From meme stocks to market reform: The journey to T+1 settlement

Marie Pupecki Date published: May 24, 24

May 27th and May 28th are exciting days for investing in Canada and the U.S., respectively. These are the effective dates for the SEC rule amendments to shorten the standard settlement cycle for most broker-dealer transactions from two business days after the trade day (T+2) to one business day (T+1). This rule applies to transactions in stock, bonds municipal securities, exchange traded funds, certain mutual funds and limited partnerships that trade on exchange.^[ii]  In securities transactions, the settlement date is when a securities trade is complete. Payment is due for purchases, securities sold must be delivered, and the transfer agent has verified the new shareholder and removed the prior one. The SEC stated, "The final rule was designed to benefit investors and reduce the credit, market and liquidity risks in securities transactions faced by market participants."^[i] 

GameStop and the impact of meme stocks

The impetus for the rule change was the meme stock events of 2021, when a massive volume of retail trades overwhelmed the capabilities and liquidity of some brokerages. The unprecedented volume of trades in GameStop stock and other meme stocks, caused brokerages such as Robinhood LLC to impose trading restrictions due to the delays in accessing payments connected to the trades. Robinhood, like most other zero commission brokerages, relies on payment for order flow (PFOF) for revenue. PFOF refers to payments that brokerages receive for directing customer trades to a market maker. Brokerages are required to give customers the best price, known as “best execution.”^[iii] 

The increased participation of retail investors trading via mobile apps and the coordinated behavior encouraged by Reddit discussion groups as well as the media coverage created a perfect storm. Large price movements and volume changes combined with the market dynamics of short selling put the trade settlement system to the test. The individual investors put pressure on the short sellers, mostly institutional investors who then had to cover short positions, creating even more volatility. Over the course of days in January 2021, the price of GameStop rose from $17 to $483. “The number of individual accounts actively trading in GameStop went from less than 10,000 to nearly 900,000.”^[iv]

Note that buyers legally own (or have legally sold) stocks at the time of order execution although funds won't settle for several days. A critical part of the trading process is the transmission, reconciliation, confirmation and settlement, which in the U.S. is managed by the National Securities Clearing Corporation (NSCC), a subsidiary of the Depository Trust & Clearing Corporation (DTCC). The DTCC maintains a clearing fund and member broker-dealers, such as Robinhood post collateral on a daily basis for settlements. There's a separate clearing agency for option trades. Robinhood couldn't meet the margin call, an increase of $3 billion required for the special risk charge the day GameStop exploded. In response, Robinhood and other firms chose to restrict the ability to buy certain stocks and only allowed the sale, bringing the orderly market for GameStop to a screeching halt.^[iii]

Recommendations from the investigation

The SEC concluded that there were four areas that contributed to this crisis:

1. The length of the settlement cycle
2.   Digital engagement practices and PFOF
3. Trading in dark pools and through wholesalers
4.   Short selling and market dynamics

The path from the chaos of 2021 has led to numerous requirements not only include the T+1 settlement but also requires Central Matching Service Providers such as the DTCC, to "establish, implement, maintain and enforce reasonably designed written policies and procedures that facilitate straight-through processing (STP) as well as quantitative metrics to measure the rates of allocations, confirmations and affirmations. "^[v]  

Industry effort and challenges

The Securities Industry and Financial Markets Association (SIFMA), the Investment Company Institute (ICI), and the DTCC, (together the T+1 Industry Steering Committee) led a concerted effort to improve operations across the industry and to meet the deadline of May 2024. They've identified the key to the successful transition is for market participant firms to adapt operations to ensure they've adequate time to allocate, confirm and affirm trades by 9:00 PM ET on trade date (the T+1 DTCC affirmation cutoff). They'll have only about five hours to manage exceptions.

In the context of institutional trades in the U.S., the affirmation process is completed prior to sending the settlement instruction to the depository. Conversely, in markets outside the U.S., affirmations are typically integrated within the depository system, a process referred to as pre-settlement matching between the local broker and the local custodian. Institutional investors outside the U.S. may be familiar with pre-settlement matching, but they may not be familiar with the U.S. affirmation process even if they actively invest in U.S. markets, as most rely on a U.S.-based custodian to manage affirmation on their behalf.

Evaluating the path forward

DTCC data shows that only 69% of all trades were affirmed by 9:00 PM on trade date in December 2023. To successfully move to T+1, the industry must focus on affirming trades earlier. Historical data shows that trades not affirmed on time have a greater risk of exceptions and are more likely to fail. Although there are currently no regulatory penalties for not meeting same-day affirmation targets or for failed trades in the coming T+1 world, there are very real implications, including the potential for higher costs to settle via delivery orders, the impact of non-compliance with US SEC requirements (specifically, 15c6-2), and the increased likelihood of trade failure, along with potential reputational impacts.^[v]

Read the report

If you’ve enjoyed our deep dive into the upcoming T+1 settlement, you’ll find our recently released report on transfer agent market share insightful!

Read now

[i] https://www.sec.gov/news/press-release/2023-29

[ii] https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/new-t1-settlement-cycle-what-investors-need-know-investor-bulletin

[iii] https://financialservices.house.gov/uploadedfiles/memorandum_for_fsc-rs_re_meme_stock_event_final.pdf

[iv] https://www.sec.gov/files/staff-report-equity-options-market-struction-conditions-early-2021.pdf

[v] https://www.dtcc.com/-/media/Files/PDFs/T1-Affirmation-Report.pdf