The Industry Should Consider Moving to Same Day Settlement

Across the capital markets industry organizations nervously struggled to determine exposure to those industry participants they considered in danger of becoming insolvent. For several stress filled days counterparty risk was the dominant exercise taking place in finance groups, middle and back offices. Regulatory organizations and politicians considered what role the government should play to ensure the marketplace remained fully operational. Sound familiar? Replay late fall 1987, now, fast forward to late winter 2008. The triggers are different but the responses the same. The major difference between then and now is the proliferation of complex instruments and the resulting segregation into two tiered operating environments by industry participants: • Tier one — mature products • Tier two — complex products For mature products, like U.S. Equities and most U.S. Fixed Income instruments, the industry is well served by reference data providers, clearing and settlement utilities, front, middle, back office and risk management application vendors. For complex products, the opposite is true as these instruments generally operate outside end-to-end processing and risk management infrastructures with limited reference data and vendor support. As such, the high degree of difficulty in determining counterparty risk on complex products is unfortunate but understandable. What is not understandable is “why” for mature products? Not why is it difficult to determine the risk , but why there is any risk at all, other than intraday risk? The reason is buyers and sellers of mature products do not exchange ownership until three days after a transaction takes place (settlement cycle). As the industry recently learned - a lot can happen in three days. Twenty one years ago the settlement cycle for mature products was five business days. Following the events of 1987, the industry recognized this created unacceptable risk and launched initiatives resulting in the settlement cycle being reduced to three days in 1995. It has remained there for the past thirteen years. Much has happened over that time as technology dramatically changed the end-to-end processes involved in the lifecycle of mature product transactions. Order executions are now measured in milliseconds, algorithmic trading and DMA (direct market access) dominate the equity markets, rapid intraday matching of buyers and sellers is standard and the majority of physical certificates are “off the street” and residing in depositories - yet the final step in the process – the 3 day settlement has not changed. With the events of the past few weeks fresh in everyone’s mind, the time is now to ask why? In the coming weeks and months there will be much dialogue around what has happened and what can be done to improve the industry operating model. Without question, moving to a same day settlement cycle should be included in that dialogue.