The T+1 Countdown: Strategies for Preventing Freeriding

The financial industry is on the cusp of a significant transformation with the shift from a T+2 to a T+1 settlement cycle. This move, designed to enhance the efficiency of securities transactions and reduce associated risks, inevitably brings to the fore the issue of “freeriding” – a practice that will be under increased scrutiny in this tighter settlement timeframe.

The Freeride Challenge in a T+1 World

Freeriding, the act of purchasing shares without having the funds available with the intent to sell before the settlement, contravenes Regulation T in the U.S. and poses a substantial risk in a T+1 environment. This shorter settlement period amplifies the potential for freeriding, given the reduced window for covering trades, potentially increasing exposure for firms not fully prepared for the transition. The question then becomes: how can firms protect themselves against this heightened risk?

Strategies for Mitigating Freeriding Risks

1. Enhanced Real-time Monitoring: Firms can invest in technologies that allow for real-time monitoring of trades and account balances. This would enable immediate identification of potential freeriding activities, allowing firms to act swiftly to mitigate risks.
2. Pre-trade Funding Checks: Implementing stringent pre-trade funding checks can ensure that clients have sufficient funds in their accounts before allowing trades to proceed. This could be a critical step in preventing freeriding from occurring in the first place.
3. Client Education: Educating clients about the implications of T+1 settlement and the legalities surrounding freeriding may deter attempts to engage in such activities. Transparency about the firm’s policies against freeriding could reinforce this deterrent effect.
4. Vendor Solutions: Several financial service vendors offer solutions aimed at preventing freeriding by integrating comprehensive risk management systems. These systems can analyze trades in real-time, assess the likelihood of settlement failures, and flag potential freeriding activities. Firms should consider partnering with these vendors to bolster their defenses against freeriding in a T+1 landscape.

The Complications of Multi-Firm Trading

A notable challenge arises when a “bad actor” engages in trading activities across multiple firms, complicating the tracking and prevention of freeriding. To combat this, firms could benefit from industry-wide collaboration and information sharing. By pooling resources and data, firms can gain a broader view of trading activities, making it easier to spot and address freeriding behaviors.

Cross-Firm Settlement and Custody: A United Front

In scenarios where trades are executed at one firm but settled and held in custody at another, establishing strong communication channels and agreements between the executing and custodial firms becomes paramount. Leveraging distributed ledger technology (DLT) could offer a novel solution by providing a secure and immutable record of trades and settlements visible to all parties involved.

How to protect against freeriding in a T+1 environment

In a T+1 settlement environment, firms can implement several strategies and controls to protect against freeriding, ensuring compliance with regulations and maintaining the integrity of their operations. Here are some key measures:

1. Enhanced Pre-Trade Checks: Firms can implement more rigorous pre-trade checks to ensure that clients have sufficient funds or securities in their accounts before executing trades. This could involve real-time balance checks and more stringent margin requirements.
2. Improved Client Education: Educating clients about the implications of the T+1 settlement cycle and the importance of having funds or securities available in advance can help reduce instances of unintentional freeriding. Clear communication about settlement rules and the potential consequences of non-compliance is crucial.
3. Automated Settlement Systems: Investing in advanced, automated settlement systems can help firms quickly identify and address settlement risks. These systems can provide real-time alerts for potential settlement failures, allowing for prompt corrective action.
4. Strict Enforcement of Penalties: Firms should have clear policies outlining the penalties for freeriding, including possible restrictions on trading activities, monetary fines, or the forced liquidation of positions. Enforcing these penalties rigorously can deter clients from attempting to freeride.
5. Real-time Monitoring and Reporting: Continuous monitoring of trades and settlements can help firms identify patterns of behavior indicative of freeriding. Real-time reporting tools can provide insights into client activities, enabling firms to take proactive measures.
6. Collaboration with Clearing Agencies: Working closely with clearing agencies to ensure smooth and efficient settlement processes can help mitigate the risk of freeriding. Clearing agencies can offer additional support and tools for managing settlement risk.
7. Margin Requirements and Collateral Management: Adjusting margin requirements to reflect the reduced settlement cycle and managing collateral more effectively can also protect against freeriding. Higher margin requirements for higher-risk trades or clients can serve as a buffer against potential settlement failures.
8. Quick Resolution Mechanisms: Establishing fast and efficient mechanisms for resolving failed trades can minimize the impact of freeriding. This includes having agreements in place with other firms and service providers for borrowing securities or obtaining quick funding when needed.
9. Leveraging Blockchain and Distributed Ledger Technology (DLT): Some firms are exploring the use of blockchain and DLT to streamline the settlement process further. These technologies can offer increased transparency, reduced settlement times, and enhanced security, making it more difficult for freeriding to occur.

