T+0: realistic target or deluded fantasy?

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T+0: realistic target or deluded fantasy?

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T+0: realistic target or deluded fantasy?

Part 2: the need for speed. 

By Tony Freeman

Faster is better – right? If you’re Lewis Hamilton: obviously yes. But suppose you’re a manufacturer based in Shenzhen making iPhone cases, your costs are all in Renminbi and Hong Kong Dollars, but your revenues are mostly in US Dollars, Euro’s and Sterling. You will probably do an FX sweep at the end of the working day to settle on a T+2 basis. You can use the T+1 window to resolve any queries on the trade. The two-day cycle is a practical timeframe, especially when you factor in time-zone issues. A 1-day settlement cycle would be unhelpful. The FX market works to facilitate global trade – it is not subservient to capital markets. Which is why the standard T+2 model is unlikely to change. Faster isn’t better.

The UK Accelerated Settlement Taskforce (of which I’m a member) has published its report. On T+0 it says: “…..there is clear consensus that it is neither practical nor sensible to seek to move from T+2 to T+0 in one step….” but it does keep the door open for a future initiative. I fully agree with this conclusion. Why?

Securities markets can operate on a T+1 basis: in fact, many already do. So, the obvious question is why can’t they go faster? It’s an inevitable query: especially in a world of ever more powerful technology. However, policymakers, regulators, market infrastructures and market users are almost universal in their caution about a T+0 settlement cycle.

The principal issue is the capability of the market and its willingness to change. As the old Irish joke goes “…..if I was going there, I wouldn’t start from here”.

The noise about T+0 settlement mostly emanates from Blockchain/DLT advocates. The actual process of settlement (normally in a Central Securities Depositary) uses a risk-reduction model called “Simultaneous Irrevocable Delivery Versus Payment”. Minimising the time-gap between delivery of cash and securities and preventing unilateral cancellation doesn’t eliminate risk, but it does reduce it to minimal levels. It deals effectively with “Herstatt Risk”, named after the German bank which went bust in the 1970’s without completing its transactions. A disconnect between payment and delivery created a systemic risk issue and led, ultimately, to the creation of CLS Bank: a payment versus-payment-platform which addresses risk in the global FX market.

Additionally, banks and brokers are members of Central Counterparty’s (“CCP’s”). Clearing involves the netting of trades done between two wholesale counterparties. Unlike buyside firms an investment bank may perform thousands of trades in a stock – both buys and sells – within a trading day. The gross amount traded looks huge but an efficient market, such as the US, can achieve end-of-day netting rates of 97% or above. When only 3% of your value requires actual settlement capital efficiency is vastly improved.

Additionally, CCP members can also “give-up” the trade to the CCP. The CCP becomes the counterparty to each side of the trade. CCP’s hold huge default funds so the trade is effectively guaranteed. It’s an incredibly valuable risk reduction process and market risk regulators love it. However, it’s important to note that institutional investor and buyside firms are not normally involved in clearing and they are not members of CCP’s. Their trades go directly into the settlement process. (The reasons are highly technical, but the main issue is that investors use intermediaries that are acting as agents: they cannot commit their client’s funds to a CCP guarantee/default process.)

Clearing offers huge benefits: it vastly reduces counterparty risk; it frees up capital to improve liquidity and aids orderly price-formation. It’s deeply embedded in most liquid markets and infrastructure providers will often state that clearing is their most valuable product offering.

It’s frequently cited that same-day settlement means that the whole clearing process becomes obsolete. Not necessarily. There are three forms of T+0 settlement: end of day, intra-day and real-time/atomic. Clearing operates on a daily cycle: after the market close positions are confirmed and submitted to the CCP for processing. Atomic settlement clearly can’t involve a CCP.  Intra-day settlement probably also obviates a clearing process: the netting function requires a viable number of transactions. This can be achieved for a full day’s trading but may not be effective if done on an hourly basis. So, the only realistic proposition is end-of-day

CCP’s and their members need to be operationally very efficient. CCP’s stipulate demanding same-day cut-off times meaning that evening and overnight working is inevitable. T+1 settlement is feasible because CCP’s and their members already operate a same-day processing model. A CCP would normally perform the netting and give-up process late evening on T or overnight early on T+1. Later in the day on T+1 the residual trading positions will be submitted to a CSD for settlement. Compressing these processes into the evening/night cycle on T hugely increases the operational risk. For buyside firms that are struggling to move to a T+1 model the issue is even greater.

Theoretically a Blockchain model could facilitate the process. But it would require a single ledger or interoperability between ledgers to which everyone is connected. It would also require everyone, big and small, to be a direct participant operating on a 24-hour basis.  This vision is so far removed from today’s reality it simply isn’t credible. It would also challenge the business model for many deeply embedded service providers in today’s environment and Turkeys don’t vote for Christmas.  CCP’s custodians, registrars and others would be left without a role unless they all have the same vision and re-engineer their business model.  Additionally, there are numerous risk, legal and regulatory issues that would need to be addressed. Perhaps when financial products have been tokenized and exist purely in a virtual state the situation may change but the how and when are unknown. Surely new and innovative infrastructure providers will emerge. Let’s hope so – but in the meantime…..

More to come in part 3 – the market infrastructure angle