Unravelling the Gordian Knot: Tackling the FX T+1 Funding Conundrum

Introduction

The Securities industry is transitioning to T+1 settlement in the US, Canadian and Mexican markets starting in May 2024; the shorter settlement cycle has wide-ranging impacts across the trade lifecycle. The industry continues to discuss many topics, such as technology, Financial Market infrastructure, and the settlement process. At a recent buy-side conference in London (c.1000 attendees), nearly 2/3 of participants in a panel poll declared themselves as having made good or advanced progress on their readiness journey; in isolation, this is a welcome soundbite, although, as I discovered in conversations during the conference, there isn’t a lot of work taking place on the funding-related challenges. This overview will delve into the most pressing operational impacts of the T+1 transition and how the industry is responding. Hopefully, it will provide insight for firms seeking to evaluate their state of readiness.

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Operational Impacts

The transition to T+1 settlement will have significant operational impacts with increased pressure to allocate, affirm and confirm within much tighter timelines on processes that are not currently 100% efficient. Firms must closely examine their post-trade processes, including trade booking, Foreign Exchange (FX) workflows, funding mechanics, liquidity, intraday, and EOD risk management.?With shorter settlement times, any delays or breaks in the trade booking chain will be magnified and more likely to cause settlement failures; identifying areas that need streamlining or automation to avoid timing mismatches between global regions and entities will also need to be resolved. Testing the booking processes end-to-end will be critical.

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At a high level, the key changes needed internally will be earlier cutoffs for FX and funding processes, increased coordination and transparency between teams, and upgrades to automation and digital tools. Workflows must be mapped out and optimised from start to finish across a trade lifecycle. A detailed understanding of all trade dependencies and timings will enable firms to model different T+1 scenarios and implement required operational changes. There is no one-size-fits-all solution, so firms must assess their unique processes, systems, and workflows to determine the impacts. In addressing operational readiness, firms will likely need to improve coordination between trading, funding, and operations to avoid aggravating risk under T+1.

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Best Execution

Under MiFID regulations, best execution is taking all reasonable steps to obtain the best possible result for clients when executing orders, which applies across all asset classes. With the move to T+1, achieving the best execution in FX becomes more challenging. Investment managers must consider how to equalise execution across different FX providers and custodians. Relying on a single provider or custodian for all FX may be operationally simpler but does not guarantee best price or execution. Factors like speed, likelihood of execution, and transaction costs must be weighed alongside price. Using established benchmark fixings can provide fiduciary assurance but may not always capture available liquidity or optimise transaction costs. As is always required, having transparency into FX execution quality will be vital; with condensed settlement times, managers have less margin for error and must demonstrate thoroughness in seeking the best results for clients. MiFID principles remain essential guideposts when adapting FX trading to the operational realities of T+1.

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Trade Processing

The transition to T+1 settlement will require significant changes to trade processing workflows. Meeting tighter cutoffs for affirmations while allowing time for necessary internal reviews will be a considerable challenge. Workflows must be tightly mapped and dependencies clearly understood to avoid breaking the chain. Key considerations around trade processing include:

?- Tighter cutoffs for trade affirmations - Trades need affirmation within a specific window after the 4pm NY close to meet deadlines.

- Mapping workflow dependencies - All downstream dependencies from trade execution need to be clearly mapped. Any lags in approvals or confirmations can break the chain and cause failure.

- Identifying workflow bottlenecks - Workflows will need to be stress tested to identify bottlenecks, whether internal reviews or external affirmations; the weakest link can hinder the entire trade settlement.

- Technology changes - Heavy reliance on manual processes will no longer be feasible. Automating affirmations, notifications, and mapping will help avoid failure.

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Liquidity Challenges

As the world rotates and geographic cut-offs kick in from East to West as markets close, could these present challenges for the timing of FX execution? With Liquidity tending to be lower at the end of the US trading day before Asian markets open, could we see a deterioration in FX pricing if trading volumes spiked? The concept of pre-funding has been around for some time and may be necessary to access liquidity before the execution of specific trades; it may be that this becomes a more standardised process so that firms can guarantee the required FX liquidity that they need, especially for trades settling across geographic regions, e.g. USD/JPY. Liquidity is a function of demand, and as that increases, we should see pricing improve as banks can offset the risk.?Assessing your liquidity needs during peak volume times and planning to manage requirements in advance because of the tighter settlement windows will be vital, as will the utilisation of external mechanisms or products to help Trading and Treasury increase automation and manage cash and costs.

