The Depository Trust & Clearing Corp. is commissioning a study on whether the U.S. securities industry should cut the time it takes to process transactions, a shift that may reduce risk and compel brokers and asset managers to spend more on further updating their systems.
The New York-based company that handles and guarantees trades in U.S. stocks, corporate bonds and municipal securities hired the Boston Consulting Group Inc. to assess the costs and benefits of settling trades in fewer than three days, the current standard, Elena Staloff, a vice president at DTCC, said in a phone interview. A shorter cycle would mean firms could post less capital to the clearing fund run by DTCC subsidiary National Securities Clearing Corp. to cover a defaulting broker’s obligations and pay less to meet the organization’s liquidity needs to handle a problem, she said.
A 2000 industry report about completing transactions in a day said the one-time cost of moving to a so-called T+1 settlement would be $8 billion for the securities industry and could be implemented within four years. The savings would be $2.7 billion annually, the study found. More trading-related processes have been automated since then and it’s unclear whether the costs now would be higher or lower, Staloff said.
“I’m hoping we get an independent read on where the industry is now in terms of its readiness to shorten the settlement cycle,” Staloff said. DTCC is working with the Securities Industry and Financial Markets Association to evaluate the case for a shorter cycle. “Shortening the settlement cycle should help our member firms with their capital and liquidity needs but we don’t know what the costs would be.”
The 2000 industry plan was put on hold as market conditions deteriorated after the 2001 terrorist attacks. Instead, the focus turned to automating post-trading systems and processes.
“We want to revisit the building blocks or obstacles identified in the 2000 study that may need to be tackled in order to evaluate how cost effective and efficient it may be to shorten the settlement cycle,” Tom Price, head of operations, technology and business continuity planning at Sifma, said in a phone interview. He said no decision has been made about whether to preserve the current T+3 environment or move to a two-day or one-day cycle, or “T+2 as a first step toward T+1.”
Exploring the Issues
While compressing the timeframe may reduce the risk that DTCC and member firms face in the event of a broker’s default, the change could increase the number of failed trades or transactions that aren’t completed on time, boosting risk, Price said. Sifma wants to explore these issues and help determine what the impact would be of an abbreviated cycle, he said.
This issue has surfaced in part because of European plans to harmonize the settlement cycles across most countries in the region to T+2 and efforts by regulators to bolster the “basic plumbing of the industry,” Price said.
“It would force changes in borrowing and lending, the financing of securities and loans and it would force the process to squeeze out more human interaction and have that happen by default by computers,” James Leman, a managing director at New York-based management and technology consulting firm Westwater Corp., said in a phone interview. “T+2 is probably one step the industry could find a way to cope with. For T+1, someone would really have to define what the benefit is and what problem is being eliminated.”
Portfolio trading groups, or those who buy and sell baskets of securities for customers, have long complained they don’t have enough time to process transactions, said Leman, who helped develop the FIX messaging protocol in the 1990s that enables securities firms and other participants to communicate electronically. Asset managers also need time to manage their so-called allocations, or instructions about the accounts to which trades should be delivered, he said.
“The costs to shorten the cycle will fall on back offices at brokers and asset managers,” or units that deal with confirming and processing transactions after they occur, Paul Rowady, a senior analyst at research firm Tabb Group LLC in New York, said in a phone interview. “The worst case is if you’re an active asset management shop and you don’t have sufficiently automated and detailed processes. Manual intervention is what ultimately slows this down.”
Clearing firms that are starting to accept more types of securities as collateral to support the processing of over-the- counter derivatives will benefit from a shorter settlement cycle, Rowady said. Brokers can’t use securities that haven’t cleared and settled as collateral, limiting the ability of those products “to move around fluidly” to support new requirements from regulations prompted by the financial crisis, he said.
‘Like a Flywheel’
“It’s like a flywheel that’s speeding up,” Rowady said. “If the settlement process doesn’t speed up, it will act as a weak link in the process.”
The evaluation of a shorter settlement timeframe comes as the securities industry prepares to build an audit trail for all orders and transactions. The Securities and Exchange Commission said the so-called consolidated audit trail, which would improve surveillance and help regulators analyze market plunges, may cost $4 billion to build and $2.1 billion a year to maintain.
Settlement refers to the transfer of cash from the buyer to the seller and securities from the seller to the buyer. Clearing encompasses the netting of trades and novation, or the replacement of contractual obligations by the clearinghouse which then becomes the buyer to the seller and the seller to the buyer, eliminating the risk each party faces in the event of a default by the other.
The study DTCC is commissioning will identify the processes that would have to change to speed up settlement to the trade date itself, DTCC said in a statement today. DTCC must also examine how a shorter cycle would affect foreign buyers or sellers of U.S. securities, Staloff said.
NSCC’s average daily clearing fund requirements would decline 15 percent to $3.42 billion if the settlement cycle shrinks to two days after trades occur and 25 percent to $2.99 billion for T+1, a December report from DTCC estimated, based on data from Oct. 19, 2010, to Aug. 31, 2011. In periods of higher volatility when clearing fund requirements increase, a T+1 timeframe would reduce that amount 37 percent to $4.62 billion, the report showed.
DTCC subsidiaries settled nearly $1.7 quadrillion in securities transactions last year, the company said. NSCC cleared trades with an average daily value of $450 billion last year, with participants’ exposure at $900 billion a day since there are two parties to each transaction. NSCC has proposed to guarantee sales and purchases soon after they’re made instead of at midnight at the end of the first day following the transaction, Staloff said.
That plan, which needs regulatory approval, will reduce the risks parties face in the event of a broker default, she said. It’s likely to be implemented this year, she said.
The Boston Consulting Group study, which will include interviews with brokers, banks, asset managers, custodians, retail securities firms and other participants, will be completed in September, Staloff said. Sifma’s operations and technology steering committee will help decide whether the industry should decrease the timeframe for settlement, or leave it at the current deadline of three days after the trade occurs.
“The process will be transparent and open,” Price said. “We want to have an eyes-wide-open approach, have an open mind and not come to this with a preconceived notion about what the outcome should be.”
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