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Efforts to cut the trade settlement cycle in half should help curb certain market risks but won’t eliminate them entirely, says Fitch Ratings in a new report.

The U.S. securities industry is planning to reduce the securities settlement cycle from two days after the trade day (T+2) to T+1 — and the Canadian industry aims to follow suit — in an effort to help reduce certain risks.

Fitch said the initiative is grounded, at least partly, in a desire to address trends such as the surge in retail trading and the rise of so-called meme stocks that have boosted market volatility.

“The proposed shortening of the settlement cycle is largely in response to notable bouts of extreme market volatility over the last two years, including in relation to the pandemic, the U.S. presidential election and increased retail trading of meme stocks,” the rating agency said in a report.

It noted that heightened volatility causes clearing and settlement agencies to raise their margin and capital demands on brokerage firms, which can prompt firms to restrict trading to address their own liquidity concerns.

“Some retail brokers faced increased liquidity pressures related to unprecedented volumes and increased initial margin requirements, with the length of settlement cited as a contributing factor,” Fitch noted.

While shortening the settlement cycle for equities could reduce some of the risks stemming from increased volatility — including liquidity and counterparty default credit risks — it would not completely eliminate the risks that arise, particularly as equity derivatives markets would not be impacted by faster equity settlement.

“Derivative trading positions could continue to pose risk-management and margining challenges for market participants, particularly as many retail brokerages increasingly offer products that can increase investor leverage,” Fitch said, noting that “synthetic leverage in the form of equity-related derivatives can exacerbate equity price movements.”

The report said options and futures positions will still require margins that are not affected by the equity settlement cycle.

“For the majority of exchange-traded derivatives, the settlement date is materially longer than two days, which, in combination with embedded leverage, results in the need to deliver higher variation margins and performance bonds if the trade results in losses and/or the volatility of the underlying asset increases,” Fitch said.

The rating agency also noted that it expects additional regulatory scrutiny on market structure and trading, the liquidity of trading firms and, potentially, the practice of payment for order flow, alongside the effort to shorten settlement cycles.