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SEC Open Meeting

Securities and Exchange Commission

Open Meeting

Wednesday, February 15, 2023

Topline

  • The Commission voted to advance both agenda items, with the first approved 3-2 and the second by a vote of 4-1.
  • The primary disagreement on the first proposal was the proposed implementation timeline. Commissioners Peirce and Uyeda could not support the proposal because of the May 2024 deadline and advocated unsuccessfully for September 3 instead.

Agenda

  • Item 1: Shortening the Settlement Cycle
  • Item 2: Safeguarding Advisory Client Assets

ITEM 1: Shortening the Settlement Cycle

The Commission voted 3-2 to adopt rules and rule amendments under the Securities Exchange Act of 1934 to shorten the standard settlement cycle for most securities transactions.

Staff Discussion

Haoxiang Zhu, of the Division of Trading and Markets, explained that the staff is proposing to shorten the settlement cycle for most security transactions from two business days after trade day to one (T+2 to T+1). He said that the Commission received over 300 comments on the proposal, the majority of which demonstrated clear support among investors for further shortening the settlement cycle. He continued by noting that the promotion of timely, orderly, and efficient settlement of securities transactions has been a long-standing objective of the SEC. Furthermore, Zhu said the staff believes that shortening from T+2 to T+1 will reduce risk, protect investors, and offer efficiency. It will also result in a reduction in the total number and total value of unsettled trades that exist at any point in time, reduce the market value of unsettled trades in the clearance and settlements system, and result in the reduction of participant exposure to market risk that arises from such transactions. Finally, Zhu added that shortening to T+1 should reduce clearing houses’ exposure to credit markets and credit risk stemming from obligation to participants and reduce the size of the resources the clearing house requires of participants.

Zhu then detailed the staff’s recommendations on additional amendments to enhance the processing institutional transactions in two ways: first, by requiring broker dealers to have contracts or policies and procedures for same day allocations, confirmations, and affirmations, and directing clearing agencies to facilitate the automation of processes without manual intervention; second, by adopting an amendment related to record keeping requirements for advisors. Zhu concluded by noting that the compliance date for the transition is May 28, 2024.

Matthew Lee, also from Trading and Markets, expanded on the overview provided by Zhu. He began by repeating the general description of the recommendation to shorten the standard settlement cycle from T+2 to T+1 and add security-based swaps to the transaction types excluded from the rule. He noted that the Division also recommends shortening the separate settlement cycles for firm commitment offerings to T+2. Next, Lee explained that they have recommended three rules to facilitate more efficient trade processing. For broker dealers, Lee said the new rule will require that they enter into written agreements with relevant parties and custodians to ensure completion of allocations, confirmations, and affirmations no later than the end of the day on the trade date. He said registered investment advisors will have to make records of confirmation, allocations, and affirmations for transactions that are subject to the rule. Finally, he stated that clearing agencies that are central matching service providers will be required to establish, implement, maintain, and enforce policies and procedures related to processing. Additionally, Lee noted that the services providers will have to submit an annual report to the Commission that includes a summary of policies and procedures, a description of progress, a quantitative report on data, and a qualitative description of actions they plan to take. The report data will be anonymized and aggregated.

Jessica Wachter, of the Division of Economic and Risk Analysis, explained that by shortening the settlement cycle, the SEC will reduce risk to central counter parties because there will be less time for prices to move in an adverse fashion. She also expects reduced margin requirements, which will lower costs for market participants. Wachter continued by noting that the amendments solve a coordination problem. From the perspective of any one firm, she said, there will be operational costs with the benefits felt by others.

Wachter then explained the other changes being adopted, including requiring policies or procedures or written agreements for the process known as allocation, confirmation, and affirmation to be done as soon as technologically practicable and no later than the trade date. She said this rule will provide greater security, reduce risk, and improve record keeping for institutional trades. Finally, Wachter noted that the rule contains provisions to facilitate the automation of post-trade processing between brokers and clients (straight through processing), which will reduce risk and cost and promote accurate clearing settlement.

Commissioner Discussion

Commissioner Hester Peirce began by stating that she supports the plan to move to T+1 but does not support the proposed timeline for making the change. She said that mandating that it occurs by May 28 could pose risks to the market and proposed a September 3, 2024 date instead. Peirce expanded on her proposal by noting that shortening the cycle is a big deal and warning against a cavalier approach. She also added that many commenters called for the later date to ensure minimal disrupt to the market and give foreign market participants time to work out any issues with the transition. Additionally, it was noted that the transition from T+3 to T+2 occurred successfully on Labor Day weekend.

Chair Gary Gensler replied to Peirce by noting that he is comfortable with supporting the rule as it is. He said that the rule has been a three-year journey and added that market participants including the DTCC came together to help with the proposal and are comfortable with 15 months for the transition (i.e., May 28).

Peirce said that the extra three months would be beneficial to investors, particularly if to avoid market disruptions. She added that postponing until September seems like a small price to pay for additional testing and allowing for alignment with Canada’s implementation of T+1.