?One operational consideration for liquidity management under T+1 settlement is managing trades during local market holidays. When a local market is closed for a holiday, additional steps will likely need to be taken to ensure timely settlement for trades in those markets. For trades involving a security in a market closed for a holiday, pre-funding may be required to cover the FX component ahead of the equity trade. This means obtaining the currency before the holiday starts, often requiring trades to be executed and funded in advance.?Holidays create liquidity challenges, as closed markets limit currency availability. Trading desks will need procedures to access liquidity from alternative sources ahead of local holidays, which may mean establishing credit lines and trading relationships in new regions (not an easy ask). Building visibility into which days various currencies may face illiquidity will allow trades to be planned accordingly. Understanding dependency chains across markets will be critical to avoid settlement failures.

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Custodial Arrangements

Custodians play a critical role in the post-trade process by settling securities transactions and handling collateral movements; however, batch processing models and cutoffs were designed around T+2 or T+3 settlement cycles. Custodians are making significant operational changes to avoid creating bottlenecks for overall T+1 readiness. Custodians also face the challenge of handling transactions across time zones and regions with different settlement conventions. For example, APAC markets settling in T+2 or T+3 may struggle to meet earlier cutoffs required for T+1 settlement in the US.? The interdependency between global custodians, global/local agent banks, and client processing creates additional complexity. Custodians will likely need to engage far in advance with client firms on cutoff changes and test existing arrangements under "fire drill" scenarios. Critical considerations for custodial arrangements under T+1 include:

?- Earlier trade and instruction cutoffs, likely moving from late afternoon to noon or early afternoon.

- Ability to make multiple collateral sweeps daily rather than just one end-of-day sweep.

- Managing earlier cutoffs across time zones, especially from APAC into the US market.

- Understanding whether delays at any point in the custody chain can create bottlenecks that impact the overall settlement timeline.

- Using automation, AI, and machine learning to handle increased transaction flows under tighter deadlines.

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Testing Readiness

With the industry-wide move to T+1 settlement, testing operational readiness is crucial. Both internal testing and testing with external counterparties and vendors should be undertaken. Internally, conducting internal systems and processes testing, and mapping out end-to-end trade flows to identify bottlenecks or inefficiencies. Stress testing at higher-than-normal trade volumes and on shortened settlement timeframes. Assessing connectivity across internal teams and systems, ensuring seamless handoffs while running simulations to identify potential failure points. Externally, connectivity and integration testing is key. Firms should be working with their core trading counterparties and custodians to test messaging, trade confirmation and instruction flows. Leveraging industry testing facilities via the DTCC is an obvious place to start and access test scripts, success criteria and reporting. Consideration should be paid to areas such as trade booking, allocation, confirmation, FX execution, payment and settlement to identify dependencies and weak links across the entire value chain.

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Conclusion

The transition to T+1 settlement will have wide-reaching impacts; however, with thorough testing and preparation, firms can identify risk areas and develop solutions to minimise disruptions. Firms need to assess their current state and map dependencies to understand pain points. Evaluating trade flows, FX components, booking models, and processing timings will illuminate where breakdowns may occur. Technology solutions for automation, data transparency, and digital reconciliation will also smooth operations. Custodians have a significant impact on post-trade processing, and their readiness will be a key gating factor in the industry's overall readiness for T+1 settlement. Firms should urgently engage with custodians to understand required changes and conduct "fire drill" testing of new arrangements. Firms should test internally first, then externally. The thorough testing of new processes, third parties, and unexpectedly high volumes will instil confidence; ultimately, strong collaboration and upgraded capabilities will enable a smooth transition into the new operating environment.

At Margin Reform , we understand the increasing pressure on firms to deliver large regulatory changes to remain operationally and commercially efficient.?

Our dedicated team is always on the pulse of what is happening, which allows us to provide our with the relevant expertise and ensure they remain relevant, compliant, and efficient.?

We can help you 'undo the knot'.

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