If time equals risk, settle quickly

Transcription

1 FEATURE MI FORUM / 2014 If time equals risk, settle quickly In investment, time equals money, while in operations time equals risk, but both ultimately mean the same thing. Time both makes and costs money, and so does risk. Which is why shortening the settlement timetable can cut costs as well as risks, say John Abel, vice president, product management, DTCC, and Tony Freeman, head of industry relations at Omgeo, a DTCC company. The crisis of led to a range of regulatory measures designed to reduce risk in the financial system. But the securities industry has explored risk management and mitigation opportunities of its own, and has now resurrected a concept which was examined at the turn of the century, but never fully pursued. The idea is that, by shrinking the post-trade settlement cycle, the industry will reduce risk. If it can be made to work, the benefits are hard to deny. If it takes less time after a trade is executed to exchange funds for securities and so settle the trade between the counterparties finally and irrevocably, there is less chance for something to go wrong. Current plans for a shortened settlement cycle (SSC) aim to eliminate a full day in the current settlement timetable in most developed markets, reducing trade date plus three days (T+3) to a speedier trade date plus two days (T+2). An SSC also creates more opportunity for operational efficiency. Around the world, settlement cycles vary between markets and asset classes. This lack of harmonisation increases complexity, costs and risks for firms with significant volumes of trading and investment activity across borders and between asset classes. Most obviously, it creates a risk of having to pay for assets purchased before funds are received from assets sold. 1

2 Already North American and European fund increased costs and risks in some domestic and months to adapt to the disciplines of a tighter managers and broker-dealers settling equity almost all cross-border transactions. Although settlement timetable before the final regulatory trades on T+3 in their own markets are trading settlement risk mitigation and efficiency were deadline of January These are important equities in markets in the Asia-Pacific region that settle on T+2 or even T+1. Those equity markets in the region that still settle on T+3, areas of longstanding concern to European policymakers, it was T2S that finally prompted the introduction of a common European lessons for other markets and regions to absorb. Furthermore, in order to meet the expedited It was T2S that finally prompted the such as Australia and Singapore, are actively looking to reduce their settlement cycle. In the European Union (EU), the 28 member- settlement cycle of T+2 via the CSD-R. The aims of the CSD-R are wider than the settlement process. It introduces a common timeline, European banks and broker-dealers embarked on development and testing exercises months in advance, in order to ensure introduction of a common European states are moving on to a common T+2 settlement timetable from January This target, set by the Central Securities Depository framework for the authorisation and supervision of central securities depositories (CSDs), with the principal ambition of increasing efficiency their internal processes were adequately reengineered to go live in October this year. With the January 2015 deadline only months settlement cycle of T+2 via the CSD-R. Regulation (CSD-R), is part of the preparations and lowering cross-border transaction costs away, all market participants are reviewing the for the introduction of the single European platform for the settlement of securities transactions. Known as TARGET2-Securities (T2S), the platform is built, owned and operated through competition. However, its authors recognised that the harmonisation of the settlement cycle would reduce risk as well as increase competition. readiness of their systems and processes, as well as those of their counterparties, to ensure a smooth transition to T+2. While Europe is moving expeditiously to shorten - John Abel, vice president, product management, by the European Central Bank (ECB) and 17 In the EU, the switch to a T+2 settlement its settlement cycle, the United States has DTCC and Tony Freeman, head national central banks in the euro area. Settlement in 22 European countries will timetable is now imminent. The first countries to adopt T2S - Italy, Greece (government only recently established a consensus on the need to move to T+2. Certain asset classes, of industry relations at Omgeo migrate to T2S between 2015 and 2017 bonds only), Romania, Malta, and Switzerland including Treasury securities and the majority in three consecutive waves. T2S will offer (euro transactions only) - are scheduled to of mutual funds, already settle on T+1. Other centralised delivery-versus-payment (DvP) settle their first trades in June More than asset classes including equities, corporate and settlement in central bank money across all 20 European markets have already agreed to municipal bonds and unit investment trusts euro-zone markets, with markets outside the complete the transition to T+2 no later than 6 (UITs), continue to settle on T+3. euro-zone free to choose to use T2S if it makes October this year, in order to minimise the risks The consensus now holds that securities and operational and financial sense. T2S aims associated with making a fundamental change funds settling on T+3 should move on to a to cut the costs of cross-border settlement, in the settlement timetable over the New Year T+2 settlement timetable, and the industry re- chiefly by eliminating the fragmentation of holiday period. evaluate a move to T+1 once that transition is the securities settlement infrastructure, and This move to meet the deadline ahead of complete. An implementation date has yet to increasing competition. schedule is important for two reasons. First, it be established, but the debate on an SSC has One of the ways in which it will accomplish shows that the securities industry can be pro- a long history in the United States. It began in these intermediate and ultimate goals is through active in implementing measures that enhance the 1990s, following the move from T+5 to T+3, a harmonised settlement cycle. At present, operational efficiency ahead of regulatory but the momentum was lost after the implosion European securities markets settle on divergent mandates. Secondly, the 6 October adoption of the TMT boom in timetables, ranging from T+1 to T+3, leading to date also gives market participants several It picked up again after the global 2 3

