The securities industry now appears ready to jettison the T+3 clearing cycle.
At least, that’s what one can conclude after a recent study by the Boston Consulting Group, authorized by the Depository Trust & Clearing Corp. and the Securities Industry and Financial Markets Association. It found most respondents support faster clearing standards. The study reviewed the costs and benefits of revising the industry’s current T+3 standard , which requires clearing of transactions within three days after the trade takes place. The costs of an accelerated clearing standard would run in the hundreds of millions to more than a billion dollars for the industry as a whole. Among the new options considered were a T+2 or T+1 clearing standard.
BCG officials, surveying industry players about speeding up clearing and settlement rules, found widespread support for faster settlements as a way of reducing counterparty risk.
“Our initial industry outreach shows that 68 percent of participants favor a shorter cycle,” said the study, “Cost Benefit Analysis of Shortening the Settlement Cycle.”
The study outlined three different scenarios: moving to T+2, T+1 or T+0, which amounts to same-day settlement. Risk reduction was the primary reason two-thirds of respondents backed a shorter cycle.
The debate comes at a time when many trading participants worry about what could happen to transactions in the next market meltdown or if a counterparty failed. The American securities industry, some industry players say, is ready for T+2 because many of the other advanced markets around the world are already at that point or heading there.
For instance, Hong Kong and Germany are already on a T+2 standard. And the rest of the European Union is slated to go to T+2 in 2014, say DTCC officials.
“Buyside firms and custodians with a significant amount of cross-border activity mentioned the benefits of improved international harmonization with T+2,” said the study.
Still, this discussion about faster clearing in American markets has come up before and died. DTCC, as the clearing industry’s utility, has repeatedly said it is “neutral” on what the industry standards are. But DTCC officials agreed the current industry T+3 standard needs to be discussed.
“With a strong focus on risk reduction and capital optimization, DTCC, along with the financial services industry, believes it’s an opportune time to examine the benefits of an accelerated trade settlement cycle,” said DTCC president and CEO Michael Bodson.
“It is imperative,” added Matt Nelson, head of strategy for industry utility Omgeo, “to have the right system in place, not just at the beginning, but in the middle and the end of the trade cycle.” He believes that faster settlement cycles are “definitely doable and long overdue.”
The current T+3 standard for equities, corporate and municipal bonds-trade date plus three days-dates back to 1995. It was under review in 2000, but the industry ultimately decided not to make a change.
“We’ve been talking about this for years,” said Charles William “Bill” Yancey, a clearing industry veteran. Yancey, now managing director of clearing and execution for FirstSouthwest, said the industry should and likely will vigorously discuss this.
“There are overtones that [T+2] would reduce risk, and these are major threads in the industry right now that are driving a lot of decision making,” Yancey said.
Omgeo’s Nelson believes that moving to T+2, or possibly to the more expensive T+1, will pay for itself in cost savings and improved investor confidence over the long term.
It will “help financial firms achieve operational cost savings and risk reduction while freeing up capital. And even under today’s cost pressures, the cost at the company level is manageable,” he said.
“There’s recognition that shortening the settlement cycle does reduce risk,” Nelson added. “It also frees up capital within the client institutions sooner to use. So this is kind of a general global trend that we’re starting to see. And we see the U.S. is starting to take this seriously.” {IMGCAP(3)]
In part, this is because the United States, unlike many international markets, doesn’t require that all trades be matched at the depository prior to settling. Owing to this, the study said, problems with reconciliation of trade details can cause institutional trades to be reclaimed on settlement day. Institutional trades, under the current T+3 system, can have unique problems.
“As the amount of risk is partly a function of the time between when parties commit to a transaction and when it settles,” the BCG study noted, “the current T+3 settlement cycle exposes firms to a greater degree of counterparty risk and market risk than a shorter settlement cycle would.”
But a faster settlement cycle, if the industry accepted it, would come with certain assumptions, industry observers have said.
So what’s the downside of junking T+3 and going to a T+2 or a T+1 rule?
The trading industry must make new technology investments. These will include standardized communications as well as standardized cross industry settlements. These measures would improve the accuracy of settlement instructions, the study said. Trade-date matching will also be needed, and regulators will have to mandate better settlement standards for institutional trades, according to the study.
