Best New Ideas in Money: How a change to a crucial piece of stock-market ‘plumbing’ could help all investors
A little over 20 years ago it took stock trades a week to settle in a brokerage account — that money was out of 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 fewer. That would be a boon to traders and investors of all sizes.
The settlement process, which entails the actual transfer of ownership of an asset, forms the hidden plumbing of the investment industry. But, like a busted pipe, if it fails, you can be in for a rude — and sometimes expensive — surprise.
That was the case earlier this year when online-trading app Robinhood, along with other trading platforms, temporarily shut down the purchase of popular meme stocks, including GameStop
as it scrambled to meet billions of dollars in margin requirements. Those margin requirements would be smaller if the settlement process were faster.
The incident — which investors said robbed them of potential gains — prompted online outrage, sparked lawsuits and led to congressional hearings. It also triggered a plea by Robinhood CEO Vlad Tenev to shorten the settlement cycle.
“There is no reason why the greatest financial system the world has ever seen cannot settle trades in real time,” Tenev told the House Financial Services in prepared testimony at a February hearing.
Kenneth Griffin, the CEO of hedge fund Citadel, in the same hearing, said it was time to shorten the existing cycle by a day, settling trades one day after execution. Robinhood routes a large chunk of its trades to Citadel, part of an arrangement known as payment for order flow, which allows online brokers to offer low or zero-commission trades but has attracted scrutiny from regulators and critics who contend it may put retail investors at a disadvantage.
The GameStop incident, meanwhile, put a spotlight on efforts already under way to speed the settlement process.
The Depository Trust Clearing Corp., which is owned by a consortium of financial-services firms, and its subsidiaries operate as the single clearinghouse and guarantor of all U.S. public stock trades. The DTCC is working with industry trade groups Sifma, which represents brokers, and the Investment Company Institute, which represents mutual fund companies, in an effort to shorten the settlement process by a day.
At the same time, a pilot project being run by crypto-services firm Paxos is attracting attention. That blockchain-based effort drew headlines earlier this year when project participants Credit Suisse and Nomura’s Instinet completed a same-day settlement of a securities transaction using Paxos’ ethereum-based blockchain technology.
ABN Amro, Bank of America, Société Générale and Wedbush have also participated in the two-year project, which was allowed by the Securities and Exchange Commission to proceed under what’s known as a “no-action” letter. The project expires on Oct. 29. Paxos has said it intends to follow up the project by filing an application with the SEC to become a clearing agency, setting up a potential challenge to DTCC’s monopoly on the clearing and settlement process.
Clearing is the process that takes place between when a trade is executed and settled. Settlement occurs when a security is officially transferred to the buyer’s account and cash to the seller’s account. In the stock market, settlement typically happens 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 Wednesday. A trade made on Friday would settle on Tuesday.
In order to manage the risk that comes with effectively guaranteeing a trade before it actually settles, the DTCC requires brokers to post collateral.
The length of the settlement cycle, formerly dictated by how long it took to physically transfer stock certificates and cash, has grown shorter 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 took until 2017 to further shorten the process to the current T+2 format.
Shortening the cycle requires significant work by exchanges, brokerage firms, clearinghouses, payment systems and other players, both in the U.S. and abroad, to ensure everything works smoothly.
But it’s an effort embraced by the industry. Part of that has to do with margin.
The National Securities Clearing Corp, a subsidiary of the Depository Trust Clearing Corp., maintains a large pool of cash ponied up by brokerage firms that can be tapped in case a firm somewhere in its system goes bust. Brokerages pay margin into the fund based on a formula designed to account for the risk of a possible default somewhere in the system. That formula takes volatility into account.
That’s where Robinhood says it ran into trouble. As customers swarmed into one-way wagers on GameStop and other popular meme stocks, collateral requirements soared. That left Robinhood no choice but to temporarily halt buy orders as it raised billions in cash, Tenev, the CEO, testified.
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,” or a 37% increase in total required margin among its members. The SEC report noted that Robinhood and other brokers have maintained that these margin requirements were the sole reason for restricting purchases of GameStop, but senior officials at the agency told reporters on an Oct. 18 call that they can’t rule out other reasons.
Shortening the settlement period won’t do away with margin requirements, but it would reduce the amount of capital required in the margin process and, of course, how long it is tied up. That makes capital free for other purposes and, most important, reduces the risk of something going wrong before a trade is settled.
The DTCC has previously noted that in 2020, more than $13 billion was, on average, deposited on margin with the National Securities Clearing Corp. The DTCC has estimated that shortening the cycle by a day would reduce the volatility component of NSCC’s margin requirements by around 41%.
Moving to T+1 “benefits investors,” Tom Price, managing director of operations at Sifma, told MarketWatch. “It puts less risk in the market. No. 2, if I sell a security, I wait two days for that security to settle; now, I can get those funds a day earlier.”
For brokerage firms, having less capital tied up in margins could mean additional investment in their platforms, the proponents argued, which would also benefit retail investors.
But it’s a complicated and slow-moving process.
“If moving from T+3 to T+2 was no small undertaking, moving from T+2 to T+1 is a bit more challenging,” Price said.
In a letter to Securities and Exchange Commission Chairman Gary Gensler, Sifma, the ICI and DTCC said the industry could move to a shorter settlement process, while outlining a number of logistical hurdles that must be cleared to shorten the process by 24 hours. The SEC would have to approve rule changes for the industry to implement a shorter settlement process.
Paxos contends its approach would help open up the settlement process to competition and innovation. Its platform allows buyers and sellers to settle transactions the same day they occur, while also supporting T+1 and T+2 settlement. Rather than using a central clearinghouse, the Paxos system would allow two parties to bilaterally settle securities trades directly with each other.
“The method of settling [Wall] Street-side equity clearing hasn’t changed in 30 years … but market structure has changed significantly,” said Greg Lee, Paxos’ managing director for securities, in an interview.
Lee said the Paxos system would significantly reduce margin requirements. Margin requirements would still rise during periods of duress, but when volatility leaves the market, margin requirements return to normal, allowing capital to return to the market, he said.
The DTCC favors maintaining the central clearing party structure, which allows “netting.” Under netting, firms track their wins and losses and pay or collect just the net amount due at the end of each settlement period. That creates a much more predictable financing requirement, said Murray Pozmanter, head of clearing agency services and global business operations at DTCC, in an interview.
Blockchain technology speeds up the process
The DTCC is taking other steps. In parallel with its efforts alongside ICI and Sifma to speed the existing equity settlement process by a day. The organization in September outlined a path to launching what it has dubbed Project Ion, which would use distributed-ledger technology modeled around a netted same-day settlement process that would allow for one-day, two-day or extended settlement periods.
Paxos’ Lee, in a statement, said that the structure of DTCC’s project “is extremely similar to the Paxos Settlement System and what we’ve built that we believe it validates our strategy for a new approach to clearing,” but argued that the use of a central clearing party model would continue to impose a huge cost burden on the industry.
The DTCC declined to comment.
Adding competition to the clearing and settlement process is appealing, said Luke Mauro, global head of operations at Instinet, a participant in the Paxos project. He imagines an eventual scenario in which much of the industry uses at T+1 settlement, while a subset of the industry operates on T+0.
“The biggest thing is that competition is good and giving clients choices is great,” he said in an interview. Instinet opted to participate in the pilot project with an eye toward how the settlement process could change in coming years.
“What I said to a lot of our clients and senior management is, if this is something we want to do in a year or two, we can’t start in a year or two,” he said.