NEW YORK (Reuters) - U.S. trading moves to a shorter settlement on Tuesday, which regulators hope will reduce risk and improve efficiency in the world's largest markets, but is expected to temporarily increase transaction failure for investors.

To comply with a rule change the U.S. Securities and Exchange Commission (SEC) adopted last February, investors in U.S. equities, corporate and municipal bonds and other securities must settle their transactions one business day after the trade instead of two as of May 28. Canada, Mexico and Argentina will speed up their market transactions a day earlier, on Monday. The UK is expected to follow in 2027, and Europe is considering the change.

Regulators sought the new standard, commonly called T+1, after the 2021 trading frenzy around the "meme stock" GameStop highlighted the need to reduce counterparty risk and improve capital efficiency and liquidity in securities transactions.

"Shortening the settlement cycle... will help the markets because time is money and time is risk," said SEC chair Gary Gensler in a statement, adding it will make the market infrastructure more resilient.

However, it comes with risk since firms have less time to line up dollars to buy stocks, recall shares out on loan, or fix transaction errors, which could heighten the risk of settlement failures and raise transaction costs.

Trades fail when a buyer or seller does not meet their trading obligation by the settlement date, which could result in losses, penalty fees and hurt reputations.

"Hopefully, we'll start to see the benefit that we expect to see which is the reduction in risk, a reduction in margin or collateral, and we're hoping that this happens without serious impact to settlement rates," said RJ Rondini, director of securities operations at the Investment Company Institute.

Settlement is the process of transferring securities or funds from one party to another after a trade has been agreed. It takes place after clearing and is handled by the Depository Trust Company (DTC), a subsidiary of the Depository Trust and Clearing Corporation.

The U.S. will be following India and China, where faster settlement is already in place.

WEEKEND CALLS

Market participants, such as banks, custodians, asset managers and regulators will be working over the coming weekend to ensure a smooth switch. A virtual command center has been created with over 1,000 participants who will join calls to discuss the transition, the Securities Industry and Financial Markets Association (Sifma) said.

On Monday, which is a U.S. holiday, all eyes will be on Canada, Mexico and Argentina. Any hiccups there could impact the U.S., said Christos Ekonomidis, T+1 program director at BNY Mellon.

On Wednesday, there will be another big test for the market as trades executed both on Friday, when T+2 was still in place, and on Tuesday, the first day of T+1, will be settled, leading to an expected rise in volume.

More trade failures are expected initially, even though DTCC and market participants have been conducting a series of tests for months. A rise in failure was observed in 2017, when the U.S. moved the settlement period to two from three days.

"It's perfectly normal that we'll see some sort of small change in settlement rates... but we expect that settlement rates will quickly return to normal," said Rondini.

On average, market participants expect the fail rate to increase to 4.1% after T+1 implementation from 2.9% currently, a survey by research firm ValueExchange showed. Sifma expects the fail rate increase to be minimal and the SEC said there may be a short-term uptick in it.

Brian Steele, president of clearing and securities services at DTCC, said more than 90% of the industry has been participating in the process since testing started in August 2023. There is still "a deep level of muscle memory" from the industry's move to T+2 in 2017, he said.

RISK/REWARD

Trade bodies say the shift will mitigate systemic risk because it reduces counterparty exposure, improves liquidity and decreases margin and collateral requirements.

Still, some market participants are concerned that the change could transfer risks to other parts of the capital markets such as trade-related foreign exchanges to fund transactions and securities lending.

Foreign investors, who hold nearly $27 trillion in U.S. stocks and bonds, must buy dollars to trade these assets. They previously had a whole day to source the currency.

Natsumi Matsuba, head of FX trading and portfolio management at Russell Investments, said the firm was using small trades weeks ahead of implementation to test market liquidity after hours during times it is known to be sparse to see how many bank counterparties were extending weekend trading hours.

Market participants may have to rely on overnight funding markets to bridge liquidity gaps caused by different asset settlement timings, which could be costly given that short-term financing rates exceed 5%.

Gerard Walsh, who leads Northern Trust's Global Capital Markets Client Solutions group, said managers need to be aware of the potential range of solutions available.

"I don't think any of that fleshes itself out on week one," Walsh said.