What FX risks arise ounce US securities will be settled on a T+1 basis?

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This week the Federal Reserve is holding a two day conference on the international role of the US dollar in conjunction with the Federal Reserve Bank of New York. While the US dollar is the dominant global currency, the US is not the place where most FX trading takes place; that’s in London. This does not matter, or rather it has not mattered in the past. But it might matter more once US securities start to be settled on a T1 basis from next week.

On May 28^th, the US will begin to settle securities trades on a T1 basis, not a T2 basis. This is of some considerable significance to international investors in US securities because the foreign exchange they transact to purchase securities will continue to be settled on a T2 basis. Could this change have a bearing on financial market prices, notably the value of the US dollar, particularly bearing in mind that there will also be the usual quarterly rebalancing of the MSCI global indices just a few days later?

There’s no doubting that international investors account for a large chunk of investment in US securities. They hold around USD13.5tr of US debt securities, which is about a quarter of the total, although the change to T1 will impact the likes of corporate bonds and municipal bonds, not treasuries. Overseas investors hold USD13.5tr of US equities, which is about 17% of the market.

The nub of the problem is that, under the current T2 settlement for both FX and US securities, investors outside the US essentially had more time to fund their securities purchases. They could use the more-liquid European (largely London) foreign exchange market. But now, unless investors have the dollars on hand, they could be forced into the less-liquid NY trading day to fund asset purchases.

As mentioned earlier, the London market is the biggest for foreign exchange, and by quite some distance with more than double the trading that takes place in New York. Much of the reason for this reflects a steep drop-off in activity late in the NY trading day once London has finished. In the past, this might not have mattered too much as investors likely targeted their FX funding of such positions in the more-liquid London market.

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As of May 28^th, and the change to T1, some investors could find themselves trying to operate in liquidity-thinned late NY markets and this, in theory could make volatility higher at this time of day and potentially lift volatility across other time zones as a knock-on consequence. Things could be significantly stressed should unanticipated shocks occur that spur a flurry of activity in US securities markets, so forcing investors to scramble in the FX market very late in the day.

But before getting too worked up about the potential for higher FX volatility, there are a few points to make. One is that market makers in NY could lift their presence to try to absorb any extra volatility. Another is that international investors may become more versed in trading late into NY, possibly transferring staff to the US and/or outsourcing FX to firms that have a strong presence outside of London trading hours.

Of course, another possibility is that investors outside the US simply ensure that they always have sufficient dollars on hand in order to avoid any last-minute dash for FX funding. It is also conceivable that FX settlement risk operators, such as CLS, adjust their practices to give investors a bit more leeway on their FX trades.

In short, while it is undoubtedly worth flagging the impending change to T1 settlement in the US as a potentially volatility-inducing move next week, it is not necessarily the case that volatility will increase. It could potentially be of some importance should unanticipated shocks happen that create large and immediate needs for international investors to transact US securities.

"Such shocks usually prompt dollar purchases as a safe-haven response, and T1 settlement in US securities could conceivably increase the severity of the volatility that we see around such events. Hence, it is something we need to bear in mind when large shocks occur, but not necessarily feed into expectations in the normal course of forecasting the US dollar", said Steve Barrow, Head of Standard Bank G10 Strategy.