Risks in reducing the settlement cycle

There is much talk about reducing the settlement cycle to T+2 on both sides of the Atlantic and its shaping up that markets will move to T+2 sometime soon in the future. Much of the motivation comes from the need to reduce counterparty risk. This really is the risk flavour of the month and appears to be driving the regulatory push with almost manic fervour. Central clearing for OTC is another that has its roots in counterparty risk reduction. Despite all the evidence that says it is just risk transference and it just moves it into other areas of the transaction chain.

Reducing the settlement cycle would increase settlement fails and thereby costs that will probably be passed onto the investor. Settlement success rates today are in the high 90% for many firms. Although it has to be noted that this is almost entirely due to bank to bank electronic trades rather than those between retail investors and the market.

In the UK there is still a very high number of physical certificated investors and almost impossible to settle in T+10 let alone T+2.

Stock borrowing forms an important financing resource for sell-side firms enabling them to offset bull financing positions against bear positions but with T+2 this would more difficult and likely to curtail this activity.

Stock lending supplies institutional investors and especially pension funds with a valuable asset of added revenue for static holdings. T+2 will reduce the lending activity and therefore the profitability of pension funds and the like.

Matching of bargains is a complicated business with plenty of central matching going on but it’s like in fact like having lots of belts and braces but still finding your trousers falling down. My recent discussion paper illustrates the costs and stupidity of the current matching processes.

The problem with central matching is, it is an oxymoron if a trade has to be centrally matched in more than one entity. In the international markets there is no central anything and the needs of competition probably dictate there never will be. So for T+2 the financial services firm is going to have to invest in some sophisticated technology to be able to conform and match in almost real-time.

T+2 appears to be a sound change to reduce counterparty risks but this only has tangible benefit, if there is no detrimental knock-on effects, such as - it does not increase risks or transfer them and the markets and investor do not lose revenue and they can operate in a shorter timescale without increasing staff. I am not convinced that T+2 is a good thing to do today or in the future. Good settlement definition is almost to deliver on the day contracted and with T+2 this is less likely to happen.