By any measure, the United States has the most liquid, efficient and cost-effective capital markets in the world. The critical role that DTCC plays may not be well-known outside the financial services industry, but it fundamentally benefits everyone who participates in capital markets, ranging from the largest public companies to main street investors who rely on markets to help fund their retirements, raise capital to start a business, buy insurance or obtain loans to purchase a house or car.
In part two of a three-part series, DTCC: Providing a Public Good, we review the key advances in clearance and settlement and how they have benefitted the markets.
Part I: From Paper Certificates to Quadrillions of Dollars in Securities Each Year
Part II: ADVANCES IN CLEARANCE AND SETTLEMENT
As a result of centralized clearing and settlement, markets are more efficient, reliable, and nimble, and DTCC has been at the forefront of this transformation. Here’s a look at some key advances in clearing and settlement and how they promote safety and soundness in equities markets.
Clearance and Settlement
Centralized Clearing and Settlement: After counterparties agree to the terms of a trade, the clearinghouse steps in to guarantee that the buyer gets its shares and the seller its cash. Initially, clearing and settlement was done bilaterally between two parties. Today, DTCC serves as the central third party that guarantees completion of the trade, greatly reducing counterparty risk. DTCC’s clearinghouses also have introduced risk-reducing practices, such as multilateral netting (discussed below), that significantly reduce the value of trades that are settled each day. The rise of DTCC (and its predecessor clearing agencies) also helped eliminate operational risks associated with messengers running stock certificates up and down Wall Street to settle every trade individually through the exchange of paper certificates.
As a result of centralized clearing and settlement, markets are more efficient, reliable and nimble.
Reducing Settlement Times: Settlement finality occurs when the parties to a transaction fulfill their obligations under a trade by exchanging funds for delivery of the securities. As clearing became more centralized, settlement times have been drastically reduced. For many years, the markets operated on a T+5 settlement cycle—meaning trade date plus five business days to settlement. In 1995, U.S. regulators reduced the settlement cycle from five business days to three business days. In 2017, after many years of a wide-reaching, extensive technology and operational effort—coordinated and harmonized across global markets and regulatory bodies—another day was removed from the settlement cycle. Today, the industry completes settlement for trades in equities and certain debt securities on the second business day after a trade is executed, T+2. NSCC has long supported processing trades on T+0 or T+1 for participants that request it, all while leveraging existing technology. Moving from T+3 to T+2 resulted in reducing the average daily capital requirements for clearing trades through NSCC by approximately 25 percent from 2017 levels, saving the industry $1.36 billion in margin requirements.
Accelerating settlement for the market to T+2 was a complex and time-consuming initiative that reinforced the biggest challenge was not technology—DTCC’s current infrastructure supports T+1 and limited T+0 settlement cycles today—but rather process and procedure. For example, market behavior, legacy infrastructure and operational processes at client firms make it challenging to accelerate further without a coordinated industry effort. The potential benefits of further accelerated settlement, including reduced market risk and lower margin requirements, have reignited industry discussions about ways to achieve additional value. Initiatives under review include settlement optimization, as well as the possibility of intraday movement and settlement of money and securities instead of the traditional focus on end-of-day settlement. In January 2020, DTCC implemented changes to the settlement night cycle, further increasing processing efficiencies. DTCC continues to closely collaborate with the industry to evaluate opportunities that would accelerate settlement beyond T+2, including potential support for varying forms of settlement such as real time gross. However, real-time gross settlement could potentially require that transactions in the U.S. market be funded on a transaction-by-transaction basis, and thus lose the liquidity and risk-mitigating benefits of today’s netting features.
In February 2021, DTCC released, Advancing Together: Leading the Industry to Accelerated Settlement, which outlines a two-year industry roadmap for shortening the settlement cycle for U.S. equities to T+1. We look forward to advancing this important work in partnership with our clients, the regulatory community and key stakeholders, as we have done for decades, to deliver greater value and risk reduction for the benefit of clients and ultimately the end investor.
Reducing Risk and Increasing Liquidity in the Market
Trade Guarantee: The clearinghouse interposes itself as the buyer to every seller and the seller to every buyer to guarantee that a trade eventually will settle, even if the original buyer or seller defaults.
Netting: Through multi-lateral netting, NSCC reduces the total value of trades that will be settled by an average of 98% each settlement day. At the end of each trading day, netting consolidates the amounts due from and owed to a firm across all the securities it has traded to a single net debit or a net credit position. To illustrate, over a 28-day sample in the months of November and December 2018, the average gross settlement balance was $326 billion, and the net was $32 billion, 90% of the funding needs were eliminated via netting. When combined with other DTCC margining and risk management protocols, the $5.1 trillion in gross notional daily settlements were reduced to a net daily obligation of almost $400 billion. As a result, faster settlement times reduced the amount of margin required, improving market efficiencies.