At first thought it all looks so much less risky if settlement is merely an overnight novation but on second thoughts, #Itscomplicated, writes Patrick L Young…

Settlement is like a vital organ. Something we take for granted 99% of the time. On the mercifully rare occasions when caught by a shortness of breath suddenly we appreciate the miracle of life…then tend to go back to taking said organs for granted. So too settlement is a process which just seems to miraculously happen. Nobody really gives it a second thought. This year, however, settlement is at the epicentre of our thoughts as market practitioners face a third major securities settlement shortening in as many decades.

T+2 Is Barely A Decade Old In Major Markets

Remarkably it’s just under a decade since the EU went from T+3 to T+2. The US only shortened to 2 day settlement in 2017! Around the exchange ‘parish’ many veterans can recall the analogue times when settlement in many locations amounted to something akin to “T+forever!”

When the “Capital Market Revolution!” got up to speed during the 1990’s the move to digital technology accelerated the settlement cycle. Previously the issue was not merely the lack of interconnected technology but the underpinning of paper share certificates. Physical delivery took time - London’s 2-3 week “account” trading period (with T+5 on top after that!) had originally been created to assist arbitrageurs delivering stock by horse and boat from the Amsterdam exchange centuries before the settlement window narrowed to just T+5 in 1995! 

Albeit Some Emerging Markets Have Settled Faster

Incidentally, sub T+2 settlement has already been achieved. Kazakhstan, and Russia achieved a remarkably frictionless T+0 with dematerialised tech-driven settlement up to a decade before US/EU went from T+3 to T+2. However internationalisation stopped that process as they had to walk back to T+2 to settle stock overseas through foreign CSDs like Clearstream, DTCC and Euroclear. With sanctions reducing the constraints of dealing with western foreign investors, MOEX in Moscow moved to T+1 settlement at the end of July 2023.

While the US will take advantage of the Memorial Day holiday weekend to move to T+1. Canada and Mexico will also move on the same day, May 28th. On January 27th, the Indian stock market took the bold leap to T+1 settlement. India’s Regulators, Sebi, are already planning for T+0. Meanwhile, it’s fascinating to note that, unlike the monoglot USA with DTCC, India has achieved T+1 settlement across 2 fully operational CSDs providing settlement, CDSL & NSDL primarily linked to the BSE and NSE respectively.

Dematerialisation & Short Selling Issues

India’s somewhat stellar dematerialisation push in recent years helped the process of settlement cycle shortening. Nowadays 99.9% of trading is in “demat” stock. Another huge advantage for India in leading the move from T+2 to T+1 was the ban on naked short selling.

Short selling per se may not be the problem but borrowing the stock to cover the ‘short’ is an issue. With T+2 settlement, there is a day “cushion” to be prepared for settlement. T+1 also impacts the settlement of stock trades by counterparties in other time zones. The spectre of Wall Street going T+1 even on simple transactions is raising concerns in the likes of Asia where staff in Hong Kong, Singapore, Tokyo et al will have only a very narrow window to settle trades before the US markets reopen late at night in South-East Asian time. Will Asian staff have to start work in the middle of the night in order to effect a smooth T+1 settlement? With the US now amounting to over 50% of global market capitalisation, there are concerns in back offices across the world, even Europe where US markets close around bedtime. Investment trade body AFME reckons the available window of office processing time for settling US trades will shrink from 12 to 2 hours for European counterparties.

T+1 settlement concerns are exacerbated by short selling & stock borrowing. This is an acute problem because many processes have often not kept up with Ultra Low Latency (ULL) front end market practice. Fax machines are not unknown in some back offices… The stock borrowing / lending business tends to exist as a broker function. Expect to see a lot more automation of stock borrowing on exchange-like platforms to facilitate the much narrower window to initiate stock borrowing, or in more complex situations, close one ‘borrow’ and open another within a narrow window ahead of a single sleep to settlement!

Apps / Microservices & Platforms To Reduce Settlement Failure?

Therefore halving settlement in pure time terms from T+2 to T+1 days may actually exacerbate the risk of settlement failures, at least in the short term until the entire ecosystem becomes more automated and seamlessly integrated. Nevertheless this will require a lot of diligence and significant investment. Moreover, it’s going to require a lot of management thinking - and ostensibly out of the box thinking - compared to the normal daily practice of settlement which remains fundamentally linear.

