The Securities and Exchange Commission on February 9, 2022 proposed to: shorten the standard settlement cycle for most broker-dealer securities transactions from two business days following the trade date (T+2) to one business day following the trade date (T+1); and adopt amendments affecting how broker-dealers, investment advisers and certain clearing agencies process institutional trades¹. The proposed amendments are a response to changes in markets, technology, operations and infrastructure since T+2 settlement was implemented in 2017. The proposed amendments are intended to: reduce credit, market and liquidity risk (thereby reducing systemic risks); and encourage technological development (to further reduce settlement times in the future). If adopted, the proposed amendments would have a compliance date of March 31, 2024. Comments on the proposed changes are due on or before April 11, 2o22.

Background

In the 1990s, the SEC determined that significant counterparty risk was created by the then-prevailing T+5 settlement cycle, and reasoned that resiliency and efficiency in the clearance and settlement system for securities transactions could be enhanced by reducing settlement time. The SEC first acted to establish a mandatory settlement cycle by adopting Rule 15c6-1 under the Securities Exchange Act of 1934 in 1993; this rule shortened the settlement cycle to three business days after the trade date (T+3). In 2017, in response to changes in markets, technology, operations and infrastructure since the T+3 requirement was instituted, the SEC adopted amendments to Rule 15c6- 1(a) to shorten the standard settlement cycle for securities transactions by broker-dealers from T+3 to two business days following the trade date (T+2)². Citing the increased market volatility in March 2020 that resulted from the outbreak of COVID-19, and in January 2021 attributed to the GameStop and other “meme” stock spikes, the SEC stated that shortening the standard settlement cycle and improving institutional trade processing is intended to mitigate these vulnerabilities in the securities market.

Proposed Settlement Cycle Changes

The cornerstone of the proposed rulemaking would reduce Rule 15c6-1(a)’s current T+2 settlement cycle to T+1. As proposed, a broker-dealer would be prohibited from “effecting or entering into a contract for the purchase or sale of a security (other than an exempted security, a government security, a municipal security, commercial paper, bankers’ acceptances or commercial bills) that provides for payment of funds and delivery of securities later than the first business day after the date of the contract unless otherwise expressly agreed to by the parties at the time of the transaction.” As such, the proposed amendments would not expand the types of securities subject to T+1 settlement, nor would they eliminate or revise the “override provision” of paragraph (d) of Rule 15c6-1, which permits the parties to a transaction to agree contractually to an alternative settlement date in unusual circumstances. The SEC further proposed to eliminate paragraph (c) of Rule 15c6-1, which currently permits a T+4 settlement cycle for “firm commitment offerings” priced after 4:30 p.m. Paragraph (c) originally was adopted to help market participants manage prospectus delivery requirements, however, the SEC expressed the view that the “access equals delivery” standard for prospectuses makes this provision no longer necessary. In its proposing release, the SEC noted that market participants already have taken steps towards a T+1 standard settlement cycle through a variety of technological and operational advances, and that there already is significant industry support for T+1 across the market³. Observing that the 2017 move to a T+2 standard settlement cycle resulted in meaningful improvements in the functions of the securities market, the SEC expressed its expectation that a move to T+1 would produce similar results. The SEC did acknowledge that there would be technological and operational costs resulting from the settlement-cycle changes, but expressed the view that such costs would be outweighed by the expected benefits.