Vendors that can assist in protecting against Freeriding.

There are several vendors and service providers that offer solutions to help firms manage and mitigate the risks associated with freeriding, particularly in a T+1 settlement environment. These solutions range from advanced trading and risk management platforms to compliance and regulatory reporting tools. Here are some types of vendors and examples that can assist in protecting against freeriding:

1. Trading and Order Management Systems (OMS): Vendors offering sophisticated OMS platforms can help ensure that trades are executed only when there are sufficient funds or securities available, thereby preventing freeriding. Examples include Bloomberg’s Trade Order Management Solutions (TOMS), Charles River Development, and Thomson Reuters.
2. Compliance and Surveillance Software: These solutions monitor trading activities in real-time to detect patterns indicative of freeriding or other non-compliant behaviors. Vendors like Actimize (NICE), Smarsh, and Behavox provide comprehensive surveillance and compliance platforms.
3. Risk Management Solutions: Firms specializing in risk management software can help identify and mitigate settlement risk, including the risk of freeriding. Vendors such as Murex, Calypso, and FIS offer risk management platforms that support real-time risk assessment and management across various asset classes.
4. Clearing and Settlement Services: Companies that provide clearing and settlement services can also offer tools and solutions to manage settlement risk effectively. DTCC (Depository Trust & Clearing Corporation) and Euroclear are examples of entities that provide infrastructure and services to ensure smooth and efficient settlement processes.
5. Blockchain and Distributed Ledger Technology (DLT) Providers: Blockchain technology can offer a more transparent and efficient settlement process, which can help in mitigating freeriding risks. Companies like R3, with its Corda platform, and IBM Blockchain offer solutions that can be applied to the financial securities settlement process.
6. Financial Infrastructure and API Solutions: Fintech companies providing API-driven solutions can enable real-time checks and balances in the trading and settlement process. Plaid, for example, offers financial data connectivity solutions that can be used for real-time balance checks before trades are executed.
7. Loffa Interactive Group Loffa provides a comprehensive suite of solutions to minimize freeriding risks in the T+1 settlement environment, including real-time monitoring, pre-trade funding verification, automated compliance tools, client education platforms, cross-firm collaboration mechanisms, and tailored solutions for smaller firms.

   a. Automated Compliance and Risk Management Solutions

   Loffa’s suite of products includes automated compliance and risk management solutions tailored to the T+1 settlement environment. These solutions automatically enforce regulatory requirements, like Regulation T, and firm-specific policies designed to prevent freeriding. Automation reduces the reliance on manual oversight, which can be both error-prone and resource-intensive.

   b. Client Education Platforms

   Understanding that informed clients are less likely to inadvertently engage in freeriding, Loffa’s onboarding is an educational platform. That is integrated into client portal, offering tutorials, guidelines, and real-time alerts about the importance of following regulations. Education is a critical component of a comprehensive strategy to minimize freeriding.

   c. Cross-Firm Collaboration Tools

   Given the challenge of tracking bad actors across multiple firms, Loffa facilitates industry-wide collaboration by offering secure platforms for transaction reporting & tracking. By creating an ledger of trades and settlement activities, firms can more easily identify and respond to suspicious activities that could indicate freeriding or other forms of financial misconduct.

   d. Customizable Solutions for Smaller and Emerging Firms

   Recognizing that smaller and emerging firms might be at greater risk due to resource constraints, Loffa offers customizable solutions that address their specific needs and vulnerabilities in the T+1 landscape. Tailored solutions ensure that all market participants, regardless of size, can effectively mitigate the risks of freeriding.

Conclusion

The transition to a T+1 settlement cycle represents a leap forward for the financial industry, promising greater efficiency and reduced market risk. However, it also necessitates a proactive approach to mitigate the potential rise in freeriding activities. Through technological advancements, stringent pre-trade checks, client education, and industry-wide cooperation, firms can protect themselves and the integrity of the markets. As the industry navigates this shift, the collective efforts of all participants will be crucial in ensuring a smooth transition and maintaining a fair and orderly trading environment.

Loffa has been helping firms for over 20 years, the CEO has extensive experience working with Prime Broker agreements, DVP trade verification, and SEC 17-A-4 letters for 20+ years.  Our Operations team is extensively trained and can assist in you your workflow processes.  Give us a call today:  Tel: 480 405-9662