Disruption, transformation, and the re-emergence of settlement compression in the drive for efficiency

Markets have benefited from the shortening of settlement cycles over the last couple of decades, but the conversation has evolved to include same-day and even atomic settlement as the industry continues its search for efficiency gains and cost savings.
By Jonathan Watkins

Every step on the lengthy road towards shorter settlement times has triggered improvements to processes, technology and operating models, and the shift to T+1 is set to be no exception.

The US, Canada and India have all announced their transitions in recent months. What differs this time around, however, is that through new technologies, both same-day and atomic settlement have entered the equation.

Speakers on a recent Global Custodian webcast panel in partnership with Citi discussed the impact of these latest rounds of proposed changes, the possibility of real-time T+0 settlement and the potential benefits of blockchain solutions.

The world will be watching with eager anticipation as the US aims to make the move from T+2 to T+1 in 2024, with Canada following around the same time. Europe also operates under T+2, though a speed-up is also seen by many as inevitable at a later date.

Aashish Mishra, APAC head of direct custody and clearing, Citi, says: “A shortened settlement cycle to T+1, or even T+0, would require the automation of processes and increased straight-through processing. To achieve this shortened settlement cycle, there also has to be far less manual intervention.”

Citi recently published a white paper looking at the shift to T+1 and beyond under the theme of the evolution within securities services. The custodian noted that many see advantages of settlement compression – risk reduction, liquidity and collateral benefits – particularly during times of high volatility. However, if it was as easy as flicking a switch, we would have made these transitions years ago, without hesitation or in-depth research.

Mishra adds: “You have to look at the costs involved in order to achieve those benefits. If you are looking at T+1 or T+0 in traditional equities or bonds then you are looking at an end-to-end overhaul of every participant’s infrastructure and procedures.”

Some of the technology, however, is already in place. When markets moved to T+2 during the last decade, some far-sighted players realised T+1 would arrive one day and built technology able to cope with further shortening.

“The market is looking at further compression of the cycle.  The migration from T+3 to T+2 had been successfully implemented for most markets in the past 10 years and we noted that a few markets have started to explore the possibility in adopting T+1 going forward,” says Catharine Wong, head of share registry and issuer services, Tricor Group. “Reducing the settlement cycle means that we can reduce market risk. It also creates greater efficiencies both on the capital and operational fronts.”

Alessio Quaglini, CEO and co-founder, Hex Trust, adds: “We need to increase automation of processes in order to improve efficiency behind different markets. The key to doing this will be to mitigate risk in collateral transactions. This can be done in different ways, but it will change the way we settle transactions for the better.”

Time zone challenges

Shifting to T+1 would not just entail taking T+2 processes and running them one day faster. In the FX market, which runs on a T+2 settlement cycle, timeliness is a key challenge.

According to Daniel Hildebrand, head of digital and depository services, SGX, different settlement cycles require auxiliary services, like lending services, increasing the cost of transactions. The FX part is critical for international investors, and the time zones make things significantly more complicated.

Singapore-based Hildebrand notes: “Our counterparties in the market tell us there might be challenges getting the settlement instructions on time because already, from a settlement perspective, it’s a T+1 settlement if you’re trading late into the US.”

Mishra agreed that time zone differences are a challenge. “If you look at the investment lifecycle, there are a number of different entities involved. There are asset managers, brokers, global custodians, sub-custodians and each one of them performs a very important role as they hand off from one to the other,” he says.

“A shortened settlement cycle in Asia will present unique challenges to global investors based in US- or EMEA, a lot of the trade lifecycle will need to be done within a single day, end-to-end. That is a significant change for an investor.”

There are also other impacts to consider. As Hildebrand of SGX says: “With T+1 or T+0, the liquidity benefit goes away, and netting efficiency is lost.”

Time for T+0?

While same-day settlement could still have some netting benefits, atomic settlement – instantaneous – would represent more than just another incremental speed-up. Settlement will likely be on a gross basis that buyers would need to have cash in hand and sellers would need to have the stock. It will cause further pressure on the intra-day liquidity and there is uncertainty as to whether the smaller brokers without access to large intra-day liquidity would be ready for this.

“Further compressing to T+0 would mean technology plays an even bigger part because you would have to look at how to completely redesign the back end,” says Wong. “Atomic settlement could introduce new risk to the system, and we have to be mindful of this.”

Blockchain and regulation

Blockchain has been proposed as a solution to the challenges of accelerating the settlement cycle. However, migrating to an entirely different form of technology is a complex process and comes with its own risks.

“The players that entered the market at the beginning of Blockchain 1.0 took the old models they were using in traditional finance to this new settlement layer. So we had new market infrastructure that allowed us to do a lot of things but we were using old technology and old processes and procedures,” says Hex Trust’s Quaglini.

“Only recently, the market realised this new infrastructure had the potential to reduce the settlement cycle.”

Blockchain technology could be used to represent any financial instrument. “It’s going to be a complex process, and regulators will have to work together to put together global standards and frameworks,” he notes.

The need for speed

Settlement has been transformed over the past decades. Before 1995, the US market operated at the relaxed pace of T+5 and has benefited from reductions since. But is the move from T+2 to T+1 worth the disruption?

Citi’s Mishra says: “As long as the challenges can be addressed, then the opportunities absolutely make sense… [when one considers] the impact on capital, margin, systemic risk and, more importantly, creating operational efficiency.”

Wong adds: “The regulator must be engaged in the market. Financial market infrastructures and industry players alone do not have the authority to mandate a settlement change. A lot of players need to have certainty before they move forward on a major change like this. We need the whole market to move in one direction, to be aligned as a whole.”