By Michele Hillery, General Manager of Equity Clearing and DTC Settlement Service, DTCC
The meme stock events of early 2021 highlighted the importance of the clearance and settlement infrastructure of the US equities markets. It also shone a spotlight on the risk that is introduced between when a trade is executed and when it is ultimately settled, and led to some calls for the replacement of the current standard T+2 settlement cycle with real-time gross settlement. While this acceleration could have some benefits, it would require complex and fundamental changes to how the industry functions today, which will take time to analyze, develop and ultimately implement. As explained in a recent whitepaper, for that reason, among others, DTCC believes, and the industry agrees, that T+1 would be the optimal settlement cycle for today, allowing market participants to accelerate settlement leveraging and enhancing existing processes while continuing to benefit from the efficiencies of netting. In the whitepaper, we also address myths around real-time gross settlement and provided an update on our forthcoming alternative settlement platform, Project Ion.
The optimal settlement cycle
It has been well documented that, after extensive consultation with the industry, there is general consensus that T+1 would be the optimal settlement cycle for the US equities market and should be the next step towards shortening the settlement cycle. For broker/dealers, a move to T+1 would lead to a significant reduction in margin and collateral requirements. An average of over $13.4 billion is held in margin every day to manage counterparty default risk across the system. Shortening the settlement cycle would help strike an improved balance between risk-based margining and procyclical impacts.
At the same time, a move to T+1 would also necessitate systemic and process improvements that would further enhance market resilience by reducing systemic risk, operational risk, liquidity needs, buy-side counterparty exposure, and broker-to-broker counterparty risk. T+1 would significantly lower the level of risk and uncertainty arising from unsettled trades during market volatility, while enhancing capital efficiency. It would also allow market participants to continue to leverage NSCC’s netting feature, creating cost savings across the industry. Every day, netting reduces the value of payments that need to be exchanged by an average of 98% across all settlement cycles. On an average day in 2020, NSCC netted down $1.77 trillion dollars in total daily trade activity to a final settlement value of just under $38 billion, delivering significant cost savings to the industry.
Differentiating between RTGS and netted T+0
During the events of earlier this year, some industry participants suggested that real-time gross settlement (RTGS) would solve the issue of margin requirements. While RTGS does provide certain benefits and may be appropriate in some cases, it also presents substantial challenges for the industry and, potentially, inefficiencies. RTGS eliminates important netting and financing opportunities because it requires that all transactions be funded on a transaction-by-transaction basis, thus requiring clients to have funds and securities available before the settlement of every transaction. This means the entire industry – clients, brokers, investors – could lose the liquidity and risk-mitigating benefits of netting, which is particularly critical during times of heightened volatility and volume.
Further, RTGS isn’t a simple technical solution: it would impose a very complicated structural change on financial markets, and the significant benefits of multilateral netting may be lost or, at the very least, seriously compromised. Areas such as financing, securities lending, processing schedules, institutional trade processing and non-US transactions would also require restructuring, and industry participants would likely need to completely abandon any remaining batch processes. Redesigning these business processes to facilitate RTGS could even introduce more risk into the processing environment.
It is important to note that RTGS is not the same as netted T+0 settlement. With netted T+0 settlement, trades are netted and settled at the end of the same trading day, which maintains the benefits of netting by providing periodic netting cycles throughout the day. In fact, NSCC offers this functionality today and DTC is already a T+0 platform and settles transactions on a near-instantaneous basis, processing around one million same-day transactions every day. That said, we support and are committed to considering, along with our clients and industry partners, what measures will be needed to deliver netted T+0 as an industry standard settlement cycle, after the industry solidifies the plan for T+1.
An alternative settlement process
When considering how the settlement cycle can be further improved, time to settlement is just one area. The employment of new technologies is another theme when considering the settlement system of the future. In early 2021, Project Ion, which uses distributed ledger technology (DLT), was introduced to bring new efficiencies to settlement. Now, with six months of successful testing of the prototype completed, there is sufficient quantitative data and qualitative feedback from clients to guide next steps, including the build out of the platform to a production-ready workflow with a detailed roadmap for full industry integration and adoption.
Project Ion will adhere to DTCC’s rigorous regulatory requirements across resiliency, stability, security, risk, and controls and will be designed to provide an additional settlement option for the industry that will deliver upon our core benefits of risk management and volume capacity, including netting, the trade guaranty of the CCP, and seamless interoperability between the Project Ion platform and DTC’s classic settlement platform.
Ultimately, the industry’s primary goal of enhancing the settlement cycle – be it through modifications to post-trade infrastructure or settlement timelines – should be achieved by creating new efficiencies without introducing additional risk to markets. We believe that central clearing and netting continues to be the most efficient and beneficial way of moving trades to settlement, and firmly believe that T+1 is the right settlement cycle for right now. However, to ensure we meet the ever evolving needs of the industry, DTCC will continue to consider ways to enhance the current system by enhancing existing infrastructure through the adoption of new technologies and processes and by advocating for shorter settlement cycles, safely and appropriately.