Transition to the T+2 Settlement Cycle

Rule 15c6-1(a) – From T+3 to T+2

In March 2017, the Securities and Exchange Commission (SEC) amended Rule 15c6-1(a), shortening the settlement cycle from T+3 to T+2. The “T” in “T+2” and “T+3” stands for transaction date, the date that a transaction occurs. T+ (1, 2 or 3) represents the settlement date, the date that ownership of the stock is transferred. Thus, with this rule change, companies now have two days to settle stock transactions rather than three. Specifically, the rule states: broker-dealers cannot enter “into a contract for the purchase or sale of a security (other than certain exempted securities) that provides for payment of funds and delivery of securities later than the second business day after the date of the contract, unless otherwise expressly agreed to by the parties at the time of the transaction” (emphasis added). Rule 15c6-1(a) went into effect on May 30, 2017.

Rule 15c6-1(a)’s Effect on Market Participants

Investors, Broker-Dealers, and Custodians

Both institutional and retail investors will be affected by the proposed shortened settlement time. According to the official rule, “Institutional investors are entities such as mutual funds, pension funds, hedge funds, bank trust departments, and insurance companies.” Further, transactions associated with these investors are complex and may require more time to complete due to their size and a need to maintain compliance with specific financial policies. Retail investors, on the other hand, conduct smaller transactions and most do not require help from additional entities to assist in the trading process.

According to Investopedia, “a broker-dealer is a person or firm in the business of buying and selling securities, operating as both a broker and a dealer, depending on the transaction.” With the change from T+3 to T+2, broker-dealers will now have less time to settle their transactions with registered clearing agencies. To clear their transactions, the broker-dealer must first become a member of the associated clearing agency and further comply with their rules and regulations. The rule states, “Broker-dealers executing trades otherwise than on an exchange (e.g., on an internalized basis) may clear and settle such trades through a clearing agency, may choose to settle those trades through mechanisms internal to that broker-dealer, or may settle such trades bilaterally. Broker-dealers that effect transactions in municipal and corporate debt securities generally are required to clear and settle those transactions through a registered clearing agency” (19). Thus, many transactions require broker-dealers to join clearing agencies, while some can be handled without the help of outside agencies.

The rule describes custodians as those that “handle the electronic payment or receipt of payment through the Federal Reserve’s Bank’s Fedwire system, which automates and streamlines the process by which broker-dealers make payments for securities transactions.” Custodians will benefit broker-dealers, who are now faced with a shorter settlement time on their transactions, much more. Specifically, DTC participants must have a custodian to “facilitate payment of their transactions cleared and settled through the NSCC and DTC,” according to the rule. In addition, “since many broker-dealers use the same custodial bank to settle their trades, NSCC and DTC can net the total amount being handled by any one custodian for all DTC participants using that bank,” making the transaction process more smooth and efficient. To read more about the NSCC’s goals, view page 12 of this link.

Financial Market Utilities (FMUs)

Two FMUs, the National Securities Clearing Corporation (NSCC) and the Depository Trust Company (DTC), provide CCP and CSD services, which are detailed below. According to Investopedia, “A central counterparty clearing house (CCP) is a corporate entity that reduces counterparty, operational, settlement, market, legal and default risk for traders…[becoming] the counterparty to the buyer and the seller and [guaranteeing] the terms of a trade.” The rule states that in the US, the NSCC “is the only CCP for trades involving securities that currently settle on a T+3 standard settlement cycle.” With the move to T+2, broker-dealers now have more flexibility when choosing CCPs. The rule describes that CSDs, on the other hand, are “[entities] that [hold] securities for [their] participants either in certificated or uncertificated (dematerialized) form so that ownership can be easily transferred through a book entry (rather than the transfer of physical certificates.” The DTC handles all CSD transactions, providing a streamlined, technologically advanced system that facilitates book entry processing of securities certificates. The continually improving DTC services help clients comply with the new, shorter T+2 requirement.

Potentially Necessary Changes for Broker-Dealers Following the Amendment

The rule explains that some broker-dealers may need to make changes to their business operations and manage additional expenses. Those that choose to finance the purchase of customer securities until they receive payment from their customers may have to pay more money due to the shorter settlement time (T+2). Read more on page 142-143 of the official rule, linked here.

Small Entities

Throughout this rule, the SEC uses the term “small entity” to mean “a broker or dealer: (1) with total capital (net worth plus subordinated liabilities) of less than $500,000 on the date in the prior fiscal year as of which its audited financial statements were prepared… [or] on the last business day of the preceding fiscal year…and (2) is not affiliated with any person…that is not a small business or small organization.” Small entities are subject to the same change as other entities, from T+3 to T+2. The SEC estimates that there are 1,235 broker-dealers that are potentially classified as small entities. One challenge for the SEC was amending the rule such that the settlement time could work for all types of entities. They caution against differing settlement cycles because this could create a “two-tiered market that could work to the detriment of small entities,” according to the rule. With a standard settlement cycle, the securities market can function more smoothly. To help minimize the effect this rule has on small businesses, this amendment grants broker-dealers flexibility over the transaction processes; they can meet the rule requirements in numerous ways.

