Update (May 13, 2018): Come late 2019, bank and broker-dealer members of the US Depository Trust & Clearing Corp. could look forward to reducing their settlement exposures by one day while retaining the current two-day settlement cycle. DTCC now says that US trades could be settled before the market opens on T+2 instead of the afternoon. The change is based on a new processing algorithm that would increase the percentage of trades settled in the night-time cycle to as high as 90 percent from the current 45 percent.
Published on February 7, 2018
What is the logical next step after moving from a three-day to a two-day settlement cycle? It isn’t necessarily to jump right into one-day or real-time settlement.
How about something in between? That’s the overall sentiment of 20 fund managers, broker-dealers and banks polled by FinOps Report over the past week. “It’s not as efficient as T+1, but easier to achieve,” says one operations manager at a US broker-dealer.
FinOps’ survey followed a recent white paper published by the US Depository Trust & Clearing Corp. Entitled “Maximizing the US Equity Markets,” it outlines the DTCC’s proposed strategy for its participants to achieve some of the benefits of a shorter settlement cycle without having to switch fully to a T+1 or real-time settlement timetable.
Instead of waiting for settlement finality to take place on the afternoon of the second day after a trade is executed, DTCC’s participants could pick “accelerated time to settlement,” or settlement finality on T+2 before the market opens, says DTCC. Technically speaking, the trade would be settling during T+2 but practically speaking it would be the late night of T+1 long after the market closes. Alternatively, banks and broker-dealers could agree to “settlement optimization” which could allow settlement would take place a little later on the morning of T+2.
The US moved to a T+2 settlement timetable in September 2017 without much fanfare. However, that was possible only because the securities industry started preparing long before the US Securities and Exchange Commission changed its rules in March 2017 to mandate the change. What’s more, most global firms had already adjusted to a two-day settlement cycle for Europe back in 2014.
Without a settled industry agreement on how an expedited settlement cycle might work, DTCC and its participants still have to reach a consensus, acknowledges DTCC. The market infrastructure would also need to consult with the SEC for some operational changes or new services. Yet even the smallest step to speed up the settlement cycle would be far better than no change, the DTCC suggests. Its white paper appears to be an introductory attempt to win over its participants to a somewhat abbreviated settlement cycle.
The process of “accelerated time to settlement” would be entirely optional, says DTCC in the white paper published late last month. Participants could agree to follow the faster settlement timeframe or continue settling during the afternoon of T+2. Alternatively, the “settlement
Although the “accelerated time to settlement” is described as voluntary, practically speaking that might not be the case. “It is likely that, once one or two large broker-dealers or custodian banks agree to adapt to accelerated settlement early on T+2, others will quickly follow suit,” predicts Michael Barrett, vice president of financial services consultancy Genpact Headstrong Capital Markets in New York.
Why? For starters, broker-dealers that settle earlier would probably have to contribute less capital to a default fund set up by the DTCC’s clearinghouse subsidiary National Securities Clearing Corp. (NSCC). Likewise, they would have quicker access to cash. Fund managers would see improved liquidity management if they receive cash payments more quickly. Custodian banks offering fund managers the ability to shorten their settlement cycle could also be more attractive as service providers, says Barrett.
Operations managers contacted by FinOps say they have not evaluated the financial merits of either of the two settlement timeables proposed by DTCC, but plan to create internal committees to do so. Already, fund management firms and custodian banks are forecasting that they will have more middle and back-office adjustments to complete than do broker-dealers.
“We will work with the DTCC, other broker-dealers, and custodian banks on industry-wide committees to figure out a timetable for when accelerated settlement could take place, what rule changes would have to be made and how the US Securities and Exchange Commission would fit into the equation,” says an operations director at a US broker-dealer. “Fund managers and custodians, who often work in batch rather than real-time processes will be farther behind technologically so they will have to invest in new systems.”
Here is how DTCC explains accelerated settlement: “an entire day of settlement exposure would be eliminated without removing a calendar day.” One ultimate benefit, DTCC agrees, is reducing the clearing fund contributions posted by NSCC’s participants, because counterparty risk would be reduced. Yet another: encouraging participants to implement more straight-through-processing abilities which would better prepare the industry for the potential of T+1 settlement, while allowing more time for innovative technologies — such as distributed ledger — to develop.
Why not real-time settlement? DTCC says that, while settling trades automatically after they are executed might sound appealing, it would eliminate the benefits of multilateral netting. Real-time settlement could even cause more harm than good by increasing capital requirements. Banks and broker-dealers would have to prefund the settlement of all their trades.
Ideally, accelerated time to settlement would go hand-in-hand with settlement optimization. However, if accelerated settlement becomes too difficult to achieve, DTCC suggests that settlement optimization or improving operational efficiency for participants could be the next best move.
One element of settlement optimization could be enhanced asset lending which would allow DTCC’s depository subsidiary Depository Trust Company to identify securities that can be lent and those that can be borrowed so that it can immediately complete a securities lending transaction. Meeting a shorter settlement cycle often requires financial firms to borrow securities.
An even more important aspect of settlement optimization would be an “additional settlement slice” which DTCC says offers the best of both worlds: it encourages intraday movement and settlement of money, while continuing end-of-day processing. Such a scenario gives banks and broker-dealers access to their cash earlier in the day and reduces their margin requirements. Any settled trades would be removed from DTC’s risk management controls. Settlement exposure would instead be limited to the activity open as of the latest settlement slice.
In promoting a shorter settlement cycle, DTCC is also encouraging fund managers, banks and broker-dealers to use its ALERT standing settlement instructions (SSI) database through a match-to- instruct service as well as an exceptions management service designed to help buy and sell-side firms clean up failed settlements more quickly. SSIs are instructions about where financial firms should transfer securities and cash to meet settlement obligations.
As DTCC explains in its white paper, match to instruct (M2i) would allow instructions for settlement to flow directly from a central dealer or investment manager match or affirmation platform, eliminating the need to instruct and match settlement data. How? According to DTCC, M2i would leverage the centralized settlement instructions in ALERT and create pre-matched settlement instructions. As a result, participants would eliminate the use of inconsistent standing settlement instructions held in local databases.
Although DTCC’s Exception Manager, which includes technology developed by London-based Taskize, can help market participants fix breaks in multiple post-trade processes, DTCC sees its primary role as preventing errors with SSIs. In a separate statement in early January announcing the launch of Exception Manager, DTCC says that 78 percent of its participants cited missing or incomplete SSIs as the biggest pain point affecting post-trade processes. Eighty percent also felt that faster resolution of exceptions is a key factor in a T+2 settlement environment.
Presumably, if financial firms determined that erroneous SSIs were the cause of settlement fails they might decide to use the ALERT database rather than local ones. Likewise, if financial firms understood other reasons for their settlement fails they would correct them and reduce the likelihood of future fails.