Catastrophe bond market deemed ready for T+1 settlement

New rules are being implemented in the United States by the Securities and Exchange Commission (SEC) that shorten the standard settlement cycle for most broker-dealer transactions from the current “T+2” to “T+1”, but in our discussions with catastrophe bond trading desks and market participants, the general feeling is one of readiness.

For the insurance-linked securities (ILS) community, these changes only apply to broker-dealer trades in the secondary catastrophe bond market.

For primary issuance of securities, the SEC regulations remain such that broker-dealers can set a settlement term that is appropriate to the transactions, which in cat bonds is often T+3 or T+5.

T+ refers to the number of business days within which a broker-dealer trade of securities needs to be completed in, so what was T+2, meaning a secondary cat bond trade made on a Monday would need to settle by Wednesday, will now become T+1 for every secondary cat bond trade, so a Monday trade will settle on the Tuesday, or first business day after the trade was made.

The SEC explains the impacts of the change to T+1 for securities dealers and investors, “If you have a securities certificate, you may need to deliver your securities certificate to your broker-dealer earlier or through different means than you do today.

“If you hold your securities with your broker-dealer, your broker-dealer will deliver the securities on your behalf one day earlier.

“Similarly, if you are buying securities subject to the “T+1” settlement cycle, you may need to pay for your securities transactions one business day earlier.

“If you have a margin account, the “T+1” settlement cycle may impact certain provisions of your margin agreement.”

The new T+1 settlement cycle rule will apply to applicable securities transactions occurring on or after today, May 28th 2024, so the market will be trading on this basis from this week forwards.

Securities and Exchange Commission (SEC) Chair Gary Gensler noted that the change will have a positive effect.

“For everyday investors who sell their stock on a Monday, shortening the settlement cycle will allow them to get their money on Tuesday. Shortening the settlement cycle also will help the markets because time is money and time is risk. It will make our market plumbing more resilient, timely, and orderly,” he explained.

In the past, what was a T+5 settlement norm was shortened to T+3 in 1993, then in 2017 it was shortened to T+2, so the capital markets have been through this type of change before.

The SEC noted that, “While previous transitions were successful, transition to a shorter settlement cycle may lead to a short-term uptick in settlement fails and challenges to a small segment of market participants.

“Despite such expected issues, the SEC has seen with each transition that shortening the settlement cycle benefits investors and reduces the credit, market, and liquidity risks in securities transactions faced by market participants.”

So, there is the potential for issues with this weeks change to T+1, but our sources in the catastrophe bond market have all told us they feel prepared.

The broker-dealer desks we’ve spoken with said their back-office infrastructure and processes won’t have any trouble handling the shorter settlement cycle.

As ever, changes such as this are not without risk and there are broader capital markets concerns about potential for some teething problems to begin, especially in very high-volume areas and classes of securities.

With catastrophe bonds, while the market has proven increasingly liquid in recent years, still the volume of trades is nowhere near the level dealers and banks manage in other asset classes.

In fact, a change like the switch to T+1 has provided an opportunity for the cat bond focused trading desks to look again at processes and IT systems, to ensure their capabilities are up to the faster settlement schedule.

The Securities Industry and Financial Markets Associatio (SIFMA) explained why this change should prove beneficial to all securities markets, “Shortening the time between the trade date and settlement date reduces risk in the system. Put simply, fewer days from trade to settlement means lower risk.

“Faster settlement means decreased daily average capital requirements. Firms can put that capital to better use. It also increases liquidity in the system.

“A large-scale project of this type, which impacts every financial institution, also helps drive innovation, automation, and process improvements. There is a benefit to streamlining operations, and to realizing greater efficiencies and making our operational systems more modern and resilient.”

Sources told us that the main chances of any issues emerging, specifically in cat bond trading, are likely to be in scenarios involving other back-office processes, or where trades have some urgency, while the market adapts to the new rules.

This could be, for example, where a new investor or fund wants to trade with a desk, but needs to be onboarded with a client account setting. So investors and fund managers need to ensure they provide enough notice for these kinds of tasks to be completed in advance of trading, if they have a trade deadline target.

There have been reports of large institutions setting aside a capital buffer to deal with any potential issues that emerged this week.

For example, Bloomberg reported that Jefferies has established a financial cushion, in case of any problems and there are some nerves that settlements could drag in some cases and fail to meet the new deadline. But with no official penalties for a late delivery of stocks or securities, the market is not expected to be unduly affected by any failure to immediately comply in every case.

In catastrophe bonds, having spoken to most of the major secondary trading desks, the overwhelming opinion is that the switch to T+1 should be relatively smooth, with nobody foreseeing issues that likely wouldn’t also have arisen under T+2 anyway.