Under pressure to reduce the operational risks in the US equity markets, infrastructure providers say they can shorten the time it takes to settle a share trade, but not eliminate it completely.
The GameStop margin call
In January, retail traders gambling on a previously obscure US share called GameStop triggered unprecedented volumes on US stock exchanges and led to a rout of short sellers (those betting on the GameStop share price going down).
But the volume spike caused problems behind the scenes. At 3am on 28 January, the National Securities Clearing Corporation (NSCC), the clearing house through which all deals in US shares are routed, made a $3bn margin call to RobinHood, the retail stockbroking app at the centre of the trading frenzy.
This was ten times the margin RobinHood normally kept at the clearing house
This was ten times the amount of margin RobinHood normally kept at the clearing house. And the firm would have only hours to come up with the extra cash.
The margin call was later scaled down and RobinHood met it. But the event sent shivers down the spines of those responsible for the safety of the financial markets.
Central clearing counterparties (CCPs) and central securities depositaries (CSDs), in which share ownership records are kept, are the most critical elements of the traditional market infrastructure. Though RobinHood didn’t fail, what if it had?
In theory, CCPs have several lines of defence against the insolvency of a member firm, starting with the margin that firm posts to support its trades. But, because of the potential contagion risks—the failure of one financial intermediary can easily have a domino effect—no one wants to test those defensive lines.
“Settlement cycles should be shortened from T+2 to T+1”
In Congressional hearings held in February to dissect the GameStop events, both RobinHood and Citadel, a market-making firm that profits from retail investor flows, called for an immediate fix: a shortening of the time it takes to settle a US equity trade.
“As we have seen, longer settlement periods expose firms to more risk in the time between execution and settlement, requiring higher levels of capital,” Citadel’s CEO, Ken Griffin, said.
“Settlement cycles should be shortened from T+2 [trade date plus two days] to T+1,” Griffin said.
On 24 February, the Depositary Trust & Clearing Corporation (DTCC), which owns NSCC and the US central securities depositary, outlined a plan to reduce settlement times in US equities from two days to one by 2023.
“The immediate benefits of moving to a T+1 settlement cycle could mean cost savings, reduced market risk and lower margin requirements,” DTCC said.
“Shortening the settlement cycle would help strike a balance between risk-based margining and reducing procyclical impacts,” DTCC went on.
At an online event held last week to discuss the US equity market’s future infrastructure, DTCC’s head of clearing agency services, Murray Pozmanter, quantified the role of the CCP in netting trades and the potential savings on offer from reducing settlement times.
“The cost/benefit dial has shifted significantly”
“There were very high volumes and high volatility in US equity trading last year,” Pozmanter said.
“The current netting system is what allowed all of that activity to settle seamlessly at the CCP and at the depositary. In 2020, on average we saw trades worth $1.77trn coming each day into the NSCC. Through netting, that was reduced by 98 percent, so only $37bn needed to be settled.”
“Two years ago, the margin held by NSCC was $6bn a day,” Pozmanter went on.
“In 2021 the average was $13bn a day, with several spikes to over $30bn in response to extreme volatility. Reducing the settlement cycle from T+2 to T+1 would take away 41 percent of the volatility component of our margin requirement. This would substantially reduce the burden on the industry.”
“The cost/benefit dial has shifted significantly. There’s increased interest in moving to T+1,” Pozmanter said.
“This is complex, but it is critical”
Craig Messinger, vice chairman of market making firm Virtu Financial, spoke of the necessity of reducing settlement times and operational costs.
“This [topic] is complex, but it is critical,” Messinger said.
The Virtu executive went on to highlight exchange-traded funds (ETFs) as a potential source of post-trade risk. Most ETFs track indices, but an increasingly popular segment of the ETF market is actively managed, including several high-profile funds run by ETF newcomer ARK Invest.
“ETFs are a great product but they are tradeable,” Messinger said. “And the trading puts more stress on the operational systems to clear and settle the component pieces.”
T+0 is not real-time
While a long-term objective for infrastructure providers is to settle share trades on the same day (‘T+0’), this does not mean settling in real time, said Michael McClain, general manager of equity clearing and DTC settlement services at DTCC.
“A lot of people confuse T+0 with real-time gross settlement (RTGS),” McClain said.
“T+0 is end-of-day settlement on trade day. This enables us to compress the amount of cash that’s needed and to net the whole day’s activity. RTGS is a much different market structure. You assume that everyone has the securities on hand and the cash on hand when the trade is executed. You lose the netting benefit. RTGS is achievable with smart contracts, but that’s much further out in the future.”
“We have the deepest, most liquid markets in the world. We should not disrupt that”
Virtu’s Messinger said that cutting the trade-settlement gap to zero would put intense pressure on technological systems.
“You need near-perfect, flawless technology across the industry to be in a T+0 environment,” Messinger said.
“We all know that is not the reality right now. Every day there are glitches. We are only as good as our weakest link in a very complex, computerised world. If something goes wrong, you need time to reconstruct the trades, reconstruct the activity. It’s tricky. It’s more complicated than I think people realise.”
DTCC’s Pozmanter pointed out that any operational glitches in a real-time settlement environment would quickly impact market liquidity.
“There is a value in having the settlement process separated from the trade process,” Pozmanter said.
“There are things that happen and there are frictions that can occur. Right now, supporting processes like financing don’t impact trading directly. If you go into a real-time gross settlement environment, settlement is necessitated by the trade. So any friction in the settlement process would immediately transmit into the trade process and impede price discovery.”
“We have the deepest, most liquid markets in the world. We should not disrupt that,” DTCC’s McClain added.
Competition from blockchain
There’s increasing competition from newcomers for the business of US share clearing and settlement.
The trades occurred at 11am and 3pm and were settled at 4.30pm, Paxos said. Its settlement service is a private, permissioned blockchain designed to allow two parties to settle securities trades bilaterally, rather than via a centralised intermediary like a CCP.
“Settlement in US equities is opaque and laden with unnecessary delays, capital costs and expenses”
According to Coindesk, Paxos’s private blockchain network is a fork of cryptocurrency ethereum’s codebase, and cash has to be held in Paxos’s custody accounts for delivery versus payment (settlement finality) to happen.
Announcing the initiative, Paxos’s CEO, Charles Cascarilla, said:
“Settlement in US equities is opaque and laden with unnecessary delays, capital costs and expenses. We are working hard to improve settlement for the benefit of all market participants. An upgraded settlement system can create safer, fairer and more open capital markets that foster innovation.”
Emmanuel Aidoo, Head of digital assets markets at Credit Suisse, said:
“Innovation in blockchain technology is incremental. We’re excited to make progress in forging a path to faster settlement times at lower costs in public equities. These advancements will ultimately benefit the broader market as more firms join the platform.”
And yesterday, Binance, the world’s largest cryptocurrency exchange, announced that it is launching trading in US equities with a pilot issue of tokens representing Tesla shares.
Trading in the stock tokens will take place in Binance’s native ‘stablecoin’ (BUSD), which is pegged to the US dollar and also issued by Paxos, Binance said.
Binance’s new Tesla tokens are backed by shares stored in a depository portfolio of underlying securities, in cooperation with Munich-based investment firm CM-Equity AG and Swiss-based asset tokenization platform Digital Assets AG, the firm said.
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