Why it matters when transactions settle
TIL PEANS which followed the recent retirement of KKR Founders Henry Kravis and George Roberts, formerly the chief barbarians of private equity, point out that the history of Wall Street is a story of big deals, daring deals and the people behind them. Those further behind them, in the back offices of banks, brokers and buyout companies, barely glance at it. Of course, their world is colorless compliance and “post-trade” processes like clearing and settlement. These are the plumbers of finance, working behind the scenes to make sure the plumbing is working, well. Every now and then, however, there is a gurgling noise loud enough to disturb even those arrogant colleagues up front.
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The stock market settlement system – making sure the buyer gets their security and the seller their money – was strained during covid-induced volatility in March 2020. It cracked again at the start of this year amid the frenzy of meme swapping in GameStop actions. A report from regulators on the episode, released Oct. 18, curtly noted that post-trade processes, “normally in the background, have entered the public debate.” It was thanks to spikes in margin calls and volatility-induced settlement risks that Robinhood, a retail broker, restricted trading in GameStop shares, causing an uproar.
The risk is a function of time. The longer it takes to complete the trade, the greater the ‘counterparty’ risk, or the possibility that one party or the other will not succeed, as anyone caught in the middle of Lehman Brothers or Archegos Capital collapsed. And, therefore, the larger the margin payments that brokers and investors have to make to clearing houses.
Hence the long-term effort to reduce transaction processing times, from 14 days (“T+14 “in the jargon) in the 18th century, when certificates were carried by horse and boat; less than a week after the reforms following the paperwork crisis on Wall Street in 1968, when a boom commercial forced the stock exchanges to close one day a week for months to allow the boys in the back room to catch up; to T+5, then T+3, and, four years ago, T+2.
Still, a lot can happen in two days on Wall Street, so why stop there? Driven by the market turmoil of the past year, a group representing banks, investors and T+1 and should unveil a plan to get there in a few weeks. The signs are that the Securities and Exchange Commission will bless him. If this is the case, the halving of the settlement time could take place as early as 2023. Europe, for its part, would probably follow suit.
Lest anyone think the titans of finance are softening up, it’s worth pointing out that they’re not pushing this just for the greater good. They are as interested in reducing their own costs as systemic risks. During the market turmoil of last year, the overall margin demanded by the DTCC, the US equity clearing agency, quintupled to more than $ 30 billion a day. Hundreds of billions more per year are linked by “nondelivery” delays, due to payment defaults (the causes of which range from typing errors to more sinister practices such as deliberate failure to achieve the goal. to manipulate the price of a share). Unlocking this capital would leave financial firms much more to invest profitably.
Why then stop at a settlement in a day? Evangelists of so-called distributed ledger technology tout the possibility of going to T+0, known as the “atomic” regulation. It seems technically feasible; in fact, some broker-to-broker transactions in the DTCC are already settled on an almost instantaneous basis.
But is it desirable? There is a big difference between reducing settlement time and eliminating it. In the latter case, the buyer should be pre-financed and the seller immediately ready to trade. Every element of a complex process should be synchronized, with no margin for error. It may also require a heart-wrenching restructuring of the giant securities lending market, which is designed to accommodate a settlement with a lag in time.
Cue cries of “Luddite!” But Buttonwood is in good company to advocate maintaining some redundancy in the process. Ken Griffin, boss of Citadel, one of America’s biggest market makers, and therefore no techno-slouch, described real-time settlement as “a bridge too far” because it requires “everything. [to] work perfectly in a world where there are still people involved ”. The message is clear: pushing things too far could replace one set of risks with another, more frightening, in which a small number of failed trades would trigger a chain reaction in back offices around the world. Atomic indeed.
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This article appeared in the Finance & Economics section of the print edition under the title “When the pipes crack”