The Benefits of Shortening the Securities Settlement Cycle
Commissioner Luis A. Aguilar
United States Securities and Exchange Commission[1]
July 16, 2015
The benefits of shortening the settlement cycle for the secondary securities market is an issue on which many agree.[2] Why is it, some have asked, that trades can now be executed in less than a millisecond,[3] yet it still takes three full days for those trades to settle?[4] The most likely answer is some combination of inertia, cost, and competing priorities.[5] Unfortunately, the Commission must also shoulder some of the responsibility. It failed to demonstrate leadership on this issue when it elected not to follow up its 2004 concept release on the settlement cycle[6] with a regulatory initiative.
The financial crisis, however, brought into sharp focus the tremendous risks and costs associated with a protracted settlement cycle. The need to better manage risks and minimize costs in the post-crisis environment has spurred the securities industry to action.[7] I commend the industry for returning to this important issue,[8] and for its hard work in developing a detailed roadmap and timeline for achieving a two-day settlement cycle (typically referred to “T+2”).[9]
The benefits of a shortened settlement cycle are well documented. They include mitigating counterparty and other risks, lowering margin requirements for clearing agency members, reducing pro-cyclical margin and liquidity demands (especially during periods of market volatility), and bringing U.S. settlement procedures more in line with global standards.[10]
Yet, while the benefits of a shortened settlement cycle are considerable, so, too, are the challenges. The transition will require fundamental changes across a wide swath of industry practices, including those involving trade processing, asset servicing, and documentation.[11] It will also require the Commission to approve a number of changes to its rules and those of various self-regulatory organizations.[12] Although a comprehensive discussion of these changes is beyond the scope of this document, there are a few issues that are noteworthy in my view:
- Thorough Systems Testing is Crucial: The transition will require significant revisions to many industry members’ core order processing systems, as well as to downstream systems that tie into their order processing systems.[13] As the recent blackout at the New York Stock Exchange revealed, implementing software changes can be a delicate task.[14] Accordingly, it will be vital for industry participants to develop and follow robust procedures for testing software updates prior to implementation.
- The Need for a More Efficient Trade Affirmation Process: The transition to T+2 will place increased pressure on firms to affirm trades as quickly as possible, preferably on the same day the trades occur.[15] There is much work to be done here. By one estimate, same-day affirmations occur only 48 percent of the time in the United States.[16] Part of the reason for this is that many institutional brokers continue to rely on manual affirmation procedures, such as emails and faxes.[17] Implementing automated trade matching procedures will minimize the incidence of delivery failures after the transition to T+2 is made.
- The Advance Notice Process: The industry’s steering committee for the transition to T+2 has identified a number of proposed rule changes that self-regulatory organizations will likely need to file with the Commission before the transition to T+2 can occur. Among them are proposed changes by the National Securities Clearing Corporation, the central counterparty for equities transactions, and the Depository Trust Company, the central securities depository in the U.S.[18] Proposed rule changes by these designated financial market utilities may also require the filing of an advance notice with the Commission and the Federal Reserve.[19] The materials submitted by the industry steering committee to date do not reflect the possible need for such filings, but the steering committee should be mindful of this as it pursues implementation of the T+2 regime.
A shortened settlement cycle could profoundly enhance the health, robustness, and resiliency of our capital markets. In particular, lower margin requirements will allow more trading to occur, and thus deepen market liquidity. A shortened settlement cycle could also mitigate systemic risk by reducing exposure between the parties to a trade, between the counterparties to the clearinghouse, and for the clearinghouse itself.[20] In sum, the effort and expense required to reach T+2 should pay considerable dividends.
[1] The views I express are my own, and do not necessarily reflect the views of the U.S. Securities and Exchange Commission (the “SEC” or “Commission”), my fellow Commissioners, or members of the staff.
[2] Commissioner Michael S. Piwowar and Commissioner Kara M. Stein, Statement Regarding Proposals to Shorten the Trade Settlement Cycle (June 29, 2015), available at http://www.sec.gov/news/statement/statement-on-proposals-to-shorten-the-trade-settlement-cycle.html. Commissioner Gallagher has also expressed his support for transitioning to T+2, though he also expressed support for transitioning to T+1, or even T+0. See Commissioner Daniel M. Gallagher (@DanGallagherSEC), Tweet (July 1, 2015) (“I absolutely agree with Cmrs Piwowar & Stein on their T+2 statement; would also support T+1 or straight-thru”), available at https://twitter.com/dangallaghersec.
[3] See, e.g., NASDAQ, How the Market Works: The Market of Innovation (noting that NASDAQ’s “Superior Technology” allows orders to be executed in “less than one millisecond”), available at http://www.nasdaq.com/services/homw.stm.
[4] Omgeo, The Road to Shorter Settlement Cycles: Creating a trade date environment in the US and across global markets, 2 (Mar. 2013), available at https://www.omgeo.com/ssc.
