Back in 2000, there was a move to reduce the settlement period in the US to T+1 – settlement would occur the day after a trade – but the initiative was abandoned in 2002, leaving the industry with the current T+3 settlement that had been introduced in 1995 when the Securities and Exchange Commission reduced it from T+5.
But the attraction of shortened settlement times in reducing counterparty risk, in freeing capital and in reducing the systemic risk in the event of the failure of a market participant meant that the idea has never really gone away, and has now been advocated by the Depositary Trust and Clearing Corp – though following a due diligence process carried out by Boston Consulting Group and informal discussions with the market, it has decided to go with T+2 rather than going the whole way to T+1.
The DTCC returned to the idea in December 2011 with a paper entitled Proposal to launch a new cost benefit analysis on shortening the settlement cycle, which explored the steps that would be necessary to reach T+1 settlement.
The original T+1 proposal in 2000 came from the Securities Industry Association, the predecessor to today’s Securities Industry and Financial Markets Association, but faced with other industry issues – not least of which was the World Trade Center attacks in September 2001 – the SIA changed its focus in July 2002 from shortening the settlement cycle to achieving industry-wide straight-through processing.
In the meantime, the DTCC continued to modify the central infrastructure to support shorter settlement cycles, and says that its systems “are now broadly configured to support settlement cycles as short as T+1”.
The changes in the platforms, coupled with a global move to shortened settlement cycles, prompted the December 2011 paper: “Significant technology upgrades both at DTCC and in the industry broadly, including real-time processing for trade capture, same-day settlement capability, adoption of Financial Information eXchange (FIX) and other protocols, have been implemented. These improvements, in conjunction with increased industry focus on risk management and an awareness of European plans to move to T+2, have led a number of industry participants to call for reducing the US equity settlement cycle,” the paper says.
In response to that, BCG carried out a cost benefit study that examined a move to T+2 or T+1. The firm came up with an estimated industry cost of $550 million to adopt T+2 settlement and suggested that such a move could be achieved within three years, provided there were no major problems affecting industry resources.
The main advantage of doing so would be to cut the counterparty risk by moving trades more quickly to settlement, which would reduce the time period during which something could go wrong, preventing the trade from being successfully completed. This can be directly translated into a monetary value. In the analysis by BCG, the potential loss exposure the buy-side carries if a broker-dealer defaults was modelled in a series of scenarios. Under T+3, the study estimated that a ‘stress scenario would cost the buy-side $300 million, rising to $2.6 billion in a major failure scenario. However, those costs would reduce to $190 million and $1.6 billion respectively under T+2 and $80 million and $600 million under T+1.
The analysis also predicted a decline in broker to broker counterparty risk as measured by the DTCC’s subsidiary the National Securities Clearing Corporation. Such a reduction would be important for the market and especially for liquidity, because it would mean that less liquidity would be needed for the NCSS Clearing Fund, freeing up capital for broker-dealers to use elsewhere. A study from April 2011 to September 2011 found that reducing the settlement cycle would cut the NSCC’s liquidity needs by 20% and 50% in a T+2 and T+1 scenario, respectively.
The decision to implement T+2 rather than T+1 might seem an odd one, given that ostensibly T+1 would offer the greater advantage in terms of reducing settlement risk and cutting costs. However, the DTCC has acknowledged that “industry pushback” prompted its decision to opt for T+2 rather than T+1 as originally planned. While participants generally agreed with a shorter settlement cycle, some felt that going from T+3 to T+1 in a single step was too far. According to Rebecca Healey, senior analyst at Tabb Group, the decision to adopt T+2 is both more realistic and is a sensible move to keep the US in line with other global markets, while reducing the burden on the buy-side.
“They went for T+2 rather than T+1 because it’s more realistic,” she said. “Not all OTC instruments are traded on exchange there are still a lot of manual processes out there, for example corporate actions. When you move from a voice trading environment towards STP, there will be challenges. There’s still a long way to go before we reach a fully automated market, and forcing the asset management community towards T+1 would have increased the burden on them. T+2 is a better choice, at least for the time being.”
A shortened settlement cycle would also help to reduce the impact of market volatility by avoiding the increases in margin and liquidity needs that can happen during these times. The Clearing Fund represents the market risk the NSCC is carrying on behalf of its customers. Under T+3, the fund was at $4 billion on average for the period from October 2010 to August 2011, but reached $7.3 billion during a high volatility period in the latter month. Under T+2, that figure would have been 15% lower at $3.4 billion and 24% lower during the volatility at $5.5 billion, according to the BCG estimates.
The DTCC figures seem to be supported by independent research carried out by other global financial institutions. In Australia, which is currently considering its own move to T+2, the Australia Securities Exchange calculated that if T+2 settlement had been in place from June 2012 to December 2013, daily cash market margins for the total market would generally have been 20-30% lower, producing an estimated reduction of A$30-A$40 million in total margin payments with a consequent saving in funding costs for the industry. It added that in over ‘90% of cases, participants’ daily cash market margins would be reduced.
