SEC Adopts Settlement Cycle Rule, Proposes New Custodial Rule

In a regularly scheduled hearing on Wednesday, the Securities and Exchange Commission made two decisions by narrow votes, adopting one rule and proposing another, both related to high-profile financial scandals.

Settlement Cycle Adoption

The new rule that has been adopted will reduce the settlement cycle for securities transactions from two days to one. It will also halve the settlement cycle for initial public offerings from four days to two.

Jessica Wachter, the SEC’s chief economist and director of the division of economic and risk analysis, explained during Wednesday’s hearing that the time between the execution of a trade and when it is considered final, known as the settlement cycle, can pose certain risks to market actors. Those risks can include a substantial market price change in the asset or that one of the parties will fail to fulfill its obligations. Reducing the cycle to one day is intended to reduce these risks.

SEC Commissioner Caroline Crenshaw, who voted to adopt the rule, explained in her statement that the shortened cycle “should reduce the number of outstanding unsettled trades, reduce clearing agency margin requirements, and allow investors quicker access to their securities and funds. Longer settlement periods, on the other hand, are associated with increased counterparty default risk, market risk, liquidity risk, credit risk, and overall systemic risk.”

Commissioner Jaime Lizárraga connected the rule change to January 2021 price volatility caused by “meme stocks,” which resulted in multiple class action lawsuits.

“The Commission has taken various actions to prevent another meme stock-type event from impacting the markets, including the recently proposed equity market structure reforms that address, among other things, best execution for retail investors,” Lizárraga said in a statement. “Shortening the settlement cycle to T+1 complements these reforms and helps mitigate some of the risks that drove stock price volatility and significant margin calls during the meme stock event.”

The rule was adopted by a 3-2 vote. Commissioners Hester Peirce and Mark Uyeda asked that the Commission postpone the compliance date from May 28, 2024, to September 3, 2024. This would allow more time for compliance and would also match the compliance date of a similar rule in Canada. The Investment Adviser Association supported the later compliance date in an emailed statement, citing the Canadian rule. Uyeda also expressed concern that a shortened cycle would leave less time to correct errors.

Despite those objections, the rule was adopted with a compliance date of May 28, 2024.

Custody Proposal

The SEC also proposed a new rule that would expand existing custodial protections for managed assets. The rule would broaden the application of current custodial rules to include “any client assets in an investment adviser’s possession or when an investment adviser has authority to obtain possession of client assets.”

Currently, these rules only apply to securities and funds, but the new rule would expand them to all assets managed by a registered adviser, including alternative assets such as crypto currencies.

Specifically, the new rule would require these assets to be segregated in their own accounts so they are protected if the assets’ custodian were to go bankrupt. Registered advisers must also use a custodian that has “bankruptcy remoteness.”

Chairman Gary Gensler referred to cryptocurrencies explicitly in his statement on the proposal. He explained that many crypto platforms “have commingled those assets with their own crypto or other investors’ crypto. When these platforms go bankrupt—something we’ve seen time and again recently—investors’ assets often have become property of the failed company, leaving investors in line at the bankruptcy court.”

Gensler continued: “Thus, through this expanded custody rule, investors working with advisers would receive the time-tested protections that they deserve for all of their assets, including crypto assets, consistent with what Congress envisioned.”

The proposal would also require advisers and custodians to enter into written agreements which require account statements and records upon request, and the rile would apply to foreign-based custodians and discretionary trading by advisers.

The rule was proposed by a 4-1 vote, with Peirce dissenting. Though Uyeda expressed concerns about compliance costs for smaller advisers, as well as possible interaction with the recent adviser outsourcing proposal from October 2022, he decided to support the proposal and invited the public to address his concerns with public comments. As written, the new rule will have a 12-month compliance window for large advisers and an 18-month window for small advisers.

Peirce, the lone dissenter, said that a 60-day comment period would be too short and shared Uyeda’s concern for smaller advisers.

The IAA said in an emailed statement that it is still considering this proposal, but a spokesperson expressed concern that 18 months will not be enough time for small advisers to come into compliance with the rule. The IAA spokesperson also said that, given the proposal’s complexity and potential interaction with other rules and outstanding proposals, the 60-day comment period may be inadequate.