A little over 20 years ago, it took a week for stock transactions to settle into a brokerage account – that money was beyond your reach to make new investments. With several projects now in place, you might soon be able to put your money to work in two days or less. It would be a boon for traders and investors of all sizes.
The settlement process, which involves the actual transfer of ownership of an asset, is the hidden plumbing of the investment industry. But, like a broken pipe, if it breaks you can get a gross – and sometimes costly – surprise.
This was the case earlier this year when the Robinhood online trading app, along with other trading platforms, temporarily halted the purchase of popular meme stocks, including GameStop GME,
as he struggled to meet billions of dollars in margin requirements. These margin requirements would be less if the settlement process were faster.
The incident – which investors say robbed them of potential earnings – sparked outrage online, sparked lawsuits and led to hearings in Congress. It also sparked a call from Robinhood CEO Vlad Tenev to shorten the settlement cycle.
“There is no reason why the largest financial system the world has ever seen cannot settle transactions in real time,” Tenev told House Financial Services in prepared testimony at a hearing in February. .
Kenneth Griffin, CEO of hedge fund Citadel, at the same hearing, said it was time to shorten the existing cycle by one day, settling trades one day after execution. Robinhood routes a large portion of its trades to Citadel Securities, under an arrangement known as payment for order flow, which allows online brokers to offer low or no commission trades, but has attracted the attention of regulators and critics who argue it could put retail investors at a disadvantage.
The GameStop incident, meanwhile, highlighted efforts already underway to speed up the settlement process.
The Depository Trust Clearing Corp., which is owned by a consortium of financial services companies, and its subsidiaries act as the single clearing house and guarantor of all US stock transactions. DTCC is working with industry trade groups Sifma, which represents brokers, and the Investment Company Institute, which represents mutual fund companies, with the goal of shortening the settlement process by a day.
At the same time, a pilot project led by crypto-services company Paxos is drawing attention. This blockchain-based effort grabbed the headlines earlier this year when project participants Credit Suisse and Nomura’s Instinet on the same day concluded a settlement of a securities transaction using blockchain-based technology. on Ethereum from Paxos.
ABN Amro, Bank of America, Societe Generale and Wedbush also participated in the two-year project, which was cleared by the Securities and Exchange Commission to proceed under what is known as a “no-action” letter. The project expires on October 29. Paxos has announced its intention to continue the project by filing an application with the SEC to become a clearing agency, thus challenging DTCC’s monopoly on the clearing and settlement process.
Clearing is the process that takes place between the time a trade is executed and its settlement. Settlement takes place when a security is officially transferred to the buyer’s account and cash to the seller’s account. In the stock market, settlement typically takes place two business days after a trade is executed. So if you buy a stock on Monday, the trade will settle at the end of the day on Wednesday. A transaction made on Friday would be settled on Tuesday.
In order to manage the risk of securing a transaction effectively before it is actually settled, DTCC requires brokers to provide collateral.
The length of the settlement cycle, once dictated by the time it takes to physically transfer share certificates and cash, has shortened over the decades. In 1995, the process was shortened from five days after execution, known in industry jargon as T + 5, to three days after settlement, or T + 3.
It was not until 2017 to further shorten the process to the current T + 2 format.
Shortening the cycle requires significant work on the part of exchanges, brokerage firms, clearing houses, payment systems and others, both in the United States and abroad, to make it all happen. good.
But it is an effort adopted by the industry. Part of it has to do with the margin.
The National Securities Clearing Corp, a subsidiary of the Depository Trust Clearing Corp., maintains a large pool of cash accumulated by brokerage firms that can be tapped into in the event that a business somewhere in its system goes bankrupt. Brokerages pay a margin to the fund based on a formula designed to account for the risk of a possible default somewhere in the system. This formula takes into account volatility.
This is where Robinhood says he ran into trouble. As customers flocked to one-way betting on GameStop and other stocks of popular memes, warranty requirements have skyrocketed. This left Robinhood with no choice but to temporarily halt buy orders as it raised billions of dollars in cash, CEO Tenev said.