3 financial crisis and the flood of new regulations that followed, most of them in the copious Dodd-Frank Wall Street Reform and Consumer Protection Act of The Depository Trust & Clearing Corporation (DTCC) began discussions on shortening the settlement cycle with industry representatives in early 2011, six months after the passage of that legislation. A year later, in 2012, the DTCC released a white paper suggesting the industry engage an independent consulting firm to analyse the costs and benefits to the United States of an SSC. The firm chosen for the task, the Boston Consulting Group, published the results of its study in October They showed that the vast majority of firms surveyed supported a shorter settlement cycle in the United States, not only because it would reduce risk, but because it was likely to generate operational savings. The Boston Consulting Group study estimated that the initial cost of moving from a T+3 to a T+2 settlement cycle in the United States would be $550 million. However, this would generate recurrent savings of approximately $195 million a year, which translates into a recovery of the investment within 2½ to 3½ years. The majority of the savings stemmed not only from greater operational efficiency within firms but also from direct reductions in the costs to all market participants of clearing trades through the National Securities Clearing Corporation (NSCC), the central counterparty for equity trades in the United States. Those savings reflected lower margin calls for users of the NSCC, and reduced liquidity requirements at While Europe is moving expeditiously to shorten its settlement cycle, the United States has only recently established a consensus on the need to move to T+2. - John Abel, vice president, product management, DTCC and Tony Freeman, head of industry relations at Omgeo 4 5

4 the NSCC itself. inevitably find it challenging to accommodate to their broker-dealers for unsettled trades. At the request of the industry, the DTCC re- the shorter settlement cycle. Yet, to achieve an The Boston Consulting Group study estimated validated the findings of the Boston Consulting SSC, all market participants must be able to that, in stressed markets, a move to T+2 would The benefits in terms of enhanced Group study by hosting a second round of industry meetings to determine the best way to proceed. The DTCC elected to work with process trades within that time-frame. There is an additional reason for proceeding deliberately. Prior to implementing T+2, the reduce buy-side risk by 35 per cent. Moving to T+1 would double that reduction to 70 per cent. In highly stressed markets, the risk reduction is operational efficiency and cost savings a number of industry associations, including the Investment Company Institute (ICI), the Association of Global Custodians (AGC), the securities industry as a whole will need to make a number of process improvements. These were described by the Boston Consulting even greater (see Table 1). It rises to 40 per cent in a T+2 regimen and to 75 per cent on a T+1 timetable. will be significant, both for individual Association of Institutional INVESTORS (AII) and the Securities Industry and Financial Markets Association (SIFMA). Group as the enablers of a shorter settlement timetable. The two unavoidable changes are modifications of the industry-established rules The reduction in counterparty risk to sell-side firms, on the other hand, is captured in reduced margin requirements. The Boston Consulting investors and the securities industry as Following a series of meetings between representatives of the industry associations and the DTCC, the industry associations ultimately and operational systems of users. However, the Boston Consulting Group study also identified a number of secondary Group study found that in an average period of volatility, sell-side risk would be reduced by 15 per cent with a move to T+2 and by 25 a whole. chose to support a move to T+2 settlement, provided it was implemented on a time-frame enablers to T+2 in the United States. These include mandatory migration to same-day per cent on a T+1 timetable. Again, the risk reduction during periods of high volatility is even agreeable to the industry. This agreement is a (T+0) matching of trades; cross-industry efforts greater. Risk for sell-side firms would fall by 24 - John Abel, vice president, product management, DTCC and Tony Freeman, head of industry relations at Omgeo major step towards getting a transition to T+2 under way in the United States. The decision not to define a specific implementation date at the outset reflects the fact that readiness for T+2 varies from firm to firm. For example, some sell-side institutions to improve standing settlement instructions; dematerialisation of the remaining physical securities; and increased penalties for settlement failure. Most of these measures are already in the process of being implemented, but the per cent on a T+2 timetable, and 37 per cent if the cycle was tightened to T+1 (see Table 2). The counterparty risk reduction to the sellside, and the corresponding reduction in NSCC margin requirements, represent direct savings to sell-side firms. tend to be better prepared, because their completion of all of the components needed Liquidity risk, which arises during the period systems are flexible enough to be adapted to to shorten the settlement cycle in the United between the sale of units in a mutual fund and accelerated transaction processing timetables, States successfully will likely take several years. payment for them, is also mitigated by a tighter while some buy-side counterparties also have However, the benefits in terms of enhanced settlement timetable. In the United States, sophisticated technology in place. operational efficiency and cost savings will the proceeds from the liquidation of units in It follows that some firms on both the buy- be significant, both for individual investors a mutual fund are typically payable on T+1 side and the sell-side in the United States are and the securities industry as a whole. The more than 70 per cent of mutual funds settle relatively well-positioned to adjust to an early most valuable of these benefits are reduced on T+1 - but the proceeds from the sale of the transition to a T+2 settlement cycle. Conversely, counterparty, liquidity and systemic risk. underlying equity components are generally not other firms that still rely mainly upon manual Take counterparty risk. Shortening the received until T+3. That implies that the fund processes - including the use of fax machines settlement cycle moderates counterparty risk must have sufficient liquidity to finance a two and spreadsheets for trade processing will for buy-side firms by reducing their exposure day gap. The smaller the gap, the smaller the 6 7

