The move by the US securities industry from a T+3 to T+2 settlement cycle in September 2017 introduced greater levels of safety and stability across equity markets, building upon the move from T+5 to T+3 almost two decades earlier. Now, the industry is eyeing a move to shorten the US standard settlement cycle for equities transactions once again, this time to T+1, or achieving settlement one day after a trade is executed. Such a move would further reduce market risks and capital requirements, bringing margin relief and greater safety and resiliency to the industry.
The industry discussion on the move to T+1 gained momentum in 2020 as the Covid-19 pandemic spread around the world, creating volatility and uncertainty across markets. A bout of additional market volatility in the first quarter of this year highlighted the level of risk that remains across financial markets, reinforcing the importance of the settlement cycle and cementing focus on the topic.
After all, any period of time between trade execution and trade settlement introduces risk, as it represents a window of time during which ownership of a security and the receipt of payment are in limbo. To address this risk, firms need to provide margin to cover potential losses should a party to a transaction default on their obligation. Today, that margin covers the trade date plus two days. A move to T+1 would reduce this funding requirement by one day, significantly increasing market efficiency and mitigating risk, especially during extreme market volatility.
At the same time, a shorter settlement cycle would free liquidity, or margin, held to ensure the completion of trades. In fact, it is 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 Depositary Trust and Clearing Corporation’s (DTCC’s) National Securities Clearing Corporation (NSCC) subsidiary collects.
While such a move would not be without complexities, the industry believes that T+1 is achievable with broad collaboration and coordination across a number of procedural and process changes to areas such as allocations, affirmation and disaffirmation processes, clearinghouse processing timelines, securities lending, prime brokerage, foreign exchange and the global movement of securities and currency. DTCC, in partnership with industry associations the Securities Industry and Financial Markets Association and Investment Company Institute, is currently working on an analysis to assess each of these areas and define solutions and next steps, including the impact such a move would have on cross-border transactions.
Bridge too far
But, why T+1? Why not focus on T+0 or real-time settlement? Before examining potential benefits and risks of shortening the settlement cycle beyond T+1, let’s first define T+0. T+0 is when a trade settles on the same day it is executed or “same-day settlement”. That is different from “real-time settlement”, when a trade is cleared and settled in real-time, or instantly.
From a processing perspective, DTCC already has the operational capability to clear and settle transactions same-day on a T+0 basis. In fact, more than one million same-day transactions are processed at DTCC’s depository every day. That said, introducing T+0 across the industry as the new standard settlement cycle for all transactions would be a far more complex undertaking, requiring foundational changes to how securities trade and settle today. This would include large scale redesigns of global settlements, margin investing, financing, foreign exchange and securities lending, among other critical considerations.
Optimal settlement cycle
A T+1 settlement cycle would substantially lower the level of risk and uncertainty arising from unsettled trades during market volatility while greatly enhancing capital efficiency. It would also allow firms to continue to take advantage of DTCC’s netting feature, a key cost savings to the industry. Central clearing and netting continue to be the most efficient and beneficial way of settling trades, which is critical to the safe and efficient functioning of the US capital markets. Every day, netting reduces the value of payments that need to be exchanged by an average of 98%. On an average day in 2020, DTCC’s NSCC netted down US$1.77 trillion dollars in total trade activity to a final settlement value of just under US$38 billion.
While the move to T+1 will deliver significant efficiency and safety to the system overall, the industry, in its continuous desire to improve, will continue to analyze the impact of a future move to T+0 and will incorporate enabling functionality where applicable. However, T+1 is the optimal settlement cycle for right now. It will bring substantial benefits to the industry and, with a coordinated effort, it is achievable.
Michele Hillery is the general manager of equity clearing and DTC settlement service at DTCC.