CCP Is More Vital Than Ever

It’s remarkable to think that as recently as 1999 there was widespread scepticism about CCP clearing for securities transactions across the industry. Nowadays it’s de rigueur for cash markets. That vital risk concentration, even across a shorter timeframe won’t novate itself away in the T+1 universe. Thus CCP clearing is more vital than ever the shorter the time horizon.

Asides from stock loans, some key concerns to settlement in the new timeframe include:

•  Time required for trade allocation, confirmation / affirmation plus custodian instruction
• Achieving forex conversions in a shorter window (perhaps outside local market hours)
• Addressing exceptions: AKA Anything that may make a settlement tricky to achieve and even  delay its completion.
• Corporate Actions
• Global products with components from markets moving to T+1 - ETFs and depositary receipts (DRs).

Holistic Automation Will Be Key To Smooth Settlement

Again automation can help deliver a smoother workflow. Albeit that means automated platforms operating beyond traditional exchange hours to enable the entire counterparty settlement chain from brokers through investors to their custodians. With so many risks to the settlement chain, the provision of CCP ‘insurance’ ought to be a welcome relief for the free functioning of markets. T+1 poses the risk of short-term volume decline as concerned counterparties reduce trading activity while ensuring their systems can support the shorter settlement window.

How Much Collateral “Saved?” A Tricky Question

While the swift math is to suggest settlement time reductions mean less collateral required for trading, it may not be as simple to calculate as say with T+3 to T+2 in 2017. Settling overnight may require more collateral to be with brokers ahead of trading - perhaps full pre-funding. This could raise net funding costs outright for some. At the broker / clearing agent it may be that more credit lines can be opened but this is likely to be subject to regulatory (perhaps even central bank) supervision at scale and be relatively costly for brokers to maintain… Again automation is key but so is regulatory common sense for cross border traders in particular.

Naturally fines may be applied for settlement failure. However overzealous penalties may simply discourage trading while more microservices are teed up to smooth the more automated settlement process!

How Will Existing Systems Fare?

In essence legacy settlement technology in terms of novation through Real Time Gross Settlement (RTGS) ought not to encounter major difficulties in the core final reckoning of Delivery Versus Payment (DvP). Clearing microservices from Vermiculus for instance can already calculate risk within microseconds and novate in similar timeframes. However, it is in teeing up the processes around that ultimate DvP function which arouses a lot of issues to which the solution must realistically be a series of new automated processes. That entails a lot of new often inter-related but separate software applications which coalesce around and communicate into the core DvP hub.

As noted, CCP clearing will be vital to oversee the risk to the entire trade chain.

• In T+1 there is acute pressure to ensure the right allocations will be made to the correct custodians when the final settlement takes place.
• Ensuring any lent stock can be reborrowed and thus settlement achieved has been hugely compressed.
• Simply moving money from A to B may take more than the settlement cycle - particularly where forex transactions may be involved.
• Purchasers may need more collateral in cash than, say bills or liquid securities to ensure they can pay for their securities.

 In relation to the above and for example ensuring trades do not involve non T+1 products (e.g. ETFs or DRs), automating a fast route to sufficient forex funds, accessing all of an institutions parties (custodians etc) means the settlement hub is now likely to sit as the epicentre hubs of multiple settlement microservice spokes, including but not limited to stock borrowing / lending platforms, financing / leverage prime brokerage funding and more…

What a Difference A Day Makes…

People talk most about risk when markets are open. However, big problems often arise post trade and after the market close. Moving settlement to T+1 may cause a sleepless night for some albeit there are considerable possibilities to deploy better technology with more interactive platforms to deliver smooth trade settlement. T+2 to T+1 is a big leap but it still leaves a LOT of seconds in the settlement system where risk can emerge… We are all used to 24 hours in a day but few consider that amounts to 86400 seconds. In an ULL trading environment that’s a lot of risk to be mitigated. CCP clearing will remain a vital tool because the settlement window is shorter!

Debate on T+0 is already apparent. It’s an exciting time for settlement change as T+1 beckons in many markets.

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Former exchange CEO Patrick L Young wrote the first bestselling book on fintech “Capital Market Revolution!” (FT) in 1999.

Patrick publishes the daily news service of the bourse business, the Exchange of Information, “Exchange Invest” read by the world’s leading thinkers in market structure and is actively involved in developing new marketplaces around the world.