NEW YORK, May 28 (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 sped up their market transactions a day earlier,

changing to one day 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 ( GME )

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 were working over the weekend to ensure

a smooth switch, the Securities Industry and Financial Markets

Association (Sifma) said last week. A virtual command center had

been created with over 1,000 participants who will join calls to

discuss the transition.

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.