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.<\/p>\n
The GameStop margin call<\/strong><\/p>\n In January, retail traders gambling on a previously obscure US share called GameStop triggered unprecedented volumes on US stock exchanges<\/a> and led to a rout of short sellers (those betting on the GameStop share price going down).<\/p>\n 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<\/a> to RobinHood, the retail stockbroking app at the centre of the trading frenzy.<\/p>\n This was ten times the margin RobinHood normally kept at the clearing house<\/p><\/blockquote>\n 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.<\/p>\n 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.<\/p>\n 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\u2019t fail, what if it had?<\/p>\n 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\u2014the failure of one financial intermediary can easily have a domino effect\u2014no one wants to test those defensive lines.<\/p>\n \u201cSettlement cycles should be shortened from T+2 to T+1\u201d<\/p><\/blockquote>\n 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.<\/p>\n “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\u2019s CEO, Ken Griffin, said.<\/p>\n “Settlement cycles should be shortened from T+2 [trade date plus two days] to T+1,” Griffin said.<\/p>\n DTCC responds<\/strong><\/p>\n 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<\/a> by 2023.<\/p>\n \u201cThe immediate benefits of moving to a T+1 settlement cycle could mean cost savings, reduced market risk and lower margin requirements,\u201d DTCC said.<\/p>\n \u201cShortening the settlement cycle would help strike a balance between risk-based margining and reducing procyclical impacts,\u201d DTCC went on.<\/p>\n At an online event held last week<\/a> to discuss the US equity market\u2019s future infrastructure, DTCC\u2019s 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.<\/p>\n \u201cThe cost\/benefit dial has shifted significantly\u201d<\/p><\/blockquote>\n \u201cThere were very high volumes and high volatility in US equity trading last year,\u201d Pozmanter said.<\/p>\n \u201cThe 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.\u201d<\/p>\n \u201cTwo years ago, the margin held by NSCC was $6bn a day,\u201d Pozmanter went on.<\/p>\n \u201cIn 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.\u201d<\/p>\n \u201cThe cost\/benefit dial has shifted significantly. There\u2019s increased interest in moving to T+1,\u201d Pozmanter said.<\/p>\n \u201cThis is complex, but it is critical\u201d<\/p><\/blockquote>\n Craig Messinger, vice chairman of market making firm Virtu Financial, spoke of the necessity of reducing settlement times and operational costs.<\/p>\n \u201cThis [topic] is complex, but it is critical,\u201d Messinger said.<\/p>\n 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<\/a>.<\/p>\n \u201cETFs are a great product but they are tradeable,\u201d Messinger said. \u201cAnd the trading puts more stress on the operational systems to clear and settle the component pieces.\u201d<\/p>\n T+0 is not real-time<\/strong><\/p>\n While a long-term objective for infrastructure providers is to settle share trades on the same day (\u2018T+0\u2019), this does not mean settling in real time, said Michael McClain, general manager of equity clearing and DTC settlement services at DTCC.<\/p>\n \u201cA lot of people confuse T+0 with real-time gross settlement (RTGS),\u201d McClain said.<\/p>\n \u201cT+0 is end-of-day settlement on trade day. This enables us to compress the amount of cash that\u2019s needed and to net the whole day\u2019s 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\u2019s much further out in the future.\u201d<\/p>\n \u201cWe have the deepest, most liquid markets in the world. We should not disrupt that\u201d<\/p><\/blockquote>\n Virtu\u2019s Messinger said that cutting the trade-settlement gap to zero would put intense pressure on technological systems.<\/p>\n \u201cYou need near-perfect, flawless technology across the industry to be in a T+0 environment,\u201d Messinger said.<\/p>\n \u201cWe 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\u2019s tricky. It\u2019s more complicated than I think people realise.\u201d<\/p>\n DTCC\u2019s Pozmanter pointed out that any operational glitches in a real-time settlement environment would quickly impact market liquidity.<\/p>\n \u201cThere is a value in having the settlement process separated from the trade process,\u201d Pozmanter said.<\/p>\n \u201cThere are things that happen and there are frictions that can occur. Right now, supporting processes like financing don\u2019t 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.\u201d<\/p>\n \u201cWe have the deepest, most liquid markets in the world. We should not disrupt that,\u201d DTCC\u2019s McClain added.<\/p>\n Competition from blockchain<\/strong><\/p>\n There\u2019s increasing competition from newcomers for the business of US share clearing and settlement.<\/p>\n Last week technology firm Paxos, broker Instinet and Credit Suisse said they had settled US share trades on the day of trading (though not in real time)<\/a>.<\/p>\n 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.<\/p>\n \u201cSettlement in US equities is opaque and laden with unnecessary delays, capital costs and expenses\u201d<\/p><\/blockquote>\n According to Coindesk<\/a>, Paxos\u2019s private blockchain network is a fork of cryptocurrency ethereum\u2019s codebase, and cash has to be held in Paxos\u2019s custody accounts for delivery versus payment (settlement finality) to happen.<\/p>\n Announcing the initiative, Paxos\u2019s CEO, Charles Cascarilla, said:<\/p>\n \u201cSettlement 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.\u201d<\/p>\n Emmanuel Aidoo, Head of digital assets markets at Credit Suisse, said:<\/p>\n \u201cInnovation in blockchain technology is incremental. We\u2019re 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.\u201d<\/p>\n And yesterday, Binance, the world\u2019s largest cryptocurrency exchange, announced that it is launching trading in US equities<\/a> with a pilot issue of tokens representing Tesla shares.<\/p>\n Trading in the stock tokens will take place in Binance\u2019s native \u2018stablecoin\u2019 (BUSD), which is pegged to the US dollar and also issued by Paxos, Binance said.<\/p>\n Binance\u2019s 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.<\/p>\n Sign up here<\/a> for the New Money Review newsletter<\/em><\/p>\n Click here<\/a> for a full list of episodes of the New Money Review podcast: the future of money in 30 minutes<\/em><\/p>\n Related content from New Money Review<\/em><\/span><\/p>\n Why settlement matters<\/a><\/p>\n