U.S. stock markets have been on a rollercoaster ride over the last two years. Starting with the stock market crash on Monday, March 9, 2020 which saw the Dow Jones Industrial Average fall by its largest amount ever, two more record-setting point drops followed on March 12 and March 16, respectively. These triggered several unparalleled instances of trade volume and market volatility spikes.
All this occurred due to the uncertainty and fears around the rapid spread of the coronavirus globally, oil price concerns, and the looming possibility of recession after a sustained period of growth and relative certainty. Thankfully, the stock markets recovered, even as the pandemic persisted, and healthy trading volumes (and returns) were restored.
That didn’t last long. A confluence of events at GameStop led to a populist movement of retail traders that ultimately led to record levels of stock trading and the skyrocketing of the video game retailer’s stock price by 8,000% over a six-month period. On January 28, 2021, Robinhood, the de facto trading app for retail traders, controversially halted buy trades in the GameStop stock. A public outcry about unfairness to retail traders subsequently led to U.S. Congressional hearings to assess the events leading up to and including January 28.
One outcome of the hearings was that the U.S. Securities and Exchange Commission (SEC) was tasked with assessing areas of improvement in the U.S. securities trading infrastructure. This included settlement cycles for U.S. securities, a vital but largely unheralded area of stock market commentary usually, and the functioning of trade margin requirements at the U.S. Depositary Securities Clearing Corporation (DTCC).
The review resulted in a robust technical analysis of post-trade settlement. In the aftermath of the GameStop event, many market participants made loud and vociferous calls for atomic settlement (T0), or the instant exchange of two assets whereby the transfer of one asset occurs if and only if the transfer of the other asset also occurs, and the certain assertions of the imminent necessity to substitute the antiquated securities infrastructure for more modern solutions such as Distributed Ledger Technology. However, U.S. post trade industry has used this high-profile event as an inflection point to properly discuss the advantages and challenges of a shortened settlement cycle for U.S. trading.
Billions, Trillions & Quadrillions
The significance of that discussion lay in the sheer size of U.S. stock markets. In 2020 alone, the DTCC and its subsidiaries cleared and settled more than US$2.15 quadrillion ($2,150,000,000,000,000) in securities trades.
At the height of the March 2020 pandemic fueled volatility, the DTCC set a new single day record, processing more than 363 million equity trades. That beat the prior high around the time of the 2008 financial crisis by 15%. Material increases in intraday margin calls during periods of heightened volatility can greatly impact trading firms, and liquidity can be strained as traders draw down credit lines and increase liquidity buffers. Longer trade settlement windows equate to higher counterparty risk which further result in increased margin requirements designed to mitigate those risks. It all adds up to additional trading costs and reduced liquidity for asset managers, usually within the most volatile and stressful trading sessions.
The last major revision to U.S. securities settlement happened in September 2017, resulting in a successful transition from T+3 to T+2 across the securities settlement ecosystem. Put simply, the longer a settlement cycle, the more time there is between trade execution and settlement for a trading counterparty to become insolvent or for the value of a trade to deteriorate. In other words, the longer its settlement cycle, the greater the credit and operational risk attached to the trade.
This time/risk dynamic impacts the amount of margin and collateral that is required to be deposited with the clearinghouse as a risk mitigation to the securities trade. It then follows that a reduced settlement time equates to a reduction in risk as well as margin and collateral requirements. So, the move to T+1 is also underpinned by a strong desire to bolster the efficient use of capital across U.S. trading markets.
On average US$13.4 billion is held in margin at the DTCC daily just to manage counterparty default risk in the system. Shortened settlement cycles could reduce this margin amount which could instead be actively deployed for trading purposes and alleviate liquidity pressures, particularly on days of heightened volatility. Therefore, the most logical way to reduce the underlying risks that drive margin requirements is to shorten the settlement cycle. DTCC’s published risk model simulations show a 41% reduction in the volatility component of its margin by moving to T+1.
In addition to reducing certain risks, shortened settlement cycles in turn open-up an opportunity for asset managers and others to capture certain ancillary benefits. These include more efficient use of funds as less cash is tied up in margin calls, thus conceivably reducing potential drag on fund performance and the opportunity costs associated with holding larger cash buffers. Market liquidity, even in times of volatility, is also likely to improve as brokers have fewer margin calls and capital concerns so can make better use of their capital to facilitate trading.
Forcing Firms to Automate
An indirect but likely effect of the shortened cycle is that it will force less efficient firms to automate manual processes and upgrade trading technology to meet the heightened demands and constrained timelines inherent in T+1. This has benefits for the wider market as its likely to create industry-wide virtuous circles of operational risk reduction and increased productivity. More efficient trade processing naturally results in the elimination of sub-optimal or redundant processes which in turn saves time, reduces errors, and decreases trading costs. The exponential market impact of everyone being a little bit more efficient and greater standardization of industry practices should not be underestimated.
Hitting the T+1 Accelerator
While the reasons for the change are compelling, there are important initial requirements for U.S. stock market participants to take in. Industry groups have already provided a useful roadmap entitled “Accelerating the U.S. Securities Settlement Cycle to T+1” setting out the technical requirements. The scale of securities in scope means that this transition has multiple considerations, and the overall project must insulate investors from further risks resulting from the changeover.
Additional important considerations include:
- Protecting the market from undue disruption caused by the change;
- Using the project as an opportunity to improve upon existing industry practices particularly where there are natural opportunities for increased process automation and efficiencies, and;
- Ensuring that the benefits of the transition to T+1 ultimately outweigh the risks and that new risks are not introduced from the modifications.
In terms of the initial practical impact assessments here are the top 10 considerations as the market looks to assess the shift towards U.S. T+1:
- Trading Workflows Compressed time-frame for all aspects of the lifecycle of a trade may require multiple operational and behavioral amendments.
- Foreign Exchange (FX) The U.S. dollar plays a seismic role in global cross border trade and U.S. T+1 triggers multiple funding and settlement considerations across almost all global FX markets.
- Corporate Actions Revisions and coordination of corporate action ex-date and record dates are necessary, which will further require material amendments to SWIFT messaging and instruction automation for U.S. securities.
- Exchange Traded Funds (ETF) The existing NSCC ETF batch service already operates to tight timeframes and operational change and credit line support are possibly required for U.S. ETFs with global securities where settlement cycle is longer than T+1 for non-U.S. securities.
- Trade Amendments Remediation of incorrect trade inputs is now under an even tighter timeframe to avoid trade fails, so increased focus on prevention and remediation of trade errors will be crucial.
- Prime Brokerage The SEC’s Prime Brokerage (PB) No Action letter will need to be revised to allow PBs to effect settlement through continuous net settlement models. Significant PB contractual changes are also required to reflect T+1.
- International Coordination U.S. T+1 will create some new settlement misalignments where foreign securities will operate to different settlement timeframes. In addition, other countries such as India are also moving to T+1 settlement. Alignment or managing such misalignments will be a key factor.
- Securities Lending Standard batch processing and security recalls should operate in a much-compressed time-frame, as such streamlined processes and tighter deadlines will apply to the current general operating model for U.S. securities lending.
- Documentation A multitude of industry documentation will need to be revised to reflect the new settlement cycle. The NSCC buckets these documents into three types: (1) transactional (2) administrative and (3) agreements.
- Not Merely a U.S. issue Given the move to a shorter settlement cycle affects any global asset manager or bank that trades U.S. securities, it’s important that there is some form of global coordination to assist this latest vast market transition.
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