The Deposit Trust & Clearing Corp. (“DTCC”) released a February 24 roadmap for shortening the settlement cycle for US equities by half over the next two years. The proposal anticipates DTCC’s completion of its “Project ION” using distributed ledger technology (“DLT”) to integrate and speed clearing and settlement processes.  Moving to a shorter settlement cycle would reduce industry costs, market risk, and lower margin requirements.

The clearing and settlement process was front and center at the House Financial Services Committee’s February 18, 2021 hearing over the GameStop (NYSE: “GME”) short-squeeze and Robinhood’s pause in GME trading. CEO Vlad Tenev pointed to its clearinghouse’s January 28 demand that Robinhood post $3 Billion in additional cash collateral as the primary reason for its halt on GME purchases.  Tenev called for a move to real-time settlement. 

The Clearing & Settlement Process

During the post-trade time interval (“T+x”) while the instructed trade is executed, cleared, and settled, those market participants involved are subject to interim risk (both market and counterparty credit risk).  Those interim risks are greater during periods of market stress and high volatility.  To protect against those risks, participants in the process require their downstream counter-parties to post cash deposits (“margin”).

DTCC’s subsidiary, National Securities Clearing Corp. (“NSCC”) is an SEC-regulated entity that provides

“clearing, settlement, risk management, central counterparty services and a guarantee of completion for certain transactions for virtually all broker-to-broker trades involving equities, corporate and municipal debt, American depositary receipts, exchange-traded funds, and unit investment trusts.

NSCC also nets trades and payments among its participants, reducing the value of payments that need to be exchanged by an average of 98% each day. NSCC generally clears and settles trades on a T+2 basis.”

That centralized netting function drastically reduces capital requirements, risk, and “friction” within US capital markets.  So it also improves market liquidity and efficiency.  The scale is immense:  On March 12, 2020, alone, DTCC processed over 363 million equity transactions -- 15% more than in October 2008.

Road Map to T+1

As technological capabilities have improved, the industry has shortened the settlement process:  From T+5 to T+3 in 1995, and to T+2 in 2017.  Transitioning to T+1 would require industry-wide buy-in, both from market participants and regulators.  DTCC’s proposed key dates include:

• Q1 2021: DTCC anticipates completion of prototype development for the Project Ion settlement system, which provides a T+1 environment for the industry on a digital platform using distributed ledger technology (DLT) and other emerging technologies. Industry testing will begin shortly after the prototype is completed.
• H2 2022: DTCC to begin transitioning to an enhanced settlement model that more closely integrates processes from DTCC’s equities clearing and settlement subsidiaries, NSCC and DTC. Studies have shown an integrated settlement model could provide an 11% reduction in the volatility component of NSCC margin.
• By 2023: DTCC proposes the U.S. settlement cycle to officially move to T+1, with the market participant and regulator alignment.

Barriers to Real-Time Clearing & Settlement

While same-day and real-time clearing and settlement are possible with existing technology, there are market-driven prudential barriers to them.  DTCC’s White Paper identifies some as

• Netting & Liquidity: Real-time gross settlement could require that transactions in the U.S. market be funded on a transaction-by-transaction basis, eliminating the liquidity and risk-mitigating benefits of today’s netting features. An instantaneous settlement would require trades to be prefunded on an unsecured basis, which could limit market liquidity.
• Increased Fails: Without netting, the number of transactions to be settled would soar and the number of failed transactions could rise significantly.
• Predictive Financing: T+0 does not allow for predictive financing, so clients would likely not know their financing needs for a given day until trading has stopped. Securing end-of-day funds, or determining intraday investment amounts, could be difficult and costly.
• Reconciliation: A move to T+0 would likely require the development of a real-time reconciliation process and real-time stock records to help comply with regulations.
• Loss of CCP Trade Guaranty: Implementing real-time gross settlement would require that all transactions be paid in full by investors, with cash in hand and securities owned for each transaction at the moment of execution. This means investors would need to have complete confidence in their trading partner to make good on the transaction even though that person would be anonymous to them.