Settlement compression – where next?
24 August 2022
Now that India, the US and Canada have confirmed they are reducing trade settlement cycles from T+2 to T+1, what are the risks and what are the benefits? flow takes a closer look at accelerated settlement
Most securities transactions currently settle within a couple of days of the actual trade date. So, for stock bought on a Wednesday, the buyer would have paid for the shares and the seller would have delivered them by the Friday, with the buyer becoming the holder of record of that security (T+2).
A combination of better technology, the sheer volume of securities trading and regulatory momentum is making this window smaller. The flow article ‘Accelerated settlement – the move towards T+0’ (Sep 2021) examined the trend of market volatility driving compression of the securities settlement cycle and outlined the benefits and risks of shorter settlements.Despite the ongoing global transition towards a harmonised T+2 settlement cycle, some market participants believe that improvements are still needed. Following unprecedented market volatility in 2020 and 2021, there are growing calls for a further compression of the existing T+2 settlement cycle to either T+1 (trade date + one day) or T+0 (same day). However, such a shift will not be a straightforward exercise.
India, the US and Canada make the leap
To date, three major markets – India, the US and Canada – have each confirmed they will transition their trade settlement cycles from T+2 to T+1. India has been phasing in T+1 for publicly traded equities since February 2022. Starting with the bottom 100 stocks by daily market capitalisation, it has since added 500 stocks each month, so that all of India’s 5,200 stocks will be settled on T+1 by January 2023. Most Foreign Portfolio Investors (FPIs) have not been affected by India’s transition yet, as their exposures are mainly to blue chip equities, which are not currently settling on T+1.
Turning to the US, after its relatively trouble-free transition from T+3 to T+2 in 2017, the Securities and Exchange Commission (SEC) confirmed in February 2022 that the market would shorten the settlement cycle from T+2 to T+1 by no later than Q1 2024. The SEC’s decision comes in the wake of a high-profile campaign pushing for T+1 adoption led by a number of market participants in the US. This includes the Depository Trust & Clearing Corporation (DTCC), the Securities Industry and Financial Markets Association (SIFMA) and the Investment Company Institute (ICI), together with market makers such as Citadel Securities and Virtu Financial.
As Canada’s financial markets are so deeply interwoven with those of the US, the country has also pledged to adopt T+1 in 2024, in lockstep with its southern neighbour. Market participants have commented that it is likely other markets with close financial links to the US will also introduce T+1 in due course.
Explaining the sweeping away of T+2
While a handful of experts have been arguing the case for T+1 for some time, it was the equity market volatility triggered by Covid-19, and the meme stock trading turmoil, which highlighted to the world the risks of having to wait two full days for a trade to properly settle. Supporters say a compressed settlement cycle will help negate settlement, counterparty and operational risk.
The principle benefit of leveraging T+1 – as opposed to, say, T+2 – is that the former has a shorter settlement duration, meaning there is significantly reduced operational and counterparty risk between different trading counterparties.
This can enable firms to lower their Central Counterparty Clearing House (CCP) margin requirements, leading to meaningful capital and collateral savings. The DTCC notes that shorter rolling settlement cycles could help unlock vast sums of untapped liquidity once market participants no longer need to post as much margin on trades to cover counterparty exposure.
While the DTCC concedes there might be some implementation costs to adopting T+1, it expects financial institutions to ultimately achieve net savings and benefit from infrastructure modernisation and the standardisation of industry processes. This could bring about greater straight-through-processing (STP) and help the industry shift away from manual-based activities, which in turn should improve accuracy and resiliency.
In India, where retail trading is dominant, local brokers – many of whom have suffered from margin contraction over the last few years – believe that T+1’s introduction could help stimulate trading volumes once again. “The key benefit is that capital can be deployed more efficiently. Imagine being able to buy a stock today and sell it off tomorrow – this might actually be possible under T+1,” says Sriram Krishnan, Head of Securities Services, India and Sub-Continent, Deutsche Bank.
T+1: no change without risk
For all the anticipated benefits, there is a tacit acknowledgement that T+1 could also pose logistical challenges. For financial institutions operating in different time zones, settlement compression can create inefficiencies, especially around trade matching, end of day reconciliations and foreign exchange (FX) management.
This is because the traditional two-day settlement window helps global investors manage FX, but a shift to T+1 would force FX to be booked on the same day/T+1, meaning all parties in the settlement chain will need to confirm trades on the trade-date – potentially resulting in issues around pre-funding.
Despite the potential risks, market participants anticipate the T+1 transition will be smooth, provided the industry makes the technology changes that are required in advance of the deadlines. “As long as the industry continues to implement new technologies to address accelerated settlement, then T+1 should be achievable,” reflects Kamalita Abdool, Head of Securities Services, Americas, Deutsche Bank.
Past precedent in the US also suggests that T+1’s adoption will be pain-free. For example, experts warned that settlement fails would skyrocket ahead of T+2’s adoption in 2017, yet these issues never materialised.
T+0: the future beckons
While there is scepticism about the merits of introducing a T+1 settlement cycle without impacting the value chain, market practitioners are also open to T+0.
Again, the benefits of shorter settlement cycles (e.g. less counterparty risk, capital and liquidity savings) ring true for T+0 just as they do for T+1. It is also clear that many of the barriers inhibiting T+1 are likely to inhibit the future adoption of T+0 as well.
“The end goal for settlement compression must be T+0”
But Mike Clarke, Global Product Manager, Securities Services, Deutsche Bank, explains, “The end goal for settlement compression must be T+0 and this can be facilitated through the adoption of disruptive technologies, such as Distributed Ledger Technology (DLT), smart contracts and Central Bank Digital Currencies (CBDCs) or digitalised versions of central bank-issued money.” He explains that by leveraging such technologies, cross-border transactions could potentially be settled more quickly, culminating in T+0 or even atomic settlement (the instant exchange of two linked securities).
This could help market users procure massive operational and cost savings, especially as instantaneous settlement would remove the need for CCPs.
Similarly, the emergence of CBDCs could play a role in bringing about T+0. CBDCs – digital iterations of fiat currencies issued by central banks, which are stored on a DLT – engineer efficiencies in securities settlement by using central bank money. As investment into these technologies increases, the possibility of delivering on T+0 will grow.
Markets such as India are already exploring the viability of such technologies, with the Reserve Bank of India poised to introduce a digital rupee in 2023.
However, technologies such as DLT, digital assets and smart contracts are not subject to uniform industry standards or common regulation. Without basic harmonisation, the ability for market participants to operate with each other in post-trade processes, such as settlement, risks being undermined.
More fundamentally, T+0 will never be achievable unless other activities in the investment value chain become real-time or instant as well. For example, if payment settlement systems and FX processing continue to rely on antiquated or legacy technologies, then T+0 will be harder to achieve. Only if there is meaningful digitalisation across the entire transactional lifecycle will T+0 become a reality.
Where do we go from here?
Having introduced T+2 smoothly, the industry is confident T+1 will be seamless, especially as there is ample time until implementation. If T+1 provides the risk management benefits claimed by its proponents, then calls for further settlement cycle optimisation will inevitably grow.
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