The Depository Trust & Clearing Corporation (DTCC) is exploring several ways to modernize the settlement system to achieve additional operational and capital efficiencies. In September 2017, DTCC, Investment Company Institute (ICI) and the Securities Industry and Financial Markets Association (SIFMA), helped usher in the transition to a standard settlement timeframe of trade date plus two days (T+2) for in-scope securities, including U.S. equity, corporate and municipal bond, and unit investment trust (UIT) trades, reducing operational and systemic risks to the U.S. marketplace.
In its recent white paper, Modernizing the U.S. Equity Post-Trade Infrastructure, DTCC puts forth two innovative proposals — settlement optimization and accelerated settlement – which would enable members of The National Securities Clearing Corporation (NSCC) and The Depository Trust Company (DTC) participants to improve workflows, optimize capital and reduce risk, further reducing settlement processing inefficiencies through automation.
If both are implemented, NSCC members and DTC participants could get to a settlement cycle of less than T+2 — potentially to T0-and-a-half — without removing a calendar day, and still maintain the significant benefits of centralized netting and risk management.
The creation of this alternate settlement model, called Settlement Optimization, would be achieved with the reengineering of four core settlement components:
- Night Cycle Reengineering
- Intraday Settlement Slices
- Enhanced Asset Lending
- NSCC Margin Pledge Facility
Each component will be explored in greater detail in this continuing series, beginning with Night Cycle Reengineering.
Part 1: Night Cycle Reengineering
by Michael Battaglini
The goal of Settlement Optimization, an enhancement to DTCC’s settlement process, is to improve clearing and settlement processing efficiency, promote settlement finality, reduce equity clearing margin requirements, and provide participants with liquidity enhancements — while still preserving the resiliency of the current infrastructure.
The first component of settlement optimization is Night Cycle Reengineering, which is designed to maximize transaction throughput by optimizing member available position and controlling the order in which transactions are processed.
“In addition to the inherit benefits of improved settlement finality and earlier settlement times, night cycle reengineering is also a prerequisite for an intraday settlement slice which introduces a host of other benefits for the industry,” said John Abel, DTCC Executive Director, Settlement and Asset Servicing Strategy, Product Management Group.
Shortcomings of Current Process
Currently, DTC processes transactions using a pre-defined set of processing rules and algorithms, however this process often leads to less than optimal settlement results. Currently settlement rates for night cycle transactions are approximately 45%, which means the other 55% have to wait until later in the date to settle.
The time between when a trade is executed and when it is settled exposes both parties in the trade to credit, counterparty, and operational risk, and can require both parties to tie up capital to fulfill margin requirements.
“It’s not hard to imagine how this happened, but our settlement system — as powerful and efficient as it is — has evolved over 40 years, and it is layered with rules and processing complexities,” said Abel. “The rigid processing logic, limited look-ahead capabilities, member prioritizations and client authorization behaviors all contribute to the low night cycle settlement rates. And these are exactly the things we think we can reengineer and improve.”
Re-engineering to Improve the Process
There are two parts to night cycle re-engineering; while they are separate efforts, they are interdependent. The first development effort would be to create a more dynamic and intelligent processing environment, with new algorithms that actively look to process as many transactions as possible — and as early in the processing cycle as possible.
“We took a hard look at our system through a different lens,” said Jack Manuel, DTCC Director, Settlement. “Through testing, we have developed a more effective settlement processing algorithm and found that the more transactions we pushed through the algorithm, the better the settlement results.”
This is where the second aspect, changing the night cycle cut-off time, becomes important.
“We believe if we move the cut-off time from 8:30 p.m. on S-1 (day prior to settlement) to 3:00 a.m. on S (settlement date) we can accumulate a sufficiently large number of transactions to run an effective settlement optimization batch,” said Manuel. “However, we think there is still more opportunity to subject more transactions to the optimization batch and further increase settlement rates.”
DTCC has conducted some internal analysis and identified 55 cutoffs that need to be changed to allow members to submit transactions to the depository prior to the 3:00 a.m. start of the optimization batch. DTCC will be implementing these cutoff changes over the next couple of months.
“We are also looking at the times when members currently submit transactions for processing, and will be working with them to see if some of their processes can also be changed to allow the earlier submission of trade input, preferably before 3:00 a.m.” said Abel.
Implementing these elements to the night cycle will be the key to optimizing settlement and increase the rate of night cycle settlement from 45% up to 90% — or perhaps greater.
DTCC is in the beginning stages of exploring settlement optimization and accelerated settlement and have set up working groups to meet regularly on the topic.
The alternative settlement models that DTCC has begun analyzing have shown extremely promising results, Abel says, and DTCC will continue to work with members to refine the night cycle reengineering proposal. DTCC is targeting implementation of the night-cycle changes for the first quarter of 2019.
“Night cycle re-engineering, a prerequisite for the intraday settlement slice – the next part of optimization – will require some changes from participants,” said Abel. “However, we believe these changes will be minimal, and certainly nowhere near the scope of the move to T+2.”