Commissioner Caroline Crenshaw noted that it has been over two years since the “meme stocks” that brought market structure into the spotlight. While no longer front-page news, she said that the issues remain front of mind for the SEC. Crenshaw spoke in favor of shortening the settlement cycle to protect investors, reduce risk, and increase efficiency. Additionally, she said it will reduce number of outstanding trades, reduce clearing margin requirements, and allow investors quicker access to their funds. In response to comments about the implementation timeline, Crenshaw said that it has already been extended by multiple months from the proposed date and added that there will be more than 15 months to prepare for the transition. Finally, she noted that a move to T+0 may be desirable and feasible in the future.

Commissioner Mark Uyeda said that he is supportive of the change conceptually but added that a key ingredient for success in shortening the settlement cycle has been acting in an incremental manner. He noted that leading up to the 2017 change, a deliberate and incremental approach was taken to make sure that changes were made correctly. Significant investment and computation testing will be required, Uyeda said, and he warned that a rough, turbulent transition could produce substantial harm in the short run. Furthermore, while he appreciated the move from March 2024 to May 2024, he noted that many have pointed to post Labor Day as a potentially more optimal choice. Because of these concerns, he did not support the final rule.

Commissioner Jaime Lizarraga said that reducing the settlement cycle from T+2 to T+1 is a significant milestone for our markets, and added that, based on comments, the benefits will accrue to retail investors in particular. He noted that this rule is another example of the Commission addressing the January 2021 “meme stock” events, along with best execution requirements. As it relates to delaying implementation, Lizarraga said that the case is unpersuasive. He noted that the May date already provides three more months than the March 2024 date originally proposed. He said he is confident that market participants will focus their energy, harness their resources, and apply innovative capacity to effectuate a smooth transition. Finally, Lizarraga said that the SEC must continue to engage with stakeholders to determine whether shortening the cycle to T+0 would further reduce risk and provide benefits to the capital markets.

Gensler said the rule will reduce latency, lower risk, promote efficiency, and provide greater liquidity to markets. He noted that this change brings the US back to the T+1 cycle that markets used until the 1920s. He also said that it aligns with T+1 cycle used by with the treasury market. Next, Gensler argued that the amendments will lower risk by requiring brokers to complete T+0 allocations, confirmations, and affirmations as soon as technologically possible. He also stated that requiring straight through processing of securities transactions will lay a better groundwork for possibly moving to T+0 in the future. Finally, the Chair again commented on the implementation timeline, noting that it is three years after industry first proposed shortening the cycle and adding that the implementation date would occur on a three-day weekend to further ease the transition.

ITEM 2: Safeguarding Advisory Client Assets

The Commission voted 4-1 to propose to amend and redesignate rule 206(4)-2 under the Investment Advisers Act of 1940 (“Advisers Act”) related to the safeguarding of client assets.

Staff Discussion

William Birdthistle, of the Division of Investment Management, said that the Division has proposed amending the Custody Rule in three main ways. First, it would broaden the application of the current rule to apply to all assets, not just client funds and securities. Second, it would make explicit that discretionary trading authority triggers application of the rules. And third, the proposal would advance the advisor’s role with respect to the qualified custodian and modify the definition of qualified custodian to ensure they provide standard custodial protections.

Next, Birdthistle explained why these changes are needed now. He argued that it is a critical time to use this authority, as industry developments have resulted in new risks that are not covered under the current rule. He continued by noting that funds and securities are not the only assets that comprise portfolios today, and an overwhelming majority of securities are uncertificated. He also noted that advisory services and practices have evolved and do not necessarily involve one to one exchange of assets. In absence of protections, Birdthistle argued, an advisor has the ability to trade on discretionary basis. Overall, he said that changes in the industry have called for reconsideration of the role of a qualified custodian and developments suggest a need to modify it. He stated that these changes will help ensure all assets would receive protections from the rule.

Christopher Staley, also with the Division of Investment Management, said that the staff is using new authority to propose to redesignate the investment advisory rule. He added that the new rule would contain amendments to design safeguards. He said the proposal would modernize the current rule by expanding the scope of assets covered. As a result, any assets that the advisor has custody over would be included, which covers crypto or other assets that may develop in the future. It would also mend the definition of custody. Additionally, an advisor with discretionary trading authority would be subject to the new rule and generally would not require surprise examinations. Staley explained that advisors with custody of the broader range of client assets would be required to name the assets with qualified custodians with more limited exceptions, and the rule would clarify that a bank must hold assets in an account designed to protect the in event of insolvency. Finally, Staley said the rule would update enhanced record keeping requirements.

Wachter began by noting that the divergence of interest may lead advisors to act in ways that investors may not choose on their own. She said the current custody rule and the proposed amendments are designed to minimize this conflict and that the custody rule invokes qualified custodians to engage in oversight and detect any such activity. The proposal would broaden this custody framework to include all assets and deepen it to require that they obtain assurance that advisors satisfy a range of conditions. Finally, Wachter noted that there may be costs associated with these proposals, including compliance costs, and cost to custodians in meeting the new definition.

