In capital markets, as in the wider economic and social environment, the recent period has presented significant challenges. First, the COVID pandemic undermined multiple aspects of market activity, while more recently, geopolitical uncertainty and concern over inflation have led to a widespread sell-off of risky assets. In a highly volatile environment, banks, brokers, and other financial institutions have scrambled to adapt and to ensure that trading and liquidity provision continue as normally as possible. In parallel, many are taking the opportunity to assess where the market will go next.
In the post-trade space, the events of the past three years have presented a unique business challenge, both in operations and operations technology. During periods of high trading volumes, many firms reported backlogs and outages, alongside high fail rates in settlements, payments, and collateral processes. This has put significant pressure on market infrastructures across the industry, with several older platforms reaching their capacity limits. Anecdotally, as many as a third of firms in cash fixed income markets have seen post-trade operational challenges.
Most firms in the market have dealt with challenges adeptly, deploying additional resources where necessary, and making adjustments to ensure markets have continued to operate smoothly. Third-party post-trade solutions also stood up well, validating many businesses in their decision to increase external partnering over recent years. However, while firms have generally withstood the impacts of the pandemic and market volatility, many are now looking to the future, and thinking about how they can cut risk and manage costs efficiently.
One of the hardest-hit areas in post-trade over the recent period has been settlements and payments, with many market participants saying they have periodically been unable to confirm settlements, leading to delays in matching and netting. A significant proportion of firms saw a spike in reconciliation errors.
As decision-makers consider the implications of operational shortfalls, it is common to hear calls for increased automation and wider use of technology. In addition, there is an emerging consensus around the need for more process simplification and standardisation. One idea gaining currency is the proposal to move to shorter settlement times. This is seen as a route to potentially lower operational costs, as well as reduced capital requirements and more effective risk management.
In December of last year, the DTCC, SIFMA, the Investment Company Institute, and Deloitte jointly published an “Industry Roadmap to achieving T+1 in 2024”. The paper argues that by cutting the US settlement cycle from T+2 to T+1, industry participants would accrue a range of benefits, including a reduction of risk during periods of high volume or volatility. Theoretically, as the volume of unsettled trades over a single trading day, and the time between trade and settlement, are reduced, there should be a reduction in systemic, counterparty, and operational risk across the settlement ecosystem. In addition, there should be a downswing of liquidity requirements, allowing broker-dealers and asset managers to better manage their capital/cash and liquidity risks.
The DTCC’s vision is predicated on a vision that the market will continue to embrace technology and reduce manual processes. This will provide an opportunity to move to straight-through-processing, boost efficiencies, and optimize margins. A more standardised process landscape, for example, to facilitate optimized information sharing, will bring tangential benefits, including more effective control of data and a significant reduction in costs.
Of course, the arguments in favour of shorter settlement times are not accepted universally market. Indeed, some market participants remain doubtful. To understand why, it is worth drilling down into the mechanics of securities settlement: The sale of securities involves two legs, the first transferring ownership from the seller to the buyer and the second transferring the corresponding cash from the buyer to the seller. Nowadays, many securities settle by delivery free of payment, under which payment or transfer of the asset comes only after the transferring party has received either the asset or money. This leads to settlement risk, payment risk, liquidity risk, all of which settlement times are designed to reduce.
To offset risks, an alternative approach to settlement is known as delivery versus payment (DvP). There are three models: DvP 1 typically settles securities and funds on a gross and obligation-by-obligation basis, with the final (irrevocable and unconditional) transfer of securities only made if payment occurs. DvP 2 settles securities on a gross basis, with the final transfer of securities from the seller to the buyer throughout the processing cycle, but settles funds on a net basis, with the final transfer of funds from the buyer to the seller at the end of the processing cycle. DvP 3 typically settles both securities and funds on a net basis, with final transfers of both securities and funds at the end of the processing cycle. This is often used when operating in non-native currencies. Many major securities settlement systems now provide fully-optimised and highly standardised straight-through DvP transaction processing, based on one of the three models.
The most common model globally is currently DvP 2, because the netting mechanism implies a need for significantly less liquidity for settlement. By contrast, the DVP model 1 requires participants to cover the principal/full value of the fund’s leg of each settlement obligation, therefore requiring a potentially larger amount of liquidity. On the other hand, an advantage to DvP 1 is that transfers become final on an obligation-by-obligation basis during the course of the settlement day, which has the effect of reducing intraday credit and liquidity exposures. DvP2, conversely, requires settlement periodically during the day.
In the context of DvP processing, some market participants argue that the case for shorter settlement times is less certain. They say that as settlement moves closer to real-time it imposes significant liquidity pressure on market participants, which must keep liquid assets on hand to be able to settle securities almost immediately. With that in mind, T+2 may be preferable because it gives firms time to manage their liquidity more effectively.
With these debates in mind, the move to shorter settlement times is not yet certain. Still, many market participants are preparing to take the plunge, and are looking at a proposed 2024 deadline for a possible switch over. In the meantime, there is little argument that the conditions that would make settlement more efficient are desirable. That is that more automation, greater standardisation, and increased transparency, would bring benefits across asset classes and markets.
This year looks to be uncertain as the last and regulatory changes, ESG scores and the blockchain are set to play pivotal roles in determining success or failure for some.
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