The financial industry’s model for clearing and settling securities has been on a long trajectory toward shorter cycles. One of the last remaining exposures in the settlement system today is time, which increases the risk an unpredictable event could affect the transfer of cash or ownership of securities from the point of execution through settlement.
From the commonly used five-day settlement cycle in the 1970s to the three- or two-day settlement cycle in many markets today, the global trend toward reducing settlement cycles is picking up speed.
Some jurisdictions in Asia-Pacific have embraced a shorter settlement cycle: Hong Kong, Australia, and most recently Thailand have adopted a T+2 settlement cycle, while both Singapore and Japan have announced firm plans to move in the coming months. The U.S., too, successfully shortened the settlement cycle to T+2 in September 2017.
These developments represent a convergence toward a T+2 settlement cycle that deepen and broaden markets. While the existing system is extremely efficient, there is opportunity to do more and to accelerate settlement without reducing the number of calendar days in the process.
Cutting Calendar Days Not the Only Option
The traditional approach to shortening the settlement cycle has been to maintain current processes while shrinking the time gap between trade date and settlement date.
However, industry-wide efforts are costly and can take years to implement. For this reason, the industry needs a coordinated approach that can be executed with more agility and with less disruption than traditional calendar-day reductions in the settlement cycle. Moreover, achieving the advantages of accelerated settlement while continuing to benefit from centralized netting and risk management is a necessity.
Although China notably operates its QFII market on a shorter settlement cycle, there are now no formal plans for an industry-wide adoption of a T+1 cycle. Yet there are opportunities to allow firms more seamless access to shortened settlement processing, both pre- and post-trade. This can be accomplished via two major proposals, accelerated settlement and settlement optimization. Both initiatives are being discussed with regulators and industry participants in the U.S. and are outlined in a white paper from The Depository Trust & Clearing Corporation (DTCC), released earlier this year. One proposal largely focuses on the pre-trade period involving a trading venue that would send matched T+1 trades to the clearinghouse. In the U.S., talks are underway with potential venues.
Reducing Exposure Without Removing a Calendar Day
More concretely at this point, the proposal to move the settlement of eligible trades from after the market close on the settlement date to the morning of settlement date is taking shape. This would eliminate an entire market day of settlement exposure without removing a calendar day from the standard trade settlement process.
This will be accomplished through Settlement Optimization, and the first phase will begin with night cycle reengineering, scheduled for implementation in the third quarter of 2019. By modifying the processes occurring in the overnight hours, DTCC seeks to significantly increase settlement rates going into the next morning.
Today’s more sequential algorithm brings an overnight settlement rate of about 45 percent for all transactions eligible to settle during that period. However, re-engineering these processes could result in that same settlement rate increasing to an estimate as high as 90 percent.
The new approach is pending regulatory approval, but it introduces an advanced settlement processing algorithm capable of evaluating each member’s transaction obligations, available positions, transaction priority instructions and risk management controls while identifying the transaction processing order that maximizes the number of transactions settled.
Achieving the predicted increase in settlement overnight is a prerequisite for the introduction of morning settlement in addition to today’s end-of-day settlement process. That will be Settlement Optimization Phase 2, moving from the afternoon of settlement date to the morning before market open, allowing the risk associated with funds settlement to be reduced, and essentially achieving T+1.5.
As we progress on this project, we believe our findings could be beneficial to the industry as adaptations of enhanced settlement algorithms might contribute to positive developments in the Asia Pacific region. Given the heterogeneity of participants and stakeholders, markets in APAC need to balance the requirements of their local market participants with those of stakeholders in different time zones – and settlement optimization could introduce not only enhanced efficiency, but also flexibility for executing settlement operations throughout the day.
By optimizing settlement and accelerating settlement beyond T+2, firms will be able to significantly reduce capital requirements, systemic risk and operational costs while preserving the resiliency of the current infrastructure. This represents an important step toward leveraging the gains we have seen with T+2 to achieve even greater efficiencies for the industry.
This article first appeared in Regulation Asia on 19th July 2018.