Commissioner Discussion

Peirce said that significant aspects of the approach and timeline raise questions about the proposed rule in terms of workability and breadth. She said she looks forward to hearing comments. On timing, she argued that 60 days does not allow the public to analyze all aspects of the proposal. She also added that the implementation period proposed is also too short. On workability, Peirce warned that getting custodians to enter into written agreements may be difficult for advisors and costly for clients. She also said that small advisors may have difficulty complying. Additionally, she expressed concern about challenges raised by the requirement to obtain internal control reports and the proposal to change the approach to discretionary trading.

Peirce also noted her concern about the proposed approach to crypto custody. She said that by insisting on an asset neutral approach, the SEC could leave investors more vulnerable to theft or fraud and also run the risk of forcing investors to move their assets away from entity with safeguards. More generally, she said the release seems designed for immediate effect, and appears to be part of a broader strategy of wishing SEC jurisdiction over crypto. Finally, she noted that the Commission does not have authority to regulate custodians directly, and said that she is worried about overriding private agreements.

Peirce also asked a few questions of the staff. First, she asked about the treatment of discretionary trading. Melissa Harke, of the Division of Investment Management, said that there is a distinction between discretionary and nondiscretionary trading, which is that there would be an exception to the surprise examinations requirement for assets kept with a qualified custodian. Non-DBP trading would not receive the exception.

Pierce also noted that one new condition would force financial institutions serving as a qualified custodian to be subject to the anti-money laundering (AML) regime. She asked about the relationship of that and the protection of client assets. Birdthistle responded that AML is an issue in its own right, but also a proxy for concerns the staff would have about inadequate custodianship.

Finally, on crypto custody, Peirce asked if under the proposed rules any existing institutions would be a qualified custodian in the crypto space. Birdthistle said that theoretically any financial institution that meets the definition of qualified custodian and meets proposed changes would be in place to satisfy these requirements.

Crenshaw said that she was pleased to support the proposal. She said that the custody rule helps prevent fraud, protect investors, and promote confidence in the integrity of the advisor-client relationship. Furthermore, she commented that today’s proposal used Dodd-Frank authority to apply the rule to all investor assets in the advisor’s custody, which would capture alternative assets that are not considered securities. She added that it would help bring safeguarding of assets in line with advisors’ fiduciary duty.

Finally, as it relates to the application of the rule to crypto, Crenshaw said that the proposal is explicit on how the SEC rules apply to crypto. She expressed concerns that many assets are not properly safeguarded or custodied. The proposed amendments, however, would apply to all assets and allow for new innovations and technologies, but not at the expense of investor protection.

Uyeda noted that one goal of this proposal is to address the interpretive questions and changes in technology, advisory services, and custodial practices that have developed since 2009.  He said that while this is a worthwhile effort, he questions whether the proposal arrives at the correct outcome in several areas. First, he noted that approach to custody appears to mask a policy decision to block access to crypto as an asset class, which deviates from the SEC’s position of neutrality on the merits of investments. Second, he said the proposal imposes significant new conditions on the types of entities that can qualify as foreign financial institutions. Third, Uyeda said that rule follows a separate proposal regarding outsourcing by investment advisers. He added that it appears that little thought has been given to how one change interacts with another. Finally, the Commissioner said that the proposed rule’s requirement that investment advisers demand certain contractual terms and obtain certain reasonable assurances from qualified custodians might disadvantage smaller advisers. Despite these concerns, Uyeda said he will support the proposal because he supports making changes through notice and comment.

Lizarraga said that the proposal strengthens and modernizes the existing rule designed to provide meaningful protections to investors. He noted that the Commission’s work in preserving market integrity through enforcement is incredibly important for investors, and added that expanding custody protections allows the public to invest with confidence, which also could increase participation in our capital markets.

Gensler said that the proposal uses important authorities that Congress granted after the financial crisis to ensure advisors do not use, lose, or abuse investor assets. He noted that custody rule has been in place 1962 and was last updated in 2009. He added that Congress granted the SEC new authorities in 2010, which allows them to expand rule and apply it to all assets, not just funds or securities. Gensler highlighted four major components:

  1. The rule enhances protection that investors receive through the custody process to ensure assets are properly segregated.
  2. It requires that advisors and qualified custodians enter into written agreements with each other, including that custodians undergo an annual evaluation and provide account statements and records upon request.
  3. It requires foreign institution to explicitly include segregation and bankruptcy remoteness.
  4. It makes explicit that the custody rule safeguards apply to discretionary trading, to make clear that advisors cannot circumvent the custody rule.

Finally, the Chair noted that the proposal would cover all crypto assets, including those that are not funds or securities. He said that through the expanded rule, investors would receive time-tested protections for all assets, as Congress laid out in Dodd-Frank.

For more information on this hearing, please click here.

For an archive of past SIFMA hearing coverage, please click here.