DTCC Pushes for U.S. to Move to T+2

The Depository Trust & Clearing Corporation (DTCC) has completed a study that supports the shortening of the settlement cycle in the U.S. financial markets for equities, corporate and municipal bonds and unit investment trust (UIT) trades, moving initially from the current cycle of T+3 to T+2, followed by a move to T+1.

Through risk studies, speaking with the industry, and retaining the Boston Consulting Group (BCG) to run a cost-benefit analysis, DTCC determined that a shorter settlement cycle “mitigates operational and systemic risk by reducing counterparty exposure, procyclicality and liquidity risk from both a clearing agency and member perspective,” the DTCC said in their white paper.

BCG’s analysis found that moving to T+2 would collectively cost the industry approximately $550 million and could be done within three years, and T+1 could possibly be achieved four to six years after that, barring other significant strains on industry resources. The cost to move straight from T+3 to T+1 would be $1.8 billion. BCG also determined a number of cost-saving risk reductions, including the potential loss exposure for the buy-side if a broker-dealer defaults. In a “stress scenario” and a more extreme “major failure scenario,” buy-side counterparty exposure would decrease by 35% and 40% respectively by moving to T+2. If the industry were to move to T+1, these reductions would be 70% and 75% respectively.

“DTCC reached this decision to recommend a move to T+2 after in-depth due diligence that included risk and cost-benefit studies, as well as considerable industry discussions. The industry identified that many of the technological and process building blocks are already in place or being worked on to successfully enable T+2,” says Neil Henderson, DTCC’s managing director of clearing. “However, through its research, DTCC, identified three enablers that pose a significant challenge in reaching T+1 settlement including: 1) building an infrastructure for near-real time processing; 2) transforming the foreign exchange process to promote more rapid settlement; and 3) successfully migrating to institutional trade date matching for institutional trades. To successfully achieve T+1, the industry would need to progress in these three areas. For that reason, DTCC recommends determining industry readiness to move to T+1 after T+2 is successfully implemented.”

However, Henderson notes that “one penalty of moving sequentially to T+2 and then T+1 is that testing must be done twice. As a rule of thumb, testing is approximately one third of the cost. Further, each firm must assess whether systems that have been changed to accommodate T+2 are suitable for the near real-time processing required under T+1. In summary, we would hope that some part of the T+2 build cost (approximately two-thirds of the $550 million for T+2 cost) would be a benefit to T+1, but it is not linear.”

Over time though, the costs for moving to T+2 would be made up in three years based on their estimate of $170 million in annual operational savings and $25 million annual return on reinvested capital from clearing fund reductions, whereas T+1 costs would take closer to ten years to be made up, based on $175 million in annual operational savings and $35 million in return on reinvested capital.

Plus, taking into the account the estimated benefits for reduced loss exposure, the payback period for the buy side could be considered about one and half years for T+2 and about two years for T+1.

BSG also found that the DTCC’s subsidiary National Securities Clearing Corporation (NSCC), which guarantees settlement of broker-to-broker transactions, would have a 15% lower margin requirement in a normal market stress environment and 24% lower margin requirement during a high volatility period, if the cycle moved from T+3 to T+2. In a T+1 environment, this would be reduced by 25% and 37% respectively, compared to the current cycle.

Plus, a shorter settlement cycle would help align the U.S. with the rest of the world, as Europe will complete the move to T+2 by January 2015, and many Asian markets already have a settlement cycle shorter than T+3.

“ICI (Investment Company Institute) strongly supports DTCC’s efforts to shorten U.S. settlement cycles on a timeframe that works for industry participants. Aligning U.S. settlement cycles with global market practices will improve the efficiency of markets and mitigate risks—all changes that will benefit investors,” says ICI President and CEO Paul Schott Stevens. “Funds and their investors benefit from efforts of this kind to strengthen our financial system.”

In addition to ICI, other industry groups have supported the move to T+2, including the Association of Global Custodians (AGC), the Association of Institutional INVESTORS (AII) and the Securities Industry and Financial Markets Association (SIFMA).

Market participants have also gotten on board with the idea of shortening the cycle.

“J.P. Morgan supports the move to a T+2 settlement period because diminishing systemic risk is a major priority for us and for our clients,” says Patrick Kirby, chief operations officer of J.P. Morgan’s Corporate & Investment Bank Operations. “Both institutional and retail investors who trade with and through us benefit from the reduction in settlement time. This is a very significant step in making the industry safer and more reliable.”

Going forward, DTCC says that it will work closely with the industry to advance this initiative, and after T+2 is achieved, they will work with the industry to assess the readiness for T+1.

“Once we get to T+2, the industry must take into consideration how long it will take to get to T+1,” says Henderson. “[A] T+1 settlement cycle could strain participant’s ability to meet new deadlines with current batch processes. The industry would need to migrate from manual and end-of-day batch processes to near real-time processes, transform foreign buyer processes to ensure effective T+1 settlement for both securities and currencies, and achieve same day affirmation for institutional trades.”