Proposed Same-Day Affirmations

To facilitate the shortened settlement cycle, the SEC also proposed new Exchange Act Rule 15c6-2. Exchange Act Rule 15c6-2 would prohibit a broker-dealer from effecting or entering into a contract with a customer for the purchase or sale of a security on the customer’s behalf, if the broker-dealer agreed to engage in an allocation, confirmation or affirmation process for the customer, but has not entered into a written agreement that requires the allocation, confirmation or affirmation to be completed as soon as technologically practicable (and no later than the end of the day on the trade date in order to complete settlement on T+1). The SEC did not include definitions of “allocation,” “confirmation” or “affirmation” in proposed Rule 15c6-2, but stated in the proposing release that that an “allocation” refers to “the process by which an institutional investor (often an investment adviser) allocates a large trade among various client accounts or determines how to apportion securities trades ordered contemporaneously on behalf of multiple funds or non-fund clients.” The SEC also noted that “confirmation” and “affirmation” refer to the “transmission of messages among broker-dealers, institutional investors, and custodian banks to confirm the terms of a trade executed for an institutional investor, a process necessary to ensure the accuracy of the trade being settled.” For the purposes of the proposed rule, the SEC stated that it would view as a “customer” any “person or agent of such person who opens a brokerage account at a broker-dealer to effect an institutional trade or purchases or sells a security for which the broker-dealer receives or will receive compensation.”⁴

As a rationale for the proposed new rule, the SEC explained that the implementation of a T+1 settlement cycle would require “significant improvement in the current rates of same-day affirmations to ensure timely settlement,” and noted that same-day affirmations accelerate the completion of the trade on the required date. Further, the SEC expressed the view that such affirmations would improve the “accuracy and efficiency of institutional trade processing” by resolving errors more quickly and reducing risks. The SEC noted that this new rule is targeted at broker-dealers, because they are the parties that the SEC views as in the best position to ensure such affirmations are completed. However, the new rule leaves certain requirements up in the air, including not defining “allocation,” “confirmation” and “affirmation."

Proposed Recordkeeping Rule Amendment for Investment Advisers

Related to the settlement-cycle changes, the SEC is proposing changes to the recordkeeping requirements of Rule 204-2 under the Investment Advisers Act of 1940. The proposed changes to Rule 204-2 would add a requirement in paragraph (a)(7)(iii) to require investment advisers that are parties to contracts under Exchange Act Rule 15c6-2 to create and maintain records of “confirmations received and allocations and affirmations sent” in relation to such contracts.

Specifically, the proposed changes to Rule 204-2 would require investment advisers to time-and-date stamp records of all allocations and affirmations as of the time, to the minute, that the allocations and affirmations are sent to a broker-dealer. The SEC noted in the proposing release that part of the motivation behind the proposed changes to Rule 204-2 stemmed from the SEC’s belief that investment advisers might not maintain such affirmation and allocation records. The SEC believes that the changes to Rule 204-2 would assist in the move to the T+1 settlement cycle.

Proposed Requirements for Certain Clearing Agencies

The SEC further proposed Exchange Act Rule 17Ad-27, a new rule applicable to clearing agencies that are central matching service providers (CMSPs). As proposed, a CMSP would be required to create, implement, maintain and enforce policies and procedures that “facilitate straight-through processing and describe in an annual report its current procedures, progress, and the steps it intends to take to facilitate straight-through processing of institutional trades.” The SEC remarked that the shortening of the settlement cycle could lead to a rise in the use of CMSPs, and explained its belief that proposed Rule 17Ad-27 would assist with the efficacy of trade processing.

The SEC intends to make CMSPs’ annual reports publicly available on EDGAR, to enable the public to review and analyze progress on achieving straight-through processing. The annual reports would need to be tagged for XBRL.

Conclusion

The proposed amendments are a long-awaited step forward in modernizing settlement cycles to reflect technological advances and address systemic risk.

Footnotes

1) Shortening the Securities Transaction Settlement Cycle, 87 Fed. Reg. 10436 (Feb. 9, 2022).

2) Release No. 34-80295 (Mar. 22, 2017), 82 Fed. Reg. 15564 (Mar. 29, 2017).

3) See Deloitte & Touche LLP, Depository Trust and Clearing Corporation, Investment Company Institute, & Securities Industry and Financial Markets Association, Accelerating the U.S. Securities Settlement Cycle to T+1

4) See Shortening the Securities Transaction Settlement Cycle, supra note 1 at 10454.