Reducing the settlement cycle presents global post-trade challenges

The recent announcement by the Depository Trust and Clearing Corporation (DTCC) advocating that the settlement cycle for US cash equities should be shortened from two days to one (T+2 to T+1) is not revolutionary, as globally there have been markets operating on same day settlement (T+0) and a T+1 basis for decades.

Many markets, such as Russia, have historically operated on a T+0 basis for certain securities markets, to ensure there is no mismatch between buyer and seller. Equally, T+1 is used in many markets, for example, in Canada and the US for products including money market funds and options as well as US, Canadian and Japanese Government Bonds and Commercial Paper which are all settled on a T+1 basis.

From a post-trade perspective, more efficient asset transfers have real advantages. DTCC has cited lower capital risk as a major benefit, as it removes one market day for the settlement of most trades which would significantly reduce the risk capital required to guarantee trades. This would allow for greater capital efficiency as lower clearing fund requirements will be needed, reducing the level of liquidity guarantee for settlement activity and ensuring the continued availability of trade netting.

During the recent retail trading boom in the US which focused on specific equities, broker Robinhood reported it had to suspend trading for its clients on several of those stocks because the lack of real-time settlement meant that risk capital had to be provided against the open positions yet to be settled. Despite being unlevered, this made cash security trades too expensive to fund.

By contrast, the instant settlement cycle of digital assets through distributed ledger technology (DLT) means investors will not experience the same settlement issue. However, if exchange-traded products (ETPs) are traded based on digital assets, these will follow the settlement cycle set by the settlement house used by the exchange which lists them. This is clearly a concern for institutional investors and their brokers, who are supporting the use of securities, digital assets and ETPs or futures which use them as underlying.

Of course, there are challenges created by differences in settlement efficiency. Operationally, having anywhere from T+0 to T+3 as settlement cycles for difference securities is difficult to manage. Back office technology may be too rigid to cope with the multiple assets being processed, and if different platforms are used for each asset class, there is a greater chance of a mismatch in settlement due to operational failure.

Mismatches between settlement periods potentially leave the investor settling trades out of order. This can incur costs from a broker who has to cover cash or securities needed to fund the trade. The ability to process delivery versus payment on a T+0 or T+1 basis creates operational challenges. Securities are typically held in custody by third party custodians; if they are traded into the market via a broker, the transfer of assets requires an investment firm to authorise the custodian to send the securities to a broker in order to trade, without introducing any implementation shortfall.

If a broker holds the securities directly, they may not have the necessary account segregation to protect client assets from being traded incorrectly or held securely in the event of bankruptcy, a problem noted during the MF Global default in 2011.

Mismatches in settlement also creates other risks further down the securities processing lifecycle; sell-side firms can have very complex management of inventory and capital obligations. Reducing the cost of holding certain assets requires money market engagement such as repurchase agreements, in order to hold lower risk assets. The collateral demands of cleared derivatives trades place great importance on the commitment of risk-free assets, and a liquidity shortfall would have serious implications for a margin call. Integrating risk management into the post-trade settlement lifecycle will therefore be very important in the new T+1 environment.

To handle multiple settlement regimes and different asset classes, an effective back-office platform must be flexible; it needs to provide real-time reporting, based on a real-time, event-driven operating model. While it may be componentised – and a modular approach can allow asset classes to be handled as needed – using a single platform is ideal to minimise messaging errors between systems.

The DTCC announcement is interesting because of the scale this implies for capital markets firms globally and the convergence with the rise of digital assets. It also highlights three key challenges:

  1. The netting of trades and payments for its participants is a key function of DTCC, reducing the value of payments that need to be exchanged by an average of 98% each day. Any log jams in a T+1 process will back-up quicker than a city freeway.
  2. To support the T+1 US move, alongside the T+0 settlement of digital assets, and the T+2 model used in Europe and other markets, banks will need to ensure their own post-trade processing is as flexible as possible.
  3. Tracking client positions in multiple asset classes with a range of different settlement cycles, potentially including different settlement times between underlying assets and the ETPs / futures which are a derivative of them, will put the risk and collateral management functions under severe strain. Operational failures will have a costly impact for both brokers and clients.

Outside of the US, the rest of the world is going to pay attention to these issues. If the domestic market operators see these benefits materialising, especially those that led the way when T+2 was introduced such as London, Paris and Frankfurt, they may also head down the same track. Banks will need to ensure their back offices are prepared for the multi-asset, multi-settlement cycle of the future with the most resilient, modular platform they can engage with.