Speech by SEC Staff:
Remarks before the SIA Spring T+1 Conference
Robert L. D. Colby
Deputy Director, Division of Market Regulation
U.S. Securities and Exchange Commission
May 20, 2002
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publications or statements by any of its employees. The views expressed herein are mine and do not necessarily reflect the views of the Commission or my colleagues on the staff of the Commission.
Good morning. It is a pleasure to be here today. As usual, before I start, I need to remind you that these comments represent my views they may not represent the views of the Commission or my colleagues on the staff.
I have been asked to share with you the SEC's thoughts on the current status of the straight-through-processing/T+1 initiative. This conference is being held at an important point in the project's timeline, given the high wire acts our industry has performed in the past months. The STP/T+1 initiative is at a crucial point in its performance, like a circus trampoline artist standing on the high platform about to leap down on the trampoline. And there are many competing acts going on under the industry Big Top. As we evaluate how the STP/T+1 project will proceed, I believe it is important to look at all the rings of this circus to help decide how additional "feats of daring" should be introduced in the future.
There can be no doubt that the challenges we faced this past year were enormously difficult and complex. The Commission is keenly aware of the remarkable pressures that have been brought to bear on the securities industry. First and foremost, the tragic events of September 11: in their shadow, business continuity and contingency planning have taken on a whole new importance. Firms also are facing new compliance requirements under the Patriot Act to ensure that our marketplace is not a conduit for illegal terrorist activities. And the industry is valiantly trying to address these pressures in a strained business climate.
For many firms, the initial reaction to these many and varied challenges may be to buckle down and cut seemingly unnecessary costs, to improve the bottom line. This is an inevitable reaction in trying times. Some firms are asking themselves, with everything that is going on, where does T+1 fit into all of this? Is there really enough room now for this act in our already crowded circus?
I think that you would agree that, in an ideal world, once a trade has been executed it would go directly to settlement. What a simple concept: you pay for your securities when you buy them. But we don't live in an ideal world. And, to get there involves costs: not just to overhaul systems, but to change behavior.
First, I'd like to start with a visit to a historical sideshow the debate we had ten years ago about the costs to shorten the settlement cycle from T+5 to T+3. I do this not because I harbor any illusions that the move from T+5 to T+3, and the move from T+3 to T+1, are the same. The STP/T+1 project is exceptionally harder and costlier because we are talking about an overhaul of our settlement process. Nevertheless, as the inscription on the National Archives building in Washington reads, "The Past is Prologue." Remembering what we learned from experience should serve us well in the future.
Second, I would like to turn our gaze to the new act being worked up for the circus- the STP/T+1 initiative- and review it from the Commission's perspective, with thoughts about how this act should be rolled out in the future.
I. T+5 to T+3
When the Commission proposed shortening the settlement cycle from T+5 to T+3, you may remember that there was significant opposition to the move. The opponents of T+3 settlement can be divided into three categories. First, some believed that T+3 was unnecessary and would not reduce risk. Second, others were concerned about the potential cost of systems changes to operate in a T+3 settlement environment. They argued particularly that they wouldn't be able to implement the necessary behavior changes: for example, getting retail investors to pay by T+3. Third, some opponents believed that T+3 would hurt competition and put them out of business.
But T+3 went forward. In looking back at the success our markets have had over the last seven years, it's evident that the T+3 settlement cycle has been successful and has achieved its goals. The concerns raised by the opponents to T+3 did not materialize in any significant adverse consequences to the securities markets, as I will discuss.
A. Issue 1: Shortening the Settlement Cycle Will not Reduce Risk
It is well settled now that the longer the period from trade execution to settlement, the greater the risk that one of the parties may become insolvent or default on the trade; the larger the number of unsettled trades; and the greater the chance that the prices of securities will move away from the contract prices. These all increase the risk that non-defaulting parties will incur a loss when replacing the unsettled contracts.
B. Issue 2: It will cost too much to operate in a T+3 settlement cycle
Broker-dealers feared increased costs in going to T+3 from two areas. First, they feared the costs associated with upgrading their computer systems and office practices to prepare for the move to a T+3 settlement cycle, together with ongoing costs associated with the faster settlement timeframe. (These included systems programming costs to enable their representatives to tell customers the cost of their trades at the time of execution, improving delivery of confirmations, or wiring funds). Second, broker-dealers feared increased financing costs if the customer did not remit payment by T+3.
