Revisiting the Past: U.S. Securities Settlement

U.S. T+1 Settlement: Hitting the Accelerator

February 09, 2022
  • Investor Services
Following dramatic market volatility events, the U.S. post-trade industry is deftly mobilizing to move securities settlement cycles to T+1. Adrian Whelan and Derek Coyle explore why shortening the U.S. settlement cycle is so significant to asset managers globally.

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.

Major Gains

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:

  1. Trading Workflows Compressed time-frame for all aspects of the lifecycle of a trade may require multiple operational and behavioral amendments.
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. 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.
  7. 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.
  8. 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.
  9. 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.
  10. 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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