When Will The U.S. Have Real-Time Stock Settlement? 🕒
At Portfolio Insider, our vision statement reads; “The future will not be reported quarterly.” This statement not only sums up our passion for democratizing access to the world’s most valuable financial data, it also sheds light on the archaic plumbing the world’s most advanced economy deploys for capital markets.
There’s no greater example of the archaic infrastructure in U.S. markets than the raising voices calling for faster transaction settlements.
After the GameStop retail trading frenzy, popular iOS trading app Robinhood was forced to restrict trading on a few highly shorted stocks amid a 10-fold increase in capital requirement from the clearinghouse.
Robinhood CEO Vlad Tenev, who aims to offer retail investors “free” trading of financial markets as Wall Street insiders normally have, blamed clearinghouse and a two-day settlement, also known as T+2, for trade restrictions during the Gamestop short squeeze.
“The existing two-day period to settle trades exposes investors and the industry to unnecessary risk and is ripe for change,” Tenev said in testimony to the House Financial Services Committee early this year.
“The clearinghouse deposit requirements are designed to mitigate risk, but wild market activity showed that these requirements, coupled with an unnecessarily long settlement cycle, can have unintended consequences that introduce new risks,” he said.
In response to increasing demand for faster settlements, the Depository Trust & Clearing Corporation, or DTCC, the firm that provides clearing and settlement services, came up with a T+1 solution that they plan to implement within the next 2 years. Since DTCC is currently complying with T+2 policy, all the retail stock trades take two days for settlement after the day the order is executed.
Rather than shifting to T+1 from T+2, several market players including Robinhood seek instant settlements. Before diving deeper into whether real-time stock settlement is possible and why DTCC selected the T+1 cycle, let’s briefly review what T+1 and T+2 is.
👉 What is Trade Settlement and What Do T+1 and T+2 Mean?
The transaction date and the settlement dates are important when it comes to buying or selling a stock. The date when a trader actually initiates a trade through a broker is known as the transaction date.
On the flip-side, the settlement date refers to the date when the ownership actually transfers. Since DTCC is working on a two days settlement cycle, every stock trade requires two days for ownership transfer.
‘T’ is the abbreviation of transaction and 1, 2, or 3 represents the number of days for settlement.
According to the current T+2 cycle, if a trader buys or sells stock on Tuesday, the settlement date will be Thursday. Here, it’s important to understand that the two days clearing cycle does not consider the date when you initiate the transaction. The transaction date is counted as a separate day. Holidays and weekends are also excluded from the T+2 cycle. For instance, if you initiate a transaction on Friday, the transaction will be settled on Tuesday.
👉 A Move to T+1 from T+2
Early this year, the Depository Trust & Clearing Corporation proposed a roadmap for shortening the two-day stocks settlement cycle to one business day after the trade is executed. DTCC claims that moving to a T+1 settlement will save costs, reduce market risk, and lower margin requirements.
According to DTCC, a move to the one-day cycle could reduce the margin by 41%. DTCC is currently holding around $13.4 billion every day in the margin to manage risk.
DTCC is not a regulatory body. So, it cannot unilaterally change the law regarding the settlement cycle. The organization just presented a proposal to shorten the settlement cycle. Therefore, industry participants including SEC, brokers, and other key players must agree to shorten the settlement cycle.
“We have been working collaboratively with a wide cross-section of the industry to build support for further shortening the current settlement cycle over the past year, and we have outlined a plan to increase these efforts to forge consensus on setting a firm date and approach to achieve T+1,” said Murray Pozmanter, Head of Clearing Agency Services and Global Business Operations at DTCC.
In a Senate Banking Committee hearing on GameStop frenzy, former Securities and Exchange Commission member Michael S. Piwowar, who was involved in the previous efforts of shortening the settlement from T+3 to two, said halving the current cycle would be a good strategy.
“As we shorten the trade settlement cycle, we reduce risks, like market risk, liquidity risk, and systemic risk, but we also … have the challenge of increasing operational risk,” he said. “In order for real-time settlement to work, everything has to work perfectly all the time.”
Although he does not rule out the use of blockchain technology for trade settlements, he believes that this isn’t a sustainable option yet.
“We may get to a point where blockchain technology or digital ledger technology gets us to a point where we can achieve a real-time settlement, but I don’t think we’re there just yet,” he said.
👉 Traders and Market Players Seek Instant Settlement
Four years after moving from T+3 to T+2, traders and some industry participants are seeking to jump to real-time stock settlements instead of T+1.
