Amid the Gamestop saga, Robinhood’s CEO has called for a fix on the ‘antiquated settlement structure’, but others in the industry argue the current T+2 settlement cycle is ‘ultra reliable’ and a real-time system could lead to many challenges
The financial system’s current standard of trade date plus two business days (T+2) has become somewhat of a hot topic over the past few months.
Amid the Gamestop saga, Robinhood’s CEO Vladimir Tenev recently called for a fix on the “antiquated settlement structure’”, and is pushing for it to be modernised, suggesting T+0 is the way forward.
But is the system ‘antiquated’ or is it extremely reliable and well understood?
The settlement date for stocks used to be T+5, or five business days after the transaction date, before moving to T+3. Now at T+2, the natural progression would seemingly be for the industry to work its way down to T+1 and then to T+0.
Although there are no real fundamental technological issues that would prevent the move to a real-time settlement system, major work would be required due to significant behavioural and operational challenges.
Real-time settlement means that as soon as a trade is executed, it is recorded immediately, the money and securities move between the two parties and the trade is complete.
According to industry expert and consultant Tony Freeman, the systems can do it but it is the willingness and capability of market participants to do it that makes the difference.
With the current system, you can have the cash or stock expected to arrive which allows for the trade to be settled. Same day/real-time settlement would mean settling every trade individually and if you are buying then the cash will need to be immediately available and if you are selling then you’ve got to have the stocks, meaning every purchase would need to be pre-funded.
Freeman says: “This would massively reduce the number of transactions that are possible in the market and also requires real-time processing. The retail market is simply not geared up to do this. They are not professional investors. While they may be technologically sophisticated in the way they trade, they are not all operations/back-office professionals.”
“There are quite a few retail investors involved in the Gamestop phenomenon that didn’t seem to understand margin. There were massive amounts of trading taking place in a relatively small stock but a lack of huge amounts of trading meant that lots of failed trades occurred, which will increase the margin required by the clearinghouse,” he adds.
“This came as a surprise to many people, which tells me that they are not sophisticated about the middle office and back-office processes, and they do not really understand the full rules of the game despite being in the market.”
He emphasises that “T+0 is a non-starter, it cannot happen”. T+1 has lots of fundamental issues that would need to be resolved as it does require quite a lot of process improvement. The cost of moving to T+1 is significantly higher.
Freeman continues: “I have heard the word ‘antiquated’ a lot. This is a pejorative term that I do not agree with. Some of the platforms in use are quite old but the benefit of that is that they are ultra-reliable and well understood. There is a significant risk in saying we are going to move to blockchain technology and the disruption risk in migrating to an entirely different form of technology is largely significant.”
It is important to remember that this is a cautious part of the market and it has to be cautious, Freeman highlights.
It is highly regulated and it has to be risk-averse. Settlement cannot fail because it would block up the whole market, which is why clearinghouses are classed as systemically important.
“Breezily saying blockchain could solve the problem is to understate the complexity and underestimate the risk in the market,” Freeman adds.
T+2 = reliable?
Robinhood’s CEO deflected blame for shutting investors off from buying $GME and other meme stocks by suggesting it was down to the T+2 settlement cycle because that creates counterparty risk.
Mark Profeti, principal consultant of Capco, says: “Yes, the two-day window between trade date and settlement date does create counterparty risk. However, this risk is addressed by central clearing counterparties (CCPs) calling margin from market participants to protect against exposures in the event of counterparty default.”
But Profeti notes that extreme price volatility is likely to impose credit and trading restrictions on some investors who do not have the financial resources to cover margin calls under such circumstances. At the same time, he says it should also be recognised that events like $GME are an exception and not the norm.
One of the major drawbacks of T+2 is that one break in the settlement chain causes the entire transaction to fail. The centralised and bilateral settlement model means cash and securities change hands through multiple transactions to finally arrive at the beneficial owners.
Ageing legacy technology severely limits the ability to have a real-time picture of securities inventory and cash pools to ensure that settlement happens on time, suggests Profeti.
He says: “This is further compounded by market infrastructure systems that operate settlement windows and cannot provide a real-time market view of settlement, asset inventory and exposure to settlement fails. Most of the time it’s down to educated guesswork – and that creates additional operational costs due to over-funding or unnecessary borrowing of securities.”
The importance of netting
Despite this challenge, the current settlement process does have many advantages.
Netting is an extremely important benefit of the settlement process and moving to T+0 would remove all of these significant netting advantages.
Same day settlement is a huge stretch target that would require immediate settlement of all transactions, no netting, no end of day processing and no overnight cycle.
The current settlement cycle model allows large amounts of trading to take place. For example, you can trade as much as you like in a particular stock — buys and sells — with the relative certainty that your net position is ok at the end of the day, or at the end of T+1 or T+2.
Experts identify this is because of all of the netting that takes place, which involves clearinghouses. Liquidity and lots of trading, particularly retail trading which is done on margin, is facilitated.
Freeman remarks: “Netting facilitates much expanded liquidity, if you didn’t have netting and you had to settle every trade individually then you would have a vastly small number of transactions, reduced liquidity and inefficient price discovery and a more inefficient market.”
Michael McClain, DTCC managing director and general manager of equity clearing and DTC settlement services, recently discussed the challenges and potential pitfalls of real-time settlement with the major aspect to this being around netting.