Another objection might be the industry costs. They range from the hundreds of millions of dollars for T+2 to more than a billion dollars for T+1. The individual cost per firm depends on the size and kind of the institution (see sidebar: “Some Examples of the Costs for Average Firms of Going to a T+2”).
Moving to a T+2 environment would require about $550 million. Upgrading systems and processes that support a T+1 standard would cost some $1.7 billion, BCG estimates.
Supporters of speeding up clearing and settlement argue that these costs could be recovered in the form of operational savings and improving investor confidence (see sidebar: “Cost Savings of a Shorter Settlement Cycle”).
Still, another objection to faster settlement cycles is that for some firms it would require considerable changes in how they clear and settle trades. Systems would have to be modernized in a large part of the securities industry.
That’s because, just to make the least improvement going to a T+2 standard, the industry would have to end manual and batch processes. Some firms have outdated systems.
“Roughly 30 percent of the buyside still isn’t automated,” Omgeo’s Nelson noted, “and this continues to be a pain point for brokers.” Also, those that self-clear would generally have a bigger bill for going to a faster clearing standard than those that depend on others for clearing services.
“That is due to the fact that most required investments will be made by service bureaus and correspondent clearing firms, and hence are captured elsewhere in the model,” the BCG study said.
Where does the securities industry go from here?
Now it’s up to the industry’s utility, DTCC, to find out whether its members are serious about faster clearing standards and whether it would be authorized to make a proposal to the regulators. But whether or not the securities industry is actually ready to impose the additional costs and technological requirements that accelerate clearing standards, there’s little doubt that the debate has been reopened by the BCG report.
A large number of financial professionals told BCG they’re ready for a better clearing standard. Industry players told CQ&D that they need better clearing and settlement for several reasons. The world’s markets are often moving faster than American ones. And these industry players said clearing and settlement standards will be vital in the next market meltdown. “I know our firm is strong,” said one brokerage executive said, “but what about that weak counterparty that could make out lives miserable?”
“I do think,” says FirstSouthwest’s Yancey, “that this theme of faster clearing will be something we will be hearing a lot about. We will probably see a trend to press forward in shorting the cycle.”
Costs for Average Firms of Going to T+2 Cycle
Institutional broker-dealers: Average cost $20 million for large players. Investments required: Core platform changes to move to near real time. Segregation processes, trade reconciliation, matching and break management.
Retail broker-dealers: Average cost $15 million for large players. Investments required: Infrastructure upgrades. Platform changes to move to near real time. Matching and break management, settlement processing.
Buyside firms: Average cost up to $2 million for large players. Investments required: Infrastructure build. Platform changes to move to near-real-time interactions. Further automation to accommodate time frames.
Custodian banks: Average cost up to $16.5 million for large players. Investments required: Infrastructure upgrade. Platform rewrite and core process redesign to move to near-real-time processing.
Self-clearing broker-dealers: Average cost between $3 million and $15 million, ranging from small to large self-clearing brokers. Investments required: Infrastructure upgrades. These would include platform changes to enable real-time processing.
Others: Costs depend on the type of player. Investments required: Additional system changes at DTCC (e.g., near-real-time processing). Process review and interface updates for non-clearing B/Ds.
Source: Boston Consulting Group
Cost Savings in a Shorter Settlement Cycle
The annual cost savings for upgrading to a T+2 standard or T+1 would be in the hundreds of millions of dollars annually, according to Boston Consulting Group. Those savings would come from annual operational cost reductions, along with the annual reduction in the clearing fund and the reduction in risk exposure on unguaranteed buyside trades.
“For the whole industry, the implied payback period based on operational cost savings is three years for the T+2 model and 10 years for the T+1 model,” the BCG report said.
How long would it take for these new settlement standards if the industry commits to them?
“Our research suggests that the industry could transition to T+2 within approximately three years once a clear direction for the industry is set,” the report said. “T+1 would be achievable within four to six years following a move to T+2.” A direct move from T+3 to T+1 would take “seven to eight years.”
