Michael McClain, DTCC Managing Director and General Manager of Equity Clearing and DTC Settlement Services.
This is the second of a two-part interview about clearing and settlement of securities transactions with Michael McClain, DTCC Managing Director and General Manager of Equity Clearing and DTC Settlement Services.
In the first interview, McClain discussed DTCC’s advocacy for accelerating the settlement cycle from the current standard of trade date plus two business days, or T+2, to T+1 or potentially T+½ to enhance market resilience, reduce risk and the related margin requirements and lower costs for investors. 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, though many market participants do not use this option due to market structure complexities, legacy business and operational processes.
In this Q&A, McClain discusses the challenges and potential pitfalls of real-time settlement.
Q: What is real-time settlement?
McClain: It's exactly what it sounds like: 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.
Q: That is exactly how we transact in many other aspects of our lives so why can’t securities settle in real time, especially with today’s modern technology?
McClain: While real-time settlement seems simple enough on the surface, it is not practical in financial markets. If I can buy something on Amazon or order groceries online and receive it the same day, why can’t my securities trades clear and settle instantly? But that presumption is flawed in one critical way: If Amazon or an online grocer doesn’t have the product, you have to wait until it’s in stock or accept an alternative. That isn’t an option when trading securities. There’s a fixed price, at a specific time, for a specific security that may be trading thousands of times a day. And the only way the markets work effectively is if buyers and sellers are absolutely certain they will receive their cash or securities.
Q: Why wouldn’t my broker have sufficient securities or money on hand at any given moment to settle my trade?
McClain: Many people buy securities on margin, which is a loan from the broker to the investor that is collateralized by the stock in their account. To pay for these securities, the broker will arrange financing. Margin financing can be done in real time only if the broker has prefunded resources in the amount of the margin loan. This would place a tremendous drain on the dealer’s resources, however, and also would be difficult for the dealer to track in a high-volume, fast-moving market. In addition, the broker would need to have almost unlimited prefunded resources, particularly around the open and close, in a real-time settlement scenario. So real-time gross settlement would significantly hamper margin purchases of stock, which is an important tool for investors.
One of NSCC’s primary roles in the industry is netting — the automatic process of offsetting a firm’s buy orders for a particular security against its sell orders for that security. Netting consolidates the amounts due from and owed to a firm across all the different securities it has traded to a single net debit or a net credit.
By allowing trades to “net” settle, it reduces the total amount of cash and securities that have to go back and forth throughout the day. This eliminates a material amount of operational and market risk.
Q: Why is netting so beneficial?
McClain: By netting down or reducing the total number of customer trading obligations that require the exchange of money for settlement, NSCC helps to minimize 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 98-99% .
Centralized netting and settlement dramatically increase the efficiency of U.S. markets by reducing the capital requirements and overall risk. NSCC’s centralized multilateral netting, trade guaranty and settlement of nearly every equity trade have contributed to making the U.S. markets the deepest, broadest and most liquid in the world.
Q: Can you give an example of how netting works?
McClain: Sure. Under a T+2, T+1 or even T+½ scenario, if an investor purchases 100,000 shares of Stock A from a brokerage in the morning, and a different investor with that same brokerage sells 98,000 shares of Stock A in the afternoon, at the end of the day, the net difference to the brokerage is only 2,000 shares. That “netting” provides multiple benefits to the markets, including reducing the amount of cash and equities changing hands by 98% in this example. This materially reduces operational and market risk that each firm takes on in the industry, and it enables firms to arrange financing on behalf of their clients.
Q: How would the lack of netting in real-time settlement negatively impact investors and the markets?
McClain: 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.
For example, looking at a typical trading day, NSCC processes an average of about $1.7 trillion in equities transactions. The multilateral netting process reduces that number by about 98%, and the total value settled is around $38 billion. Netting allows brokerages to transfer that $38 billion between parties only once at the end of the day. Put another way, in a real-time settlement scenario, netting is not possible, meaning trillions of dollars in cash and securities would be moving through the financial system on a continual basis throughout the trading day, creating massive market and capital inefficiencies, increasing credit and operational risks, and increasing costs between trading parties, possibly undermining the stability of the markets.
Q: Would real-time settlement make it impossible to fund trading on a secured basis?
McClain: Yes. This point was highlighted in a white paper, “Steampunk Settlement,” which Greenwich Associates and DTCC published in June 2019. The paper explains that real-time settlement doesn’t allow traders to pledge shares they have yet to transact as collateral. Instead, trades would have to be prefunded and on an unsecured basis, which could diminish market liquidity. In other words, sellers must have the shares on hand and buyers must have cash on hand. If either party doesn’t, the trade can’t be completed. It also assumes that no clients would be buying securities on margin, or credit, from the brokerage.
Q: What would be the impact of real-time settlement on predictive financing?
McClain: The challenge is that clients likely would not know their financing needs for a given day until the markets have closed, which could make securing end-of-day funds or determining intraday investment amounts difficult and very costly.
Q: Is the industry able to perform real-time reconciliation and create real-time stock records to comply with regulations?
McClain: Yes, the industry has the technology to move to these straight-through processing features. As I noted earlier, real-time settlement is technically possible but eliminates important netting and financing opportunities in the market.
Q: Do you think real-time settlement will ever be a viable option and eliminate the need for a central counterparty?
McClain: It's possible that some type of service could exist to match end buyers and end sellers, but the same problem exists: How do you trust that the buyers have the cash and the sellers have the securities? Remember, the transaction is complete at the click of a button, and you’d need to have a lot of faith in that new system. This still doesn’t resolve all the inefficiencies and added risk that would be created using a real-time settlement model.
Buyers and sellers would be anonymously matched on exchanges and each party would rely on the credit of an anonymous counterparty. Many participants are not willing to accept this kind of credit risk.
Q: What’s the best option to accelerate settlement beyond the current T+2 schedule?
McClain: We strongly support moving to T+1 or even T+½. The reality is that we already have the capability to clear and settle in T+1 or even the same day using existing technology, and in fact, we clear a number of T+1 trades every day. In our discussions with the industry, many firms appear ready to start revising their processes to accelerate settlement. They realize it’s in their best interest: Shortened settlement times reduce market risk and margin requirements, which would allow firms to use those resources in other ways.