Since the T+3 settlement cycle has been implemented, broker-dealer costs have steadily increased. Nevertheless, at the same time, because of increased trading volume, the revenues of brokers soared and their return on equity generally exceeded previous norms. Doesn't feel like it now, I know, but over time it was true.
C. Issue 3: T+3 would harm competition
Several opponents argued that T+3 would place firms that do not hold customer funds or securities at a competitive disadvantage. Broker-dealers, primarily regional broker-dealers that did not currently offer cash management type accounts, feared that the cost of establishing these accounts would be prohibitive. They also were concerned that their clients would not be willing to leave cash on deposit with a broker-dealer.
While the securities industry is a highly concentrated business, with large New York city based broker-dealers accounting for 70 percent of the industry's total revenue, the percentage of revenue generated by regional broker-dealers has not decreased since the implementation of a T+3 settlement cycle. Of course, many have been bought, changing their respected old names to "First Fourth Bank of the Universe Securities, Inc." or the like but their revenue has held up.
While there was substantial apprehension in the industry about moving to T+3, there was ample incentive from our experiences with the 1987 market break and the failure of Drexel Burnham Lambert. Some of us can remember when the Group of Thirty initiated its study in response to the 1987 market break. While the G-30 recommended shortening the settlement cycle, the goal of the project was to develop a framework that would reduce risk, increase efficiency, and lower cost in the clearance and settlement systems, so there were eight other recommendations in addition to reducing settlement times.
That effort prompted the Commission to request that U.S. industry participants form the Bachmann Task Force in 1992, to determine what changes were necessary in the U.S. to achieve a safer and more efficient system.
The Bachmann Task Force operated under the premise that there are universal benefits to be gained from increasing the safety and soundness of the clearance and settlement system and reducing systemic weakness. Its fundamental principle was that "time equals risk." Many believe that this "law of nature and Nature's God" still controls. But then as now, the Bachmann Task Force also emphatically stated that the industry and the Commission must carefully balance the benefits achieved by enhancing the existing settlement systems with the costs imposed on broker/dealers, and institutional and public investors.
While this may be an interesting history lesson, the more important question is what have we learned for the future?
Historically, many changes in the securities industry have been reactive. For instance, after the 1987 market break, study after study concluded that while the U.S. clearance and settlement system was strong, substantial enhancements were necessary. These changes were necessary before the market break, but there was simply not the will to do them. Further back, the 1975 Amendments to the Exchange Act that established a national system for clearance and settlement were enacted largely in response to the Paperwork Crisis of the 1960s. Some think the country is in a "react to the Enron crisis" mode today.
The STP/T+1 initiative developed differently, because there was no "event" that sparked it. Instead, a forward-looking industry acted in a proactive way to face looming challenges. You did not wait for a financial crisis to begin implementing necessary changes for the continued health and prosperity of our securities markets. You prepared a business case that showed that changing the way trades are processed would make economic sense. I expect that the revised business case will continue to show that.
If our markets are going to be successful, protecting investors and maintaining investor confidence should always be the goal. I was reminded of this axiom a couple of years ago by a small but painful "Internet crisis." For those of you who didn't experience it, on December 22, 1999, "Toys R Us" announced that they had a higher number of Internet sales than expected and they would be unable to make deliveries before Christmas to some of their Internet customers. Confidence in Santa fell to an all-time low. While ultimately the number of disappointed children was low, the stress on the parents has left lasting scars, and discouraged Internet shopping. This is not the sort of settlement problem that any industry wants to experience.
As we all know, the ability to settle a transaction is essential in maintaining investor confidence in the market investors want to know that their trades will settle on time at the agreed upon terms and that they won't lose their funds or securities because of the insolvency or mismanagement of a firm or the system. The transition to T+3 occurred successfully because the industry and the Commission believed in the long-term benefits the shortened settlement cycle would bring to our markets and investors.
II. The road ahead
Now that we've peeped into the T+3 sideshow, let's check out the center ring under the "Big Top:" that is, STP and T+1.
Let me begin by saying that as a regulator, I may have a different vantage point from many of you in this room. As you know, the Commission has the responsibility to promote the prompt and accurate clearance and settlement of securities transactions. As regulators, we are concerned both with the system's efficiency, and with the burdens that changes may have on the industry. We are in a sense the ringmaster of the settlement circus (but not the lion-tamer or the Human Cannonball!).
