Just when you thought the Securities and Exchange Commission was taking a breather from proposing rules that affect advisors, the securities regulator is at it again. This time, the SEC is revisiting the controversial issue of next-day settlement of trades, or T+1.
Yes, shortening the current settlement cycle from three days (T+3) to one is rearing its ugly head again. There hasn’t been much talk about T+1 for a couple years, but the SEC issued a concept release (it’s at www.sec.gov/rules/concept/33-8398.htm) in March asking for comments about next-day settlement and the regulator’s new same-day affirmation proposal. Most people in the industry opposed T+1 when it was first floated by former SEC Chairman Arthur Levitt in the late 1990s. And by looking at some of the comment letters the SEC has received recently, most people in the investment industry remain opposed to the idea.
David Tittsworth, executive director of the Investment Counsel Association of America (ICAA) in Washington, told the SEC in June that “a regulatory mandate requiring same-day affirmation or shortening the current T+3 settlement cycle is not warranted by any objective cost/benefit analysis, and that such regulations would be ill advised, counterproductive, costly, and difficult to implement and monitor.” Tittsworth told the SEC that “there’s no evidence that the current settlement and confirm/affirm processes and the accompanying regulatory framework are broken.” The better approach, he says, “is to encourage the development of market-driven initiatives to promote advances in straight-through-processing that ultimately will be embraced by the vast majority of market participants.”
Like Tittsworth, most industry officials think the SEC is sticking its regulatory fingers where they don’t belong. The critics include Tim Lind, senior analyst with the investment management practice at TowerGroup in Needham, Massa- chusetts. Lind recently authored a research paper, “The Sequel to T+1: Will the SEC Mandate Operational Efficiency?” I chatted recently with Lind about the SEC’s concept release on T+1, and what effect any SEC rulemaking would have on advisors.
What does the SEC’s concept release on securities transaction settlement mean for investment advisors? The most obvious concern is whether [RIAs, broker/dealers, and money managers] will be subject to additional [SEC regulatory] oversight in operational areas. A rulemaking on the timing of the affirmation is the most likely. We don’t really believe that the SEC will move aggressively forward on a shortening settlement cycle mandate. We think most of the comments the SEC receives will suggest that the infrastructure is not in place to support next-day settlement, or T+1. By infrastructure, I mean the communications infrastructure between asset managers–the collective money management community–and their universe of broker/dealers, as well as with their connections to custodians. The applications on both sides, both the money management and broker/dealer side, are not in place to achieve next-day settlement, so [these firms] will recommend the SEC stand down at this time on specific rules changing from T+3 to T+1.
The SEC will move ahead with the same-day affirmation rule? For RIAs, I think the greater probability is that the SEC will potentially move forward with a same-day affirmation rule, which is the new part of this [SEC concept release]. The [investment] community has been talking about T+1 since Levitt brought it up in 1998 or 1999. It was a big deal in 2000 and 2001 until it went off the table in 2002. What we’re really talking about now is “How do we achieve the same risk benefits without shortening the settlement cycle?” Most have latched on to this notion of same-day affirmation. Most of the people you talk to [about T+1 and same-day affirmation] talk about the mechanics of compliance, rather than answering the question, “What risk is involved?” I find that somewhat frustrating. If the government tells me I have to wear a helmet each day, please tell me what risk you’re trying to protect me from. So we have to come to a consensus on the nature of the risk in this area of securities settlement.
Explain same-day affirmation. T+1 would say that the finality of settlement–the exchange of securities and cash resulting from a trade–must be complete on the day after execution. Same-day affirmation preserves the current settlement cycle of three days from execution. However, the trading parties would be obligated to confirm the economic details of the trade on the same day it’s executed. It locks in your and my understanding of the [trade] execution and effectively highlights any dispute or disagreement over what security was to be executed or the price it was supposed to be executed at, and what account it was supposed to be executed for. If we do discover a trading error, the earlier we discover it the better we can react and remedy the error without prices moving away too far. The risk of having to reverse a trade in the market can leave somebody out of pocket at an inferior price. This is the heart of what this [same-day settlement] rule is trying to achieve.
Would it be harder for a smaller firm to do same-day affirmation than a larger one? It would be predicated more on trading style than on the size of assets under management. It’s a volume game. If I have a value-based investment style, where I ponder the balance sheet of a security, and put my funds into a long-term-perspective value fund, compliance would not be quite as dramatic. The volume [of trades] really dictates how difficult it will be for you to comply. There is nothing to say that RIAs can’t do this manually, but I think it’s self evident that they’ll need some sort of automated communication mechanism with the broker/dealer so if they’re trading on behalf of multiple accounts, they can tell the broker/dealer the allocation of those various trades to those various accounts. The broker can then confirm the various allocations, and the buy-side signifies its agreement through this affirmation. Then we have a meeting of the minds and a contract. It would be difficult to argue that it’s not sound business practice to lock in the details of the trade as soon as possible. In principle, what the SEC is suggesting is a healthy and diligent practice. I think that should be stipulated for the argument. [The] disagreement is regulation in this area; that’s where you’ll run into differing opinions. I think it’s more TowerGroup’s perspective that in order for you to justify regulation, you first must prove an unacceptable risk is involved in the current process. Regulating efficiency is not something the government typically does unless there is a greater public policy issue at stake.
Does the SEC think there is a greater issue? I think that the SEC is searching to prove that and the SEC suspects there might be, that there are undue risks. The question is [whether] there is a systemic risk. If there were a systemic risk, then as a function of public policy it warrants the SEC’s attention. The government looks at nuclear power plants and other things that would pollute our environment. Is the behavior of securities intermediaries so dangerous or reckless that it would cause third parties to lose money or expose them to undue risk? That’s the heart of the matter.
Why did Arthur Levitt see the need for T+1? Did he notice a systemic risk? [Levitt didn't get the T+1 idea based on] people who are experiencing large financial losses resulting from this type of risk. I think it was more based on principle. [Levitt thought] that these are sound practices. I think everyone would agree that in the absence of a regulatory mandate, behavior is slower to change. But the argument is whether government regulation is warranted here. If you think more like my firm, we should allow the market to dictate efficiency. The government doesn’t step in and tell Ford Motor Company how to manage its supply chain unless there’s a danger to the public. Bad trades happen every day. The same-day affirmation rule does nothing to cure the disease; same-day affirmation of trades is a function of early detection. Trading mistakes will occur; we will have to go back into the market and reverse those trades, and people will lose money. The magnitude of those losses is the question. We [at TowerGroup] don’t believe the magnitude of those losses represents a systemic risk to third parties. We don’t believe there is some sort of danger to the value of portfolios resulting from this type of credit risk. The most exposed parties in this world are not those exposed to the RIA. RIAs aren’t hedge funds; they’re not seeking leverage in the way they invest. RIAs are typically pretty good credit risks. So it’s not the RIA community we’re worried about. There isn’t one case that can be described where a firm lost significant money, or became insolvent, as a result of counterparties’ failure to settle a trade. I think that’s the heart of the matter.
Why do you think the SEC is issuing this concept release on T+1 and same-day affirmation now? Is it because of the heightened regulatory scrutiny the SEC has brought into other investing areas? That’s part of it. There are crooks in the [investing] business. And a lot of people in the asset management community have not been observing their fiduciary duty to us, the retail shareholders, and we’re losing money. I don’t blame the SEC for turning over every one of these stones to see if there are more things going on. But [in the area of securities transaction settlement], regulatory involvement isn’t terribly compelling.
Washington Bureau Chief Melanie Waddell can be reached at [email protected]