Amendment Benefits – Risk Reduction, Cross-Border Harmonization, and Technological Advancement

The SEC outlines risks that the CCP faces, which are mitigated by the amendments to Rule 15c6-1(a). The primary risk that the CCP faces occurs if a member defaults on a payment. This can cause the CCP to have to liquidate that member’s assets to cover additional expenses, or, if a buyer defaults, to pay for more expensive securities. The SEC cites an example: “if the market value of the unsettled securities has increased after the trade date, in the case of a seller default, the CCP may be forced to obtain the replacement securities in the market at a higher price.” By shortening the settlement cycle, the CCP is “less exposed” to these risks according to the SEC, and can initiate and settle transactions with less net loss than in a T+3 environment. The amendment emphasizes that shortening the settlement cycle to T+2 results in fewer unsettled trades, which can translate into less financial expenses for CCP members. To read comments regarding risk and the CCP, view page 26 and 27 of the rule.

Other markets also benefit from the transition to T+2; they gain, according to the rule, “quicker access to funds and securities following trade execution…reduced margin changes and other fees that clearing broker-dealers may pass down to other market participants.” These benefits would in turn give market participants more financial resources to use in the market.

Cross-Border Harmonization refers to creating a standard settlement cycle that is globally consistent. A consistent market provides numerous benefits, outlined within this rule. Some comments described that cross-border harmonization would “increase efficiency in coordinating trading among investors across international markets…[and decrease] operational risk because investment managers would not need to balance inconsistent settlement cycles across broad asset classes common to both U.S. and international markets.” Other comments noted that market participants would not have to worry about juggling different settlement deadlines for securities when conducting international and local transactions. Learn more about cross-border harmonization and its benefits on page 38 of the rule.

The last reduced risk the SEC mentions is systemic risk. They describe that the accumulation of reduced external risks (some are detailed above) may result in a collectively reduced risk for the financial market itself. The SEC states that a shortened settlement time will help protect the market from adverse changes and improve the CCP’s ability to clear and settle transactions.

In a dynamic (and continually improving) technological landscape, the transition from T+3 to T+2 was appropriate, said the SEC. They, and many commenters, said the reduced risk and ability to transition to T+2 is directly tied to improved “technology, market infrastructure and operations.” Commenters said that technology would, among other benefits, lead to more automation in transaction processes and, overall, improve the efficiency of operations.

Three Paragraphs of Rule 15c6-1(a)

Three portions of Rule 15c6-1(a) (b, c, and d) remain unchanged despite other amendments to the rule. An overview of these unchanged paragraphs is below, provided by the SEC.

“Rule 15c6-1(d) provides that, for purposes of paragraphs (a) and (c) of the rule, parties to a contract shall be deemed to have expressly agreed to an alternate date for payment of funds and delivery of securities at the time of the transaction for a contract for the sale for cash of securities pursuant to a firm commitment offering if the managing underwriter and the issuer have agreed to such date for all securities sold pursuant to such offering and the parties to the contract have not expressly agreed to another date for payment of funds and delivery of securities at the time of the transaction.”

Conversely, some commenters debated with the SEC concerning the future of the override provision of Rule 15c6-1(a). The SEC wanted to maintain T+2 standard settlement time, but also wanted to provide broker-dealers with flexibility in case of unforeseen circumstances, and give them a chance to extend their settlement date. They believed that the provision should only be used in unusual circumstances; however, some commenters argued that this is not appropriate. Refer to pages 48 and 49 of the rule to view more details of the discussion.

Changes to Other Rules

Certain rules have changed as a result of the amendment to Rule 15c6-1(a). Below is a brief summary of how some of these rules have changed. These rules include: Regulation SHO, financial responsibility rules under the Exchange Act, Exchange Act Rule 10b-10, prime-broker no-action letters, and prospectus delivery. These changes are too extensive to describe for the purpose of this article; view section 3C of the rule to read more about the specifics.

Two Active Exemptions

With the transition from T+3 to T+2, the SEC asked those who commented to give their opinions on whether they should maintain two currently active exemptions, designed to exempt from T+3 settlement cycles. The first exemption was created in 1995, which “[granted] a limited exemption for securities that do not generally trade in the U.S. by providing that all transactions in securities that do not have transfer or delivery facilities in the U.S. are exempt from the scope of Rule 15c6-1.” This policy is remaining unchanged following the transition to T+2. The second exemption concerns registered insurance products, which the SEC also decided to retain.

Potential Alternatives

The SEC considered a couple of alternatives to the T+2 transition: a shift to a T+1 standard settlement cycle and a straight-through processing requirement. The SEC described that T+1 and T+0 “would require market participants to incur comparatively larger investments and would necessitate more lead time and greater coordination.” However, they do believe that, if investors were prepared to accept these burdens and move to either T+1 or T+0, it could reduce liquidity, credit, and other types of risks more than the current T+2 settlement cycle.  The number of unsettled trades, and thus financial losses, would also be reduced. The SEC determined that given the current state of financial markets and technological advancements, T+2 was the best solution. They also considered mandating straight through processing (STP), which involves the electronic processing of transactions during the settlement process; this is more efficient and faster than manual entry. Despite these benefits, the SEC said that “such an approach may not reduce counterparty exposures and attendant risks.” They primarily support T+2 settlement cycles due to their tendency to reduce numerous financial risks for market participants and increase the efficiency and sustainability of clearing corporations.


Rule 15c6-1(a)

Eric Mellmer
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