“There is no reason why the greatest financial system the world has ever seen cannot settle trades in real-time. Doing so would greatly mitigate the risk that such processing poses,” Vlad Tenev said.
Real-time settlement advocates are of the opinion that the two days clearing requirements are designed to reduce risk, but GameStop’s retail trade frenzy highlighted that long delays in trade settlement can produce new risks for stakeholders, particularly during wild market activity.
While DTCC is still hesitating to insure T+0 stock settlement, the financial technology company Paxos Trust Co. LLC has aggressively been working to get a clearinghouse license from regulators.
The startup, which is backed by large banks and other prominent venture capitals, claims to offer trade settlements in minutes.
Furthermore, instant trade settlements do not require brokers to hold a huge amount of deposit. The platform will also permit brokers and dealers to settle stock trades directly with each other, erasing the need for intermediaries.
Paxos designed its own Ethereum version technology to enhance the traditional banking system for asset management and trades settlements.
In 2019, Paxos was permitted by the SEC to launch a pilot program for setting trades. Recently, the Bank of America, Credit Suisse Group AG, Nomura Holdings, Societe Generale Group and Wedbush Securities have started using the technology to settle trades.
👉 What are the barriers to Real-time Settlements?
DTCC’s equities clearing and settlement subsidiaries, National Securities Clearing Corporation (NSCC) and Depository Trust Corporation (DTC), repeatedly stated that they have the capability to support T+1 and same-day settlement.
However, the clearinghouse say many market participants are still unable to adopt that change due to market structure complexities, legacy business, and operational processes. Below are the few barriers in a shift to real-time settlements:
1️⃣ Netting:
Experts say the useful impact of netting that really helps brokers and dealers might be difficult to attain in instant settlements.
For instance, on a typical trading day in 2020, DTCC transacted $1.7 trillion in U.S. equities through their system, but the netting impact declined the total settled value to under $40 billion.
What is netting? The primary role of the National Securities Clearing Corporation is netting. The process of automatically offsetting a firm’s sell orders for a particular stock against the buy orders is known as netting. Consequently, netting substantially drops the actual settled amount.
“By allowing trades to “net” settle, it reduces the total amount of cash and securities that have to go back and forth throughout the day. This eliminates a material amount of operational and market risk,” said Michael McClain, DTCC Managing Director and General Manager of Equity Clearing and DTC Settlement Services
He says netting slashes the value of payments by an average of 98–99%, which helps in reducing operational risk and enhances brokers’ potential to arrange the financing for their clients. Moreover, the number of transactions that need to be settled every day will soar dramatically without netting, which could increase the risk of failed transactions.
2️⃣ Predictive Financing:
The shift to instant settlements could negatively impact predictive financing amid a lack of clarity regarding the real financing needs.
3️⃣ Reconciliation:
The clearinghouse is yet to develop a real-time reconciliation process and real-time stock records before moving to instant settlement.
4️⃣ Margin Trading
The shift to instant settlements could also negatively impact margin trading. This is because clearinghouses guarantee the completion of trading activity, which works like an insurance policy. On the other hand, the clearinghouse collects cash from brokers against the guarantee for settling transactions. In T+2, the risk is spread over two days. However, in the case of instant settlement, the brokers need to have pre-funded resources in the amount of the margin loan, which could substantially impact brokers’ liquidity position.
In Conclusion: Is Real-Time Stock Settlement Possible?
Several new startups are currently using blockchain technologies to end the long delays and offer instant trade settlements. However, the market participants are still dividend on instant settlement amid a huge infrastructure upgrade requirement along with the need for massive liquidity.
In fact, the move towards instant settlement should happen in phases, according to Tom Price, the managing director of Securities Industry and Financial Markets Association. He added that regulators were only required to change 48 rules when they moved from three days cycle to T+2.
“What you don’t want to do is create something so fast that the cash and securities get delivered and there is no way to validate and reconcile,” Price said. “It’s easy to say, let’s go real-time. The complication is, the devil is in the details. How do we really do it?”
That said, we believe “the future will not be reported quarterly,” and stock trading will eventually have real-time settlement.
It’s hard to imagine the snail-like pace of securities and ACH settlement in a futuristic civilization that aspires to shed its Kardashev limitations to become multi-planetary.
Portfolio Insider aspires to be part of this bold future by democratizing the fastest financial analytics & accelerating the evolution of capital markets for all of humanity. 🚀 — ad astra.