The DTCC concluded that investors would benefit from shorter settlement, since under US law the Securities Investor Protection Act, trades that have not yet settled are considered house trades or trades owned by the broker-dealer. They do not become client trades until the settlement completes, so if the broker-dealer goes bust before the settlement, the open positions are liquidated by the NSCC to cover the counterparty’s settlement. The end investor is subject to the risk of default prior to settlement, but by receiving their funds or securities faster, investors face reduced risk in periods of stress.
The move to T+2 is broadly supported by the industry. In the first half of 2014, various industry groups voiced their support, including the Investment Company Institute, the Association of Global Custodians, the Association of Institutional Investors and the Securities Industry and Financial Markets Association.
“ICI strongly supports DTCC’s efforts to shorten US settlement cycles on a timeframe that works for industry participants,” said Paul Schott Stevens, president and chief executive at ICI. “Aligning US settlement cycles with global market practices will improve the efficiency of markets and mitigate risks – all changes that will benefit investors. Funds and their investors benefit from efforts of this kind to strengthen our financial system, and we applaud DTCC’s efforts.”
It was also supported by some of the major global tier one banks, on the grounds that it would make the market safer. “JP Morgan supports the move to a T+2 settlement period because diminishing systemic risk is a major priority for us and for our clients,” said Patrick Kirby, chief operations officer of JP Morgan’s corporate and investment bank operations. “Both institutional and retail investors who trade with and through us benefit from the reduction in settlement time. This is a very significant step in making the industry safer and more reliable.”
While agreeing with the move in principle, some market participants have pointed out that there will still be challenges posed by shortening the settlement cycle, which will probably affect smaller buy-side firms more than brokers or large asset managers. On the plus side, the streamlining of risk workflows would provid benefits by putting the mid- and back-office centre stage, which was needed, according to Tabb Group.
“There’s nothing wrong with T+2,” said Healey. “We have had automation in execution but not really in the mid and back office. This has to happen eventually, and by taking manual processes out you can reduce risk. The main hurdle is that smaller firms will struggle to meet this. Looking at the mass of other regulatory challenges they are dealing with right now, this is not high on their priority list and many of them may get caught short.”
Those other challenges include Dodd-Frank and Basel III, which are designed to increase transparency in the equities and OTC derivatives markets and to force large banks to set aside more capital, as well as to make bilateral derivatives trades more expensive and to encourage more trading activity on exchange. The rules come with trade reporting obligations as well as the need to connect to new trading venues such as swap execution facilities for derivatives and CCPs for clearing.
Other preparations would also need to be made for T+2. In Australia, the ASX produced a checklist of factors that need to be in place for T+2. These included achieving higher rates of same day trade affirmation, improving matching and settlement efficiency, accelerated clearance of retail funds, managing the potential for increased settlement failure through changing the settlement batch cut off time or the introduction of alternative mechanisms for dealing with late settlements, and the sequencing of any potential Australian T+2 implementation with European or other major markets.
On this last point, the ASX was in touch with the same sentiment behind the DTCC white paper, which also cited moves towards T+2 settlement in Europe and Asia.
In Europe, most countries are due to move to T+2 in January 2015. There are some exceptions, but these are largely countries that are either already on T+2 or are moving ahead of time. Germany has already been using T+2 for a number of years, while France, Belgium and the Netherlands are moving in October this year. In Russia, the Moscow Exchange moved from T+0 settlement to T+2 over the summer of 2013, bringing one of the most significant BRIC markets into line with the emerging international standard.
In the UK, T+2 settlement will be introduced in 2015 under the Central Securities Depositories Regulation, which will create a common regulatory framework for securities settlement across the European Union. The CSDR mandates the introduction of a shorter, harmonised, T+2 settlement cycle across all 28 member states.
The DTCC also noted that much of Asia is already on a settlement cycle shorter than T+3. Hong Kong settles its securities on a T+2 basis, while Singapore is planning to move to T+2 by 2016. Japan is still T+3, but has also been considering a move to T+2 since 2011. Meanwhile the ASX launched a consultation on shortening the settlement cycle from T+3 to T+2 during February and April 2014, with a view to implement the change early in 2016. The possibility of aligning settlement cycles across geographies could help harmonisation, which would mean global funds would be better placed to manage cash flows, reducing and simplifying financing needs, according to the DTCC.
“After a comprehensive assessment of the potential impact on market participants, it’s clear that time equals risk,” said Michael Bodson, president and chief executive at the DTCC. “A shortened settlement cycle will substantially reduce risk across the industry and for underlying investors. As the industry is focused on mitigating operational and systemic risk and protecting the integrity of the US financial system, DTCC supports this critical step that will create greater certainty, safety and soundness in the capital markets.”
Proposals are still at an early stage, and there is not yet any confirmed timeline for the proposed change to T+2. The DTCC is currently seeking to set up an Industry Steering Committee for T+2, which would consult with the industry and begin to work out a date for the new shorter settlement cycle to be implemented. Assuming the plan proceeds without any significant obstacles, the DTCC expects the US to adopt T+2 later than Europe, which will move to T+2 in January 2015.