What T+3 settlement means for municipal bond market participants.

• Author: Johnson, Hal
• Position: Settlement cycle for securities trading

Shortening the settlement cycle for municipal securities transactions presents some unique challenges but not any insurmountable obstacles.

On June 7, 1995, a dramatic change will occur in U.S. securities markets. On that date, the standard settlement cycle for securities transactions - the number of days between the day a trade is executed and the day that the trade is settled - will be converted from five business days to three business days. In the securities industry, this conversion has been labeled T+3 settlement, which is shorthand for settlement on trade date plus three business days.

The conversion to T+3 settlement should not directly affect new-issue sales by issuers of municipal securities. The underwriter and the issuer will continue to be able to set the closing date for the purchase of a new issue to accommodate the needs of both the issuer and the underwriter. In addition, all municipal securities transactions executed by dealers before the closing date, known as when-issued transactions, are exempt from the T+3 requirement. However, under rules of the Municipal Securities Rulemaking Board (MSRB) - the self-regulatory organization governing municipal securities dealers - municipal securities transactions executed by dealers after the closing date of an issue generally will be subject to the T+3 settlement requirement.

The oft-repeated mantra that has brought T+3 settlement to U.S. securities markets is "Time equals risk." This means that securities transactions that remain open and unsettled present certain risks to individual market participants and to settlement systems as a whole. The fundamental component of this risk simply is that one's counterparty in a securities transaction may be unable or unwilling to pay for (or deliver) securities on settlement date. By reducing the number of days between trade date and settlement date in the standard securities transaction, the number of such unsettled transactions existing in the clearance and settlement system, and the consequent systemic risk, can be reduced.

The compression of the settlement cycle has broad implications for all broker/ dealers, including those who market municipal securities. This article explains why U.S. securities markets are moving to T+3 settlement and discusses how the securities industry - and the municipal securities industry in particular - is coping with the change.

The Genesis of T+3 Settlement

While the Securities and Exchange Commission (SEC) has been the primary regulatory force behind T+3 settlement in the United States, the idea originated with the Group of Thirty, an international, nonprofit organization of world financial leaders. The purpose of the group is to "deepen understanding of international and economic issues, to explore the international repercussions of decisions taken in public and private sectors, and to examine the choices available to policymakers."

In 1989, the Group of Thirty issued a report containing nine recommendations for reducing risk and improving clearance and settlement of securities transactions in world securities markets. Efforts subsequently were launched in most developed countries to meet these recommendations. Because clearance and settlement practices vary widely from country to country, the tasks required in each country were different. In the United States, most of the nine recommendations - such as the use of central securities depositories and the practice of delivering securities against payment - already were being observed. The U.S. was not in compliance, however, with two of the recommendations: 1) the settlement of securities transactions within three business days of trade date and 2) the payment for transactions in same-day funds. (Same-day funds are those that are "good" on the same day of receipt - for example, a transfer of funds on the Federal Reserve Board's Fedwire system.)

To help meet Group of Thirty goals in the United States, a U.S. working committee was established. The working committee includes representatives of the securities...