The SEC, in a long-awaited report released on Oct. 18, noted that the NSCC “made intraday margin calls from 26 Clearing Members totaling $ 6.9 billion,” a 37% increase in the total margin required. among its members. The SEC report noted that Robinhood and other brokers maintained that these margin requirements were the only reason to restrict GameStop purchases, but senior agency officials told reporters on a call from the October 18 that they could not rule out other reasons.
Shortening the settlement period will not remove the margin requirements, but it would reduce the amount of capital required in the margin process and, of course, its downtime. This frees up capital for other purposes and, more importantly, reduces the risk of something going wrong before a trade is settled.
DTCC previously noted that in 2020, more than $ 13 billion was, on average, deposited on margin with the National Securities Clearing Corp. DTCC estimated that shortening the cycle by one day would reduce by about the volatility component of NSCC’s margin requirements. 41%.
The move to T + 1 “benefits investors,” Tom Price, chief operating officer at Sifma, told MarketWatch. “It puts less risk in the market. No. 2, if I sell a title, I wait two days for this title to settle; now I can get these funds a day early.
For brokerage firms, having less capital tied up in margins could mean additional investment in their platforms, proponents argued, which would also benefit retail investors.
But it is a complicated and slow process.
“While going from T + 3 to T + 2 was no small feat, going from T + 2 to T + 1 is a bit more difficult,” Price said.
In a letter to the chairman of the Securities and Exchange Commission, Gary Gensler, Sifma, ICI and DTCC said the industry could move to a shorter settlement process, while outlining a number of logistical hurdles that must be overcome to shorten the 24 hour process. The SEC is expected to approve the rule changes for the industry to implement a shorter settlement process.
Paxos argues that its approach would help open up the settlement process to competition and innovation. Its platform allows buyers and sellers to settle transactions on the same day they occur, while supporting T + 1 and T + 2 settlement. Rather than using a central clearing house, the Paxos system would allow two parties to bilaterally settle securities transactions directly with each other.
“The method of payment [Wall] The clearing of equities on the street side has not changed for 30 years… but the structure of the market has changed considerably, ”said Greg Lee, Paxos Managing Director for Securities, in an interview.
Lee said the Paxos system will significantly reduce margin requirements. Margin requirements would increase further during times of stress, but when volatility leaves the market, margin requirements return to normal, allowing capital to return to the market, he said.
DTCC is in favor of maintaining the structure of the central clearing party, which allows “clearing”. As part of netting, companies track their gains and losses and only pay or receive the net amount due at the end of each settlement period. This creates a much more predictable funding need, said Murray Pozmanter, head of clearing agency services and global business operations at DTCC, in an interview.
Blockchain technology speeds up the process
DTCC is taking further action. In addition to its efforts alongside ICI and Sifma to speed up the settlement process for existing actions by one day. In September, the organization outlined the path forward to launch what it dubbed Project Ion, which would use distributed ledger technology modeled around a same-day net settlement process that would allow periods of settlement of the same day. ‘one day, two days or extended.
Lee from Paxos, in a statement, said the DTCC project structure “is extremely similar to the Paxos settlement system and what we have built that we believe validates our strategy for a new approach to clearing.” But argued that using a central clearing house model would continue to impose a huge financial burden on the industry.
DTCC declined to comment.
Adding competition to the clearing and settlement process is appealing, said Luke Mauro, global operations manager at Instinet, participating in the Paxos project. He imagines a possible scenario in which a large part of the industry is using at T + 1, while a subset of the industry is operating at T + 0.
“Most importantly, the competition is good and giving customers choices is great,” he said in an interview. Instinet chose to participate in the pilot project thinking about how the settlement process might change in the years to come.
“What I’ve said to a lot of our clients and to senior management is that if it’s something we want to do in a year or two, we can’t start in a year or two,” did he declare.