NEW YORK/LONDON (Reuters) - Participants in the United States' multitrillion-dollar securities markets face an early test of their ability to cope with regulatory reforms to speed up trade settlement, as a major index rebalance scheduled to occur just days after the planned switch risks causing a spike in failed trades.

Starting May 28, U.S. stocks and corporate bonds must settle one business day after trading instead of two. Markets in Canada and Mexico are also adopting the reforms, which have been designed to reduce counterparty risk and improve market liquidity.

But just three days after this new standard - known as T+1 - takes effect, MSCI ( MSCI ) global indexes will rebalance in a quarterly event, leaving some participants concerned that one of the largest trading days of the year could strain markets adjusting to the new regime. The rebalance means funds must readjust their holdings to keep their mandates tracking the index.

"This really is the rubber hitting the road immediately after T+1 goes live," said Gerard Walsh, who leads Northern Trust's Global Capital Markets Client Solutions group.

"The MSCI ( MSCI ) rebalance occurs across thousands of funds, ETFs, portfolio structures," Walsh added. "It's a big deal."

The industry should brace for an immediate spike in failed settlements on account of several "separate-but-related market events," including the rebalance, Walsh added.

During the last rebalance, average global volumes spiked 120% in what was a $47 billion trading event across both developed and emerging markets, data from Northern Trust shared with Reuters showed. In the U.S., those volumes rose 199%.

"The concern is what hasn't been thought of rather than those things that have been solved for," said John Oleon, managing director of clearing and settlement operations at Clear Street, who also expects the fail rate to increase over the first week of the switchover.

Trades fail when a counterparty cannot deliver the securities or funds to meet their settlement obligations, which heightens the risk of financial losses, raises transaction costs and damages reputation, according to financial tech firm Gresham Technologies.

The U.S. Securities and Exchange Commission said faster settlement will make markets more efficient, but foreign investors will have less time to recall their U.S. securities and gather the dollars necessary to trade.

Some market participants are worried that the number of transaction failures could increase, which could hamper investors' efforts to adjust portfolios in line with MSCI ( MSCI ) benchmarks.

According to the Depository Trust Company, 83.5% of transactions from U.S. and non-U.S. firms in April were affirmed by the cut-off time of 2100 ET on trade date. Affirmation, where the parties to the trade agree on its details, is not required for settlement but helps to smooth the process and reduces the risk of failed settlement.

"DTCC is well prepared for the implementation of T+1 and we are confident in our ability to capture and process the additional volumes from the MSCI ( MSCI ) rebalance," said Brian Steele, president of clearing and securities services at DTCC. "We will continue to work across the industry and key stakeholders to ensure a successful T+1 implementation."  

Failed trades or delays in securities lending recalls can attract overdrafts or interest charges. Northern Trust's Walsh said overdrafts required to bridge the gap between trade and settlement can cost around 1.5 basis points per day.

"Index rebalancing could create some risks for funds and other entities as they shift their portfolios in a period where trading costs could become more elevated and settlement operations could require more attention," said Daniel Takieddine, chief executive MENA at brokerage BDSwiss.

Stephane Ritz, T+1 global lead, at CapCo, said clients expect to see around 3%-5% of trades failing immediately after the switch, in line with current fail rates. But clients are bracing for a higher fail rate in Asia, where the time frame is tighter, he said.

MSCI ( MSCI ) said it has been closely monitoring the evolution of clearing and settlement equity cycles globally, and has not changed its methodology or processes for markets that are speeding up.

"The alignment of settlement systems is critical for maintaining the stability of securities markets and protecting investors' assets," it said.

FORWARD PLANNING

Natsumi Matsuba, head of FX trading and portfolio management at Russell Investments, said there is a liquidity concern around the MSCI ( MSCI ) rebalance every quarter, but "if you are cognizant of making sure you can align both settlement cut off and peak liquidity - and get those FX trades in time, impact should be minimal."

The components of the rebalanced index are announced weeks prior to avoid taking markets by surprise, said RJ Rondini, director of securities operations at the Investment Company Institute.

"Likely, there's going to be added volume into trading on the Friday, May 31," Rondini said. "But the industry participants are very well aware of that rebalance. And we're hearing from members that it's going to add some volume, but not necessarily any complexity."