Now some have said that there are some large circus animals around us. Let's call them camels, because, after all, a camel is a horse designed by committee. (Camels also are expensive, messy, and ill-tempered.) One type of camel is the dromedary, with just one hump like STP. Achieving straight through processing will streamline back-office procedures, increasing efficiency to the system while minimizing operational risk. Through automation, manual intervention will become the exception rather than the norm. As a result, fewer fails will occur by human error, and accurate trade data will reach the clearing corporation and the depository more quickly. Back office staff can then focus on processing today's trades rather than correcting yesterday's errors.
The other type of camel is the Bactrian camel, with two humps like STP and T+1. In addition to bringing the benefits of STP, T+1 would benefit the industry by minimizing credit and market risk, and allowing investors to obtain the proceeds of securities transactions sooner. As Chairman Pitt said in a recent speech to the Bond Market Association, "The push to reduce the transaction settlement period underscores one of the lessons learned in the wake of 9/11: settlement processes are vulnerable to outside interruption. By reducing the overall amount of transactions required to be in settlement at any one time, we significantly reduce systemic risk." (This speech, for one, did not get much press play, so I am reusing his material.)
Which camel will carry us further? While I am not deeply steeped in camelian lore, I would bet on the two-hump model, our new friend the Bactrian camel. Achieving STP and T+1 will eventually realize costs savings to the industry and, ultimately, investors.
While future cost savings are desirable, implementing T+1 requires market participants to make sizeable investments of their time and resources in the near term. The SIA's initial Business Case estimated that the industry will wind up spending about $8 billion to accomplish all of the T+1/STP goals.
The Business Case has recently come under fire. The initial assessment involved a high-level review of the costs associated with implementation, but did not fully quantify risk reduction or evaluate the operational risk of settling trades in one day. I understand that the SIA's T+1 Executive Board is addressing these concerns by updating the business case, and reanalyzing the risk reduction and operational risk from T+1.
We recognize also that as firms are reprioritizing projects, some are questioning whether we need to go to T+1 or whether STP will adequately reduce risk. Others may believe that the June 2005 implementation date isn't realistic given the current business environment.
Consensus across the industry is critical to advancing the STP/T+1 initiative. In many cases, progressive business practices and shared goals can forge consensus. In other instances, consensus can be catalyzed by rulemaking. In ideal situations, these two forces can act in tandem.
In this context, Chairman Pitt recently said, "To achieve T+1, firms will have to focus their efforts and dedicate appropriate resources. Many of you may be waiting for us to propose to reduce the settlement cycle to one day; let me assure you the rule proposal is on its way."
A T+1 rule proposal can be a focal point for STP and the other changes to make our post-trade system more efficient. Focal points can have positive and negative aspects. A good focal point keeps one focused on the actual goals and allows for flexibility in achieving the goal. A bad focal point provokes unnecessary opposition (and gets the people that proposed it in trouble). I believe that a rule to mandate T+1 settlement could be a focal point of the good variety. The goal is not solely next day settlement the industry's initiative is much more than that rather, the proposal can serve as the driver for the entire STP/T+1 project.
Of course, as we develop a new rule, costs and benefits are important considerations. As Chairman Pitt said, "We will consider these costs, and the scope of the benefits, as part of the T+1 rule proposal." And we will certainly seek comments on this issue.
Even now, you can do much to prepare for the systems changes needed for STP/T+1. As you ready your firms for anti-money laundering compliance, move your operations from batch to real-time processing, and set up contingency plans, keep T+1 in mind. If you use a service provider, find out whether it will be able to comply with T+1 standards. Take advantage of this opportunity to coordinate automation efforts rather than spend unnecessary time and extra money making changes in the future. Many firms are moving forward now with straight-through-processing initiatives. In addition to cost and time savings, competitive advantage may be another reason to focus your efforts on long-term improvements.
As the show progresses, I also encourage you to come join the circus by participating on the various T+1 subcommittees and commenting on the rule proposals as they emerge.
Some say the circus is big enough right now. Others say that, in choosing camels, the one-humped dromedary is the better performer: in other words, that STP can occur without T+1 rulemaking. But will it? We will certainly explore the question; yet I believe that keeping our eyes on the T+1 goal can be the focal point for the industry to achieve greater efficiency and reduced risk. "Two humps are better than one." But at all times and in all ways, we must strive to maximize automation, strengthen investor confidence, and improve our national clearance and settlement system. We must stretch the Big Top. We will continue to work with you to maintain our system's leading role in the global marketplace. So bring on all the circus acts, the elephants and the camels, for the Greatest Show on Earth!