Be careful what you wish for

The drive to T+0 is understandable, but it does not necessarily take into account the risks inherent in cross border transactions across time zones, writes John Gubert

The debate about T+0 is amusing for old timers like myself as so little has moved since it first was raised more than a couple of decades ago. Technology has changed and operations have become more efficient, but these two core components of a move to T+0 do not change materially the challenges it poses. The aim of T+0 has to be to reduce credit risk, and thus systemic risk, in markets. It has to ensure that it does not replace those risks with market or cash liquidity risk. And it has to consider information flows integral to settlement across the transaction life cycle of both buy- and sell-side of the market.

T+0, perhaps using Blockchain technologies, is a fantastic risk reduction vehicle for principal-to-principal trades as long as both sides of the trade have adequate funds and stock to settle the transaction. Replacing pending trades with increased levels of failed trades is not a risk reduction process. Trusted counterparties, such as those in the HSBC-Wells Fargo blockchain-based arrangement, can bypass infrastructures such as CLS, and settle on a mutually agreeable basis outside the platform constraints that global compatibility automatically creates and in a more capital-sensitive way. However, to date that model is a PvP one rather than the more complex DvP required in our markets.

Markets are now both fluid and global. There are actions being taken to consolidate trading in the indigenous market of the relevant listed security, especially within the EU. Theoretically, this would facilitate T+0 by concentrating cash and stock in a single location, but it would not be without problems. Too many constraints, especially for offshore investors, could lead to the creation of surrogates such as depositary receipts or repackaged securities. These may create market liquidity risk by fragmenting trading or even location risk by redomiciling trading volumes.

The concept of T+0 appeals most to the broker-dealer and principal trader populations for their activity model creates capital demand and risk assumption due to the gap between trades and settlement. A population that has a dearth of capital and a business model that requires them to take on risk levels with certain counterparties that are beyond their prudent appetite is logically hungry for any new model that can minimise that challenge. But, others with lower transaction levels relative to their capital base and operating on more of an agency model have other challenges and may feel that sound, irrevocable and simultaneous delivery versus payment models and an active assessment of counterparty risk are adequate controls for their needs.

Operational risk, at each point of transfer in the transaction life cycle, is a further issue and is the most telling with institutional investors and global custodians. Time zones are critical and it would be naïve to think that investors are going to transform their days into 18–24-hour cycles, even if they are WFH! Allocation rules are a further issue. The reality of seamless messaging, especially as we bring on new instruments and issues, remains a show-stopper.

Let us take each in turn. An institutional trade could impact a single asset manager, a single broker, several funds, two or three global custodians, two or three broker agents, different sub-custodians and banks as well as local payment and stock settlement systems; all of whom, for T+0 to be effective, have to be aligned on either cash or stock, or both, in real time and communicating perfectly across the entire life cycle of the single transaction. That, of course has to done in a way that is compatible with 3:00pm in London being equal to 11:00pm in much of Asia and 10:00am in parts of the USA. Moving to becoming totally dependent on STP in real time also poses challenges around technical resilience and the scale of contingency that will be demanded. And that assumes that all counterparties are actually interpreting message standards in a compatible way.

T+1, which is still a challenge for many of the same reasons as T+0, overcomes some of these issues, mainly by giving more time to position stock and cash and overcome operational failures. But the mood music at the moment appears to be that such a solution is not enough for the perfectionists. And using T+0 for domestic settlement, as has been proposed by some, and a later period for cross border, is inane as the larger, and thus highest risk-bearing transactions, are not single trades but a series of interlinked ones which undoubtedly commingle domestic and foreign investors in many of their inter-dependent settlement chains.

So, what is the way forward? The work being undertaken by institutions such as DTCC is very valuable. They need to ensure that they involve the hearts and minds of all parties in their debate. I am fearful that this could smack of the main issue faced by the lamentable and failed GSTPA initiative in the early years of this millennium. Its primary issue was the lack of symmetry between cost, including cost of disruption, of its plan versus the benefits accruing across different interest groups in the market. Is the way forward tokenisation, which is often proposed as the panacea for all settlement challenges? I doubt if tokens reflecting underlying listed securities are much different from depository receipts and they have again the problem of splitting liquidity as they would not be universally acceptable, especially in early years. Could we bring agency trades into principal form? When I worked on the last G20 report, that was briefly considered and then put back in its box as too complex given the varying concept of the role of the de facto or legally defined fiduciary in different countries and the links between such functions and domestic property laws.

As one who was brought up in a domestic equity settlement system that settled, on a single day, trades transacted in an earlier two-week period, progress to date appears amazing. Although attention needs to be paid to time zones and points of settlement in different markets, technically T+1 appears viable. Perhaps, we really should stop there and revisit the driver for T+0 if we believe it is a step too far. Maybe the simpler solution would be to question if the capital structure of the different parties to settlement is adequate; and, if not, give them a timeline to rectify the situation!