[5] See id. (observing that the “most likely” reason the U.S. securities industry remains at T+3 is “simply because that is the way it has always been,” and that there are also “technology and automation challenges that limited firms’ abilities to support an accelerated cycle . . . .”), available at https://www.omgeo.com/ssc; Aite, T+2 Settlement: Technology Challenges for the Day After Tomorrow, 5 (Apr. 2014) (noting that, in 2004, the industry balked at the estimated costs of transitioning to a shorter settlement cycle, and turned its attention instead to “encouraging an increase in straight-through processing (STP) rates overall.”), available at http://gbst.com/wp-content/uploads/2014/04/GBST-T2-Settlement-in-US.pdf?n=19316.
[6] Concept Release: Securities Transactions Settlement, Securities Exchange Act Release No. 49405 (Mar. 11, 2004), available at https://www.sec.gov/rules/concept/33-8398.htm.
[7] See Omgeo, The Road to Shorter Settlement Cycles: Creating a trade date environment in the US and across global markets, 2 (Mar. 2013) (noting that “[d]uring the crisis, clearing and settlement came sharply into focus, specifically regarding the length of time that counterparties were exposed to risk during the Lehman Brothers’ collapse. In this case, since the US operated and continues to operate on a three day settlement period (known as T+3, trade date plus three), counterparties were exposed to risk for three days — during the period between trade date and settlement date. The crisis highlighted that a three day settlement period can create substantial systemic risk in times of extreme market volatility and uncertainty.”), available at https://www.omgeo.com/ssc.
[8] Aite, T+2 Settlement: Technology Challenges for the Day After Tomorrow, 5 (Apr. 2014) (noting that “[t]he idea of moving to a T+1 cycle was initially mooted by the U.S. securities industry in 2000, five years after the market had moved from a T+5 to a T+3 settlement cycle.”), available at http://gbst.com/wp-content/uploads/2014/04/GBST-T2-Settlement-in-US.pdf?n=19316.
[9] See PwC, Shortening the Settlement Cycle: The Move to T+2, 11-25 (June 18, 2015), available at http://www.ust2.com/pdfs/ssc.pdf.
[10] See id.
[11] The Boston Consulting Group, Cost benefit analysis of shortening the settlement cycle, 23 (Oct. 2012), available at http://www.dtcc.com/~/media/Files/Downloads/WhitePapers/CBA_BCG_Shortening_the_Settlement_Cycle_October2012.pdf.
[12] Letter from the Investment Company Institute and the Securities Industry and Financial Markets Association to Mary Jo White, Chair of the U.S. Securities and Exchange Commission, 3-8 (June 18, 2015) (citing various changes that will be needed to Commission and self-regulatory organizations’ rules for the transition to T+2 to be successful), available at http://www.ust2.com/pdfs/SSCregfinal.pdf.
[13] Aite, T+2 Settlement: Technology Challenges for the Day After Tomorrow, 14 (Apr. 2014) (noting that “[t]he idea of moving to a T+1 cycle was initially mooted by the U.S. securities industry in 2000, five years after the market had moved from a T+5 to a T+3 settlement cycle.”), available at http://gbst.com/wp-content/uploads/2014/04/GBST-T2-Settlement-in-US.pdf?n=19316.
[14] Dave Michaels, NYSE, SEC Suspect Software Update Triggered Trading Halt, BloombergBusiness (July 8, 2015), available at http://www.bloomberg.com/news/articles/2015-07-09/nyse-sec-said-to-suspect-software-update-triggered-trading-halt.
[15] According to one survey, retail broker-dealers “did not mention trade matching as a potential impediment to a shortened settlement cycle, mainly based on the different dynamics between them and their end customers as compared to the relationship between institutional brokers and their buy-side clients.” Aite, T+2 Settlement: Technology Challenges for the Day After Tomorrow, 19 (Apr. 2014), available at http://gbst.com/wp-content/uploads/2014/04/GBST-T2-Settlement-in-US.pdf?n=19316.
[16] Aite, T+2 Settlement: Technology Challenges for the Day After Tomorrow, 19 (Apr. 2014), available at http://gbst.com/wp-content/uploads/2014/04/GBST-T2-Settlement-in-US.pdf?n=19316.
[17] Id.
[18] See PwC, Shortening the Settlement Cycle: The Move to T+2, 36 (June 18, 2015), available at http://www.ust2.com/pdfs/ssc.pdf.
[19] Title VIII of the Dodd-Frank Act provides regulators with enhanced authority over financial market utilities, including clearing agencies that are designated as systemically important by the Financial Stability Oversight Council. In particular, Title VIII requires any such designated financial market utility to provide 60 days advance notice to its Supervisory Agency, such as the SEC, before making any change to its rules, procedures, or operations that could materially affect the nature or level of risk that the entity presents. See 17 CFR 240.19b-4(n)(1)(i).
[20] Depository Trust & Clearing Corporation, DTCC Recommends Shortening the U.S. Trade Settlement Cycle, 4-5 (Apr. 2014), available at http://www.dtcc.com/~/media/Files/Downloads/WhitePapers/T2-Shortened-Cycle-WP.pdf.