NEW YORK, May 28 (Reuters) - U.S. trading on Tuesday

moved to a shorter settlement cycle for securities transactions,

putting investors and regulators on alert for increased trade

failures and other hiccups in the world's largest financial

market.

Investors in U.S. equities, corporate and municipal bonds

and other securities now must settle their transactions one

business day after the trade, instead of two, to comply with a

rule change adopted last February by the U.S. Securities and

Exchange Commission.

Regulators hope faster settlement will reduce risk and

improve efficiency. They 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.

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.

A big test for the market occurs on Wednesday, when trades

executed last Friday, when T+2 was still in place, and on

Tuesday, the first day of T+1, will be settled. This is expected

to lead to a rise in volume.

"There will be some growing pains and a few hiccups," said

Joe Saluzzi, co-head of equity trading at Themis Trading.

"Tomorrow morning we'll see if anything happened."

Another test occurs on Friday, when MSCI ( MSCI ) global

indexes will rebalance in a quarterly event, leaving some

participants concerned that one of the year's biggest trading

days could leave markets strained as they adjust to the new

system.

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, a subsidiary of the Depository Trust and Clearing

Corporation.

Trades fail when a buyer or seller do not meet their trading

obligation by the settlement date, which could result in losses,

penalty fees and hurt reputations.

The U.S. will be following India and China, where faster

settlement is already in place. Canada, Mexico, Argentina and

Jamaica implemented it on Monday.

"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.

TRADE FAILURES

Market participants such as banks, custodians, asset

managers and regulators worked over the weekend to ensure a

smooth switch.

"To date, all T+1 implementation activities have been

completed according to plan," said Jeff Naylor, chief industry

operations officer at ICI.

A rise in trade failures is expected initially, even though

DTCC and market participants have been conducting a series of

tests for months.

"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.

More failures could trigger "tens of millions of dollars

each day in penalty fees," said BNY Mellon.

On average, market participants expect the fail rate to

increase to 4.1% after T+1 implementation, from 2.9% currently,

research firm ValueExchange showed.

Sifma expects the fail rate increase to be minimal, and the

SEC said there may be a short-term uptick.

Ted O'Connor, senior vice president at financial technology

firm Arcesium, said some market participants were keeping

increased cash on hand to address issues that could arise from

the shift.

"The mid-size and the smaller managers are the ones that

we're going to be watching closely because they tend to be more

reliant on manual processes," he said.

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 and regulators say the shift will mitigate

systemic risk because it reduces counterparty exposure, improves

liquidity and decreases margin and collateral requirements.

"Shortening the settlement cycle ... will help the markets

because time is money and time is risk," said SEC chair Gary

Gensler in a statement.

Still, some market participants are concerned 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.

The move also requires exchange-traded funds (ETFs) to

juggle multiple jurisdictional requirements and capital needs.

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.