5 liquidity resources required, and the smaller the period of exposure between counterparties exposure and liquidity requirements, and by from key firms active in the various segments of risk of a mutual fund experiencing a shortfall. and, in cleared markets, the period of exposure mitigating pro-cyclical effects; lessens clearing the industry. The liquidity risk to sell-side firms stems from between sell-side firms and the clearing house. house margin requirements by reducing risk The responsibilities of the steering committee the prudential obligation laid on the NSCC to An obvious consequence is a reduction in the exposure; delivers cost savings and operational are set. They include defining an overall maintain at all times sufficient liquidity to cover risk incurred by the clearing house itself. In efficiency as a result of the changes required project plan and timeline for moving to T+2; the monies owed by the largest firm or fund highly stressed markets, these exposures all to accommodate a shorter settlement cycle; overseeing the SSC initiative on behalf of all family using its services. Again, the longer the increase considerably, creating a pro-cyclical and cuts liquidity risk by bringing the settlement market participants; making recommendations liquidation period, the more liquidity the NSCC effect that exacerbates financial instability. A cycles of mutual funds and their underlying to the DTCC; and communicating the changes must maintain, and the greater the risk that the shorter settlement timetable, by reducing the securities into closer alignment. required to all parts of the industry. Above all, NSCC will encounter a liquidity shortfall. As margin calls from the clearing house, mitigates These benefits are sufficiently worthwhile to the steering committee is charged with ensuring with the counterparty risk reduction, a lowering that pro-cyclical effect, and so reduces systemic warrant the investment necessary. The DTCC the securities industry delivers the primary of the liquidity requirements of the NSCC risk. is now assembling a steering committee drawn and secondary enablers identified by the translates into direct savings to member-firms All of these risk reductions translate into from all parts of the American securities industry Boston Consulting Group as necessary to the of the NSCC. improved protection for end-investors, especially to work out how and when to implement achievement of a T+2 timetable in the United Last but far from least, a shorter settlement during periods of market stress and high volatility. a shorter settlement cycle in the United States. cycle also mitigates systemic risk. It An SSC mitigates the operational and systemic States. The committee will consist of senior In addition to the steering committee, the DTCC accomplishes this chiefly by reducing the risks they face through reduced counterparty representatives from industry associations and has also proposed the creation of one or more Table 1: Table 2: Decline in buy-side counterparty exposure Reduction in NSCC clearing fund requirement Settlement cycle T+3 T+2 T+1 Settlement cycle T+3 T+2 T+1 Stress scenario $300m $190m -35% $80m -70% Average period $4 bn $3.4 bn -15% $3 bn -25% Major failure scenario $2,600m $1,600m -40% $600m -75% High volatility period $7.3 bn $5.5 bn -24% $4.6 bn -37% Source: DTCC recommends shortening the U.S. trade settlement cycle Source: DTCC recommends shortening the U.S. trade settlement cycle 8 9

6 industry working groups. Their responsibilities will be to validate the enablers identified by the Boston Consulting Group as critical to the achievement of a T+2 settlement cycle; the identification, review and finalisation of the business and rule changes required of the NSCC, the DTCC and their users to move to T+2; the documentation of the necessary operational, technological and regulatory adaptations required to support the business changes; and the definition of a plan and a timetable, including dates for addressing the reforms necessary to turn the ambition of settlement on T+2 into reality. The concrete plans now being laid in the United States are just one set of initiatives among many now being pursued around the world to shorten settlement timetables. They represent a series of important steps towards the harmonisation of settlement timetables across markets and asset classes on a global scale. Those steps are symptomatic of the growing international appreciation of the benefits of shortening settlement cycles. It is now understood that time equals risk when it comes to settling a securities transaction. A shortened settlement cycle will substantially reduce risk across the industry, and not only for intermediaries such as banks and brokerdealers and financial market infrastructures, but for end-investors as well. The result, when T+2 is in place in all markets, will be greater certainty, safety and soundness in capital markets across the globe. John Abel Vice president, product management, DTCC Tony Freeman Head of industry relations at Omgeo 10