DTCC’s equities clearing and settlement subsidiaries, National Securities Clearing Corporation (NSCC) and Depository Trust Corporation (DTC), already support some T+1 and even same-day settlement using existing technology.
McClain emphasises that by netting down or reducing the total number of customer trading obligations that require the exchange of money for settlement, NSCC helps to minimise risk and free up trillions of dollars of capital each year.
Every day, NSCC nets down these trades and payments among its participants, reducing the value of payments that need to be exchanged by an average of 98 to 99 per cent.
According to McClain, centralised netting and settlement dramatically increases the efficiency of US markets by reducing the capital requirements and overall risk.
In terms of how the lack of netting in real-time settlement would negatively impact investors and the markets, McClain argues that this is a significant issue when you consider the volume of transactions being processed every day.
“With real-time settlement, the entire industry – clients, brokers, investors – loses the liquidity and risk-mitigating benefit of netting, and that is particularly critical during times of heightened volatility and volume,” says McClain.
Tried and tested?
If you look around the world, there are no other markets that operate in real-time same-day settlement.
Saudi Arabia moved to a T+0 settlement and reverted back to T+2 to make the market more attractive to overseas investors.
“I would not say the US market, for example, has a similar dependence on overseas investors, but a very large part of US volume does come from abroad so overseas investors need to be considered when you analyse the pros and cons of shorter settlement cycles,” says Freeman.
This brings the issue of timezones into play, and it is important to note that the foreign exchange (FX) market operates on a T+2 settlement cycle.
Given that Saudi riyals cannot be held in a sterling or dollar-based investor’s portfolio, it would be inefficient to conduct a FX transaction every time the investor wanted to buy Saudi stock.
Freeman explains: “This is because you would have to reverse it back into your base currency. You have to wait two days for that FX transaction to settle whereas you’re settling the stock trade one day so you have a one-day funding situation — you borrow money at an agreed rate, and it is more operational grit in the system. So the FX market remains a T+2 settlement cycle — a barrier towards T+1 securities settlement cycles.”
However, settlements can be made quicker in the FX market through a continuously linked settlement (CLS), a specialist bank for FX transactions. Freeman says it is large, important but also low profile — it doesn’t make much noise.
The concept of CLS was created a long time ago. There is a risk issue called Herstatt risk, named after a bank that went bust in the 1970s. They carried out speculative FX transactions and they received payments from one part of their counterparts but they hadn’t paid out to their counterparties on the other side of the transaction resulting in their counterparties being out of pocket significantly. Their counterparties lost out on a permanent basis.
Freeman comments: “CLS is designed to eliminate the Herstatt risk. Most banks are members of CLS. It is a background process. Institutional investors or hedge funds can settle their FX transactions via their agent bank through CLS but it costs extra money. The T+1 settlement cycle is more expensive than a T+2 settlement cycle. This is why I think Saudia Arabia moved back to T+2.”
New data needed?
While previous studies carried out have identified that the majority of industry participants found there to be too many challenges with a T+0 platform, could the industry be in need of new data for this?
In October 2012, the Boston Consulting Group (BCG) completed a study of the potential impacts of accelerating settlement for US equity trades, which reported that shortening the time period between trade execution and settling payment for US cash securities transactions could reduce the industry’s costs and risk exposure by several hundred million dollars annually.
At the time of the study, the securities industry completed settlement for trades in equities and certain debt securities on the third day after a trade is executed (T+3).
The report noted that most players considered a move to T+0 to be infeasible for various reasons, including the impact on foreign counterparties and limited timeframe for exception processing and reconciliation.
It highlighted that this would result in major challenges with processes such as trade reconciliation and exception management, securities lending and transactions with foreign counterparties — especially where time zones are least aligned.
Payment systems utilised for final settlement would also need to be significantly altered to enable transactions late into the day.
More recently, on 24 February 2021, the DTCC launched a two-year industry roadmap to shorten the settlement cycle for US equities to one business day.
By the end of Q1 2021, DTCC anticipates the completion of prototype development for the Project Ion settlement system, which provides a T+1 environment for the industry on a digital platform using distributed ledger technology (DLT) and other emerging technologies.
Another key date in the two-year roadmap is H2 2022, where DTCC plans to start transitioning to an enhanced settlement model that more closely integrates processes from DTCC’s equities clearing and settlement subsidiaries, NSCC and DTC.
Studies have shown an integrated settlement model could provide an 11 per cent reduction in the volatility component of NSCC margin.
Meanwhile, the final date is 2023 when DTCC proposes the US settlement cycle to officially move to T+1, with market participant and regulator alignment.
Looking to the future beyond T+1, Capco’s Profeti believes digitisation and tokenisation of assets will be the catalyst for the move towards T+0.
Capco envisages that crypto assets will be the first T+0 standard markets, and eventually will be followed by private markets in tokenised assets (including collateral) that operate on single DLT ledgers supporting the end-to-end product and trade lifecycle.
According to Profeti, industry-wide adoption is a longer-term ambition and the overall journey is likely to cause some market fragmentation – but on the other side of the argument creates a more truly competitive landscape that allows markets to evolve and innovate.
Profeti concludes: “T+0 settlement is not a practical objective in a centralised settlement model – the multiple legs in the settlement chain, IT system limitations and lack of real-time transparency of securities and cash inventory across multiple accounts and depots mean that the settlement efficiency rates and costs would take a real hit in a T+0 settlement enviro
