CDOR, CORRA and T+1, oh my!

The project to reduce the securities settlement cycle from the current T+2 (trade date plus two days) to T+1 is being driven by the U.S. markets’ need for speedier settlement, and Canada is on board to keep pace.

Similarly, policymakers around the world are shifting to alternative interest-rate benchmarks following failed efforts to overhaul and preserve Libor — the world’s biggest, most important benchmark — in the wake of market manipulation scandals.

The move to T+1 by the first half of 2024 will be a major undertaking. Previous efforts to speed up settlement cycles — from T+5 to T+3, and then down to T+2 — revealed how much work is involved in upgrading the industry’s basic plumbing.

Already, the industry group leading the renovation, the Canadian Capital Markets Association (CCMA), is grappling with how to cram trades through the settlement process more quickly — a task that involves coordination among investment dealers, fund managers, trading venues, custodians, counterparties and third-party service providers.

The CCMA already has determined that merely tweaking the existing trade settlement processes won’t be enough to reduce settlement time. Instead, deadlines throughout the settlement chain will have to be tightened so the bulk of daily trading activity can be included in the batch-settlement process that happens overnight on the same day a trade occurs. This involves reporting, confirming and allocating trades, and correcting errors.

According to the CCMA, only about one-third of institutional trades (both debt and equities) are currently entered and confirmed on the day of the trade, and are ready for overnight settlement. For T+1 settlement to work, the group aims to get the industry closer to 95%.

Achieving this will require sweeping changes to industry processes and probably more automation. The CCMA has indicated this might mean increased real-time trade reporting so large volumes of trades are not left to be reported and confirmed at the end of the day. As is often the case, smaller dealers and investment firms with less technological or human capacity may be most challenged to keep up.

Moreover, these shorter timelines will have to be met not just in ordinary market conditions, but also in times of stress when trading volumes spike sharply.

The move to T+1 also will have implications for mutual fund and ETF trading, securities lending and various routine corporate actions (such as companies declaring dividends).

For example, the CCMA’s working group on the mutual fund sector has identified liquidity as a potential issue for fund managers under a shorter settlement cycle. Only about 9% of mutual funds currently settle in T+1, and a shortened settlement period could challenge fund managers facing large redemption demands. As a result, investment dealers may be expected to warn fund managers of large redemptions so they have time to finance those requests.

Efforts to develop solutions for these kinds of issues are underway. The CCMA plans to begin introducing process improvements this fall, and this activity is expected to run throughout much of next year before industry-wide testing can begin ahead of 2024.

However, the effective date for T+1 still is uncertain.

In draft rules, the U.S. Securities and Exchange Commission (SEC) targeted March 31, 2024, but the industry wants more time. U.S. industry trade groups initially asked for Memorial Day (May 28, 2024), but the Canadian industry has requested the deadline be set on a common U.S./Canadian holiday weekend: Labour Day 2024.

When markets moved to T+2, the transition happened on Labour Day weekend. But the SEC may not choose a date for several months.

In the meantime, Canada’s industry is committed to working with the SEC’s schedule.

“Given the close interconnectedness between Canadian and U.S. markets, any deviation in settlement practices risks bringing severe disruption to our members, their clients and Canadian capital markets generally,” the Investment Industry Association of Canada (IIAC) noted in a letter to the SEC in mid-April.

Keeping up with the U.S. will put Canada’s markets out of step with most other foreign markets, which haven’t moved to reduce settlement times.

However, the payoff of moving to T+1 will go beyond simply staying in sync with the U.S. markets. Shorter settlement times mean less settlement risk and lower collateral needs, and investors should be able to be access the proceeds of securities transactions more quickly.

The IIAC also indicated the Canadian industry believes that “accelerating settlement will introduce additional efficiencies and risk reduction to our investors and markets.”

This work will be running in parallel to another major change: benchmark reform. Last month, London-based Refinitiv announced the Canadian dollar offered rate (CDOR), Canada’s predominant financial benchmark, would be replaced by a new risk-free alternative rate, CORRA (Canadian overnight repo rate average), in mid-2024. That move follows a general trend of replacing benchmarks based on banks’ offered rates with benchmarks that reflect actual transactions.

New derivatives contracts and securities that reference interest rate benchmarks will be expected to start using CORRA by June 2023, and the industry will have until the end of June 2024 to deal with “legacy” securities still geared to CDOR (which won’t be published after June 28, 2024).

Companies will have to revise their financial contracts, systems and processes to replace CDOR with CORRA.

“This will be a significant task, as CDOR is currently the most widely used interest rate benchmark in Canada, serving as the reference rate for over $20 trillion worth of financial contracts,” noted the Canadian Alternative Reference Rate working group, which is overseeing benchmark reform in Canada.