to be spent on modifying internal processes to ensure compliance with compressed settlement deadlines (US$790 million), sharing in the development of industry matching utilities and linkages for all asset classes (US$195 million) and standardizing reference data and industry protocols (US$675 million). Canadian investment managers will have to undertake their own assessment of the costs of the changes required, which include:

Upgrades to trade accounting to accelerate the matching of order fill details to trade orders and provide notification of errors in real time
Communication of trade details in real time to brokers and settlement agents
Implementation of real-time trade clearing and settlement systems
Communication more quickly and with additional detail on bulk trade allocations.

With the certainty of winners and losers, we will see increased measurement of the cost and source of problems. The good news is that already one investment manager, with information from its custodian, pinpointed changes to make, at virtually no cost, to significantly improve its STP rate: namely, devote some administrative time to counterparty codes and securities identifier cross-references.

This being said, the decisions investors and investment managers will face are standard ones: build, buy, outsource, exit. The cost of build-and-buy options may be high, depending on the state of a firm's current systems and business. Firms thinking that they do not have to worry because they will outsource should think again. As with Y2K, the question for those using service providers is 'will their service providers be ready?' and, for those not already using service providers, 'will there be service providers available?' as it is no easy task to outsource a back office. And exiting? Already some investment managers in the U.S. and, it is understood, in Canada will no longer deal with brokers that cannot provide their information electronically. U.S. research firm Tower Group estimates that 25 per cent of brokers will be out of business within 10 years due to STP and T+1. There may be similar consolidation of investment managers.

What should investment managers do to start preparing for STP and T+1?
Assess where you are - use the T+1 Readiness Checklist of the CCMA, (found at www.ccma-acmc.ca)
Inventory your status quo
Map your current workflow
Measure and cost your current performance
Determine if T+1/STP is strategic or tactical

In the securities industry, it is often said that "nothing good happens between trade and settlement." This is due, in part, to the complexity of the capital markets and variations on securities transactions. Beyond buy or sell transactions and variations on these, funding arrangements may need to be secured, foreign exchange contracts may have to be executed and, if securities are on loan, they may have to be recalled. For T+1, the same activities must occur within little more than 24 hours. The compression of processing will require adoption of advanced communications and technology, as well as operational and behavioural/cultural change. As we look at these changes, there are still a few questions:

Would settlement on T+1 have prevented any settlement problems in capital markets following the events of September 11?
T+1 would not have; STP would. Clearing and settlement in the U.S. were only minimally affected by the terrorist attacks. There were only a few certified trades, and some transactions where instuctions were unconfirmed by the counterparty by the intended settlement time, which failed to settle. The Federal Reserve's U.S.$38 billion cash injection, coupled with the extension of agency settlement hours of operation, are credited with easing the possibility of failed trades. Greater straight-through processing and replacement of certificates with electronic holdings necessary for getting to T+1, rather than T+1 per se, would have helped. For example, firms with affirmed September 10 trades (indicating use of STP) are credited with being better off than ones that had unaffirmed trades and investors without certificated securities were better off than those still holding paper. They now face the time and cost required to replace their holdings before they can sell in volatile markets.

If the benefits of T+1 are good, aren't the benefits of T+0 - settlement on the same day as the trade - better? Should T+0 be the goal?
Yes and no. Yes, T+0 is better. T+0 has been achieved in Canada for money market instruments and T+0 settlement could be achieved for marketable debt and soon, potentially, equities. No because the U.S. is moving to T+1 and has concluded that the move to T+0 is too radical a move at this time. For Canada to move to T+0 would add operational complexity at a time that the industry is already undergoing dramatic change. Firms are encouraged to design with T+0 in mind, so that such a change in the future can be easily accomplished.

The ultimate question is one that only individual organizations can answer:

Do the risks of remaining in a manual, paper-based environment now outweigh the risks of jumping into the future?
September 11 has caused every thinking participant in the securities industry to re-assess their disaster and business recovery plans and identify changes that will more fully bullet-proof their services. The outcome of this assessment should spur greater haste in moving to straight-through processing, even as there is a delay in moving to T+1.

In light of the U.S. decision to delay their T+1 target conversion date from June 2004 to June 2005, the CCMA agrees that Canada's target T+1 conversion date will similarly be delayed to June 2005. This means that by June 2004, Canada must be ready to begin industry-wide testing and testing with the U.S. The CCMA will press forward with other changes to promote industry-wide adoption of straight-through processing in all markets, where reasonable, as soon as possible. The terrorist attacks of September 11th emphasize the need for more extensive straight-through processing and the reduction of manual processing of trade information and physical movement of paper certificates, cheque payments and documentation. Plans in this regard are set out in three papers being issued for comment in November and December, 2001, with a comprehensive plan expected to be released in the first part of the New Year.4 The CCMA will continue to design and plan for T+1 implementation in concert with the U.S. to make sure that Canada remains globally competitive.

Thanks to Keith Martin, an independent consultant, for reviewing the drafts of this article and for providing input on the Bank for International Settlements' recommendations regarding risk management in securities settlement systems and proposals for a regulatory minimum capital requirement for operational risk. *

1 The Canadian G-30 has now been succeeded by the Canadian Capital Markets Association, a not-for-profit organization identifying, analyzing and recommending ways to meet the challenges and opportunities facing Canadian capital markets.

2 Recommendations for Securities Settlement Systems, Report of the Committee on Payment and Settlement Systems ("CPSS") and the Technical Committee of the International Organization of Securities Commissions ("IOSCO") Joint Task Force on Securities Settlement Systems, Bank for International Settlements, Basel, Switzerland, January 2001 (www.bis.org or www.iosco.org).

3 According to a November 2000 study commissioned by the Canadian Capital Markets Association (CCMA).

4 For more information and updates, see www.ccma.ca.


Arthur Andersen Consulting and The Capital Markets Company. T+1 Business Case: Final Report, July 2000, Securities Industry Association.

Basel Committee on Banking Supervision. Operational Risk - Supporting Document to the New Basel Capital Accord, Bank for International Settlements, Basel, Switzerland, January 2001.

Basel Committee on Banking Supervision. Working Paper on the Regulatory Treatment of Operational Risk, Bank for International Settlements, Basel, Switzerland, September 2001.

Canadian Capital Markets Association. Institutional Trade Processing T+1 White Paper, March 2001.

Charles River Associates. Free-riding, Under-investment and Competition: The Economic Case for Canada to Move to T+1, November 10, 2000.

Forrester Research Inc., "The Real Benefits of T+1," The Forrester Report, September 2001.

John Kennedy, "A Perspective On Changes To Canada's Securities Settlement System" (unpublished), October 7, 1999.

Report of the Committee on Payment and Settlement Systems ("CPSS") and the Technical Committee of the International Organization of Securities Commissions ("IOSCO") Joint Task Force on Securities Settlement Systems (www.bis.org or www.iosco.org). Recommendations for Securities Settlement Systems, Bank for International Settlements, Basel, Switzerland, January 2001.

Barbara Amsden is treasurer of the Canadian Capital Markets Association and assistant vice-president, Planning and Communications, at the Canadian Depository for Securities




Contex Group Inc.