By Patrick Warch, Baker Tilly
In an ideal situation, all securities trade transactions would settle as close to real time as possible. Therefore, the securities industry continues to evaluate an accelerated settlement cycle for U.S. equities by 2023, from the current two business day (T+2) settlement cycle to a one business day (T+1) settlement cycle. These efforts are in response to the 2021 road map released by the Depository Trust & Clearing Corporation (DTCC), a financial services company that provides clearing and settlement services for financial markets.
Over the past 30 years, substantial steps have been taken to shorten the traditional settlement time. For many years, prior to 1995, the U.S. markets operated on a five business day (T+5) settlement for transactions. This meant that the transaction needed to be paid for or settled within five business days after a transaction. In 1995, this shifted to a three business day (T+3) settlement to expedite the overall process. Then, in 2017, the U.S. Securities and Exchange Commission (SEC) adopted an amendment to shorten the standard settlement cycle even further for most broker-dealer securities transactions from the T+3 to T+2. The goal was to expedite the process while enhancing efficiency. At the time, the SEC acting chair, Michael Piwowar, stated, “As technology improves, new products emerge, and trading volumes grow, it is increasingly obvious that the outdated T+3 settlement cycle is no longer serving the best interests of the American people. The SEC remains committed to ensuring that U.S. securities regulation is reflective of modern times, and in shortening the settlement cycle by one day we aim to increase efficiency and reduce risk for market participants.”
The shortening of settlement times would lead to benefits such as a decline or reduction in counterparty exposure risk, liquidity needs, collateral calls, market risk and overall collateral needs. On average, more than $13.4 billion is held in margin every day to manage counterparty default risk that cannot be utilized for other purposes, according to the DTCC. If transactions settled more quickly, these funds could be used by entities for other purposes. The actual process of being able to reduce the settlement time is an involved process that requires a great deal of assessment by identifying operational and business impacts and ensuring that no new risks are introduced by speeding up the process.
When the shift was made in 2017, the DTCC stated that once the T+2 settlement time was achieved, it would continue to work with the industry to assess readiness for a further move to T+1 settlement. This shift would lead to further reduction in capital requirements and the associated market risk. These goals became even more accelerated in 2020 during the COVID-19 pandemic based on the increased trading volume and market volatility. A quicker settlement cycle could reduce risks and margin calls required during times of increased activity. The DTCC estimated that, “removing one day from the settlement cycle could bring a system-wide average of approximately 41% reduction in the volatility component of the margin that DTCC’s National Securities Clearing Corporation (NSCC) subsidy collects.”
The shift to T+1 settlement will require significant work among organizations as it would be a fundamental change to market structures and processes. T+1 will allow for the industry to continue to retain the risk-mitigating benefits of netting. If netting was not possible, then each transaction would need to be funded on a transaction-by-transaction basis and would significantly increase cash movement. Through netting, the DTCC estimates that every day it reduces the value of payments being exchanged by an average of 98%. According to the DTCC, on “an average day in 2020,” its NSCC netted down $1.77 trillion in total trade activity to a final settlement value of just under $38 billion. Being able to retain this ability to net is essential to mitigate risk as it reduces the required cash flow from one entity to another.
The time frame associated with this change to T+1 is still being finalized as there will be a great deal of modifications that need to be planned and tested to ensure they have been appropriately implemented. The DTCC released a proposed staged rollout in February 2021 estimating this change could be made over a two-year period in which the shift would target completion in the second half of 2023. The DTCC noted that the timeline is subject to developments and review of market participants, however, they believe it is realistic. The U.S. is not the only country making this push to T+1; it is an evolving goal of multiple countries. Each transition will be monitored to see if there are any additional risks or unexpected consequences that other countries can learn from during their own implementation.
Overall, this shift could add greater efficiency to the settlement process and potentially help us strive for even quicker settlements in the future. There will be a push for T+1/2 or even same-day settlement (T+0) once T+1 has been implemented, but those potential changes will require a more complex makeover and redesign of numerous aspects of the U.S. system. The goal is always to ensure that any advances aren’t outweighed by inefficiencies or new unintentional market risks and, hopefully, will lead to a process that is as optimized as possible.