A new white paper from Omgeo suggests that, if achieved on a global scale, improved settlement efficiency could be one of the most positive examples of post-trade infrastructure reform since the onset of the financial crisis.
The paper, 'The road to shorter settlement cycles', focuses on efforts to create a trade date environment in the US and across the global markets. Omgeo, a provider of post-trade processing services, defines a trade date environment (TDE) as the completion of the middle-office, post-trade processes on trade date. This includes the confirmation/affirmation/matching process that occurs between brokers and investment managers, and the delivery of settlement instructions to the appropriate settlement agent (clearing broker/global custodian).
The move to shorter settlement cycles (SSC) in the US and other major markets has been accelerated by the experience of the global financial crisis, says the report. Regulators, policymakers and market participants recognise the benefits of SSC as reduced risk, lower operational costs and increased liquidity.
The initiative will occur first in Europe through the forthcoming CSD Regulation (CSDR), with the US likely to follow. "Should the US accelerate, that, combined with the EU initiative, will likely drive some Asia Pacific markets on a T+3 cycle to reconsider, such as Australia and Japan.
Omgeo sees TDE as a prerequisite to such a development. "TDE can only be obtained through mandated trade date matching (encompassing a settlement matching requirement) and improved accuracy and expanded coverage in the account and standing settlement instructions (SSI) process," the paper suggests. Central trade matching and faster communication of accurate SSI data will be dependent on the use of automated processes.
The white paper describes today's global settlement landscape as one of multiple non-harmonised settlement cycles ranging from five days after execution to zero (same-day settlement), with each market determining its settlement cycle individually. There is also widespread disparity in settlement cycles across asset classes. Equities generally employ two, three or five day settlement cycles, but fixed income instruments are frequently settled in one or two days. Money market instruments often settle same day or in one day, and FX trades often employ a two-day cycle.
The US status quo
The settlement cycle for US equities, corporate bonds and municipal bonds has not changed since 1995 when the market moved from T+5 to its current T+3 cycle, the paper points out. "While the US was once a leader in looking to accelerate to a T+1 cycle over a decade ago, the initiative was tabled after September 11, 2001, as firms turned their attention to other areas of risk. At the time, it was also acknowledged that there were technology and automation challenges that limited firms' abilities to support an accelerated cycle, forcing the T+1 discussion to the back burner," it notes. However, with the industry continuing to explore ways to minimise US market and counterparty risk, participants have re-started the conversation around implementing SSC in the US.
The paper cites a business case analysis by Boston Consulting Group (BCG) of the impacts of shortening the trade settlement cycle in the US financial markets for equities, corporate and municipal bonds and unit investment trust (UIT) trades. "While it does not make any recommendations on accelerating the settlement timetable to T+2 or T+1, [BCG] states that up to 75% of all survey respondents view SSC as a way to reduce risk across the industry, with 68% supporting the move and up to 60% mentioning their firms would benefit directly from risk reduction," it observes. Other key benefits cited included process efficiency, reductions in loss exposure and cost savings.
As part of its proposed changes to the US settlement process, DTCC, the US central securities depository, is suggesting a "settlement matching" rule. "Currently, the US is the only market in the world that does not require a match, or a formal agreement on the economic details of a trade between the settling parties, before a trade is settled," Omgeo points out. "This gap leaves the US market exposed to increased risk reversals and trade failure. Requiring settlement matching across institutional trade processing is an essential step to improving settlement efficiency and intraday finality."
The paper acknowledges that a move to T+2 or T+1, in any market, will require industry-wide infrastructure changes including, but not limited to, operations, market practice, behaviour and technology. In operations specifically, firms will be required to look across the entire trade lifecycle, with a particular focus on the middle office, where post-trade activities occur. "The past decade has seen massive increases in execution capabilities in the front office, stemming from a rise in communication speeds and processing power and an explosion in the use of highly automated, algorithmic trading systems, which can execute thousands of trades or more per second," the paper observes. "By contrast, the post-trade lifecycle has not kept pace, and in many firms, remains littered with manual processes that limit a firm's ability to handle volume fluctuations, increase their operational risk and slow trades from moving to settlement. In a T+1 or T+2 environment, these middle office processes will need to be improved in order to achieve the proposed timelines set out by regulators and industry bodies."