DTCC’s latest white paper, Advancing Together: Leading the Industry to Accelerated Settlement outlines a two-year industry roadmap for shortening the settlement cycle for U.S. equities to one business day after the trade is executed (T+1).
Mike McClain, DTCC Managing Director and General Manager of Equity Clearing and DTC Settlement Services, discusses the findings in the paper and the next steps necessary to galvanize support and lead the industry to an accelerated settlement cycle.
Q: What are the industry benefits of accelerated settlement?
A: Time to settlement equals counterparty risk, and margin requirements, which are designed to mitigate those risks, represent cost to members. The immediate benefits of moving to a T+1 settlement cycle could mean cost savings, reduced market risk and lower margin requirements.
Today an average of over $13.4 billion is held in margin every day to manage counterparty default risk in the system. Shortening the settlement cycle would help strike a balance between risk-based margining and reducing procyclical impacts.
In one significant finding in the paper, our risk model simulations have shown that the Volatility component of NSCC’s margin could potentially be reduced by 41% by moving to T+1, assuming current processing and without any other changes in client or market behavior.
Q: What is multilateral netting and why is it so beneficial?
A: 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.
Allowing trades to “net” settle reduces the total amount of cash and securities that have to go back and forth throughout the day, and eliminates a significant amount of operational and market risk. 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 netting reduces the value of payments that need to be exchanged by an average of 98-99%.
Q: Why stop at T+1 or T+½? Why not go to real-time settlement?
A: Real-time settlement is a simple technical solution but a very complicated market structure change. While the industry should continue to aspire to real-time, it is more pragmatic to reduce the settlement cycle in stages to capture the benefits faster. With real-time settlement in today’s market structure, 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, on 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. In a real-time settlement scenario, netting is not possible and trillions of dollars in cash and securities must move through the financial system on a continual basis throughout the trading day. This creates massive market and capital inefficiencies, increases credit and operational risks, and increases costs between trading parties, possibly undermining the stability of the markets.
Accelerating settlement requires careful consideration, industry coordination, and a balanced approach so settlement can be achieved as close to the trade as possible (for example, T+1 or T+½), without creating capital inefficiencies and introducing new, unintended market risks, such as eliminating the enormous benefits and cost savings of multilateral netting.
Q: What needs to be accomplished to accelerate the industry’s settlement cycle to T+1 and beyond?
A: DTCC is prepared to move quickly to lead the industry to accelerate the settlement cycle to T+1 and beyond. NSCC and DTC already support T+1 and even some 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. Many don’t realize, DTC has always been a T+0 settlement platform ever since its inception in 1973 -- even when the industry settled at T+5, T+3 and now T+2.
As we describe in the paper, 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.
Equity clearing and settlement is part of a much larger ecosystem of linked financial markets. Accelerating the settlement cycle would have upstream and downstream impacts on other parts of the market structure, including derivatives, securities lending, cash borrowing, foreign exchange and collateral processing, and developing a new accelerated settlement system could fundamentally change current market structure. In order to move to T+1, industry participants must align and implement the necessary operational and business changes, and regulators must be engaged.