Trades are executed in microseconds, payments delivered in seconds and yet settling a spot FX trade still takes 48 hours! A recent trial in the equities space, coupled with fallout from the Robinhood margin call crisis, kicked off a major debate across financial markets on the pros and cons of same day settlement. Critics argue new technology isn’t a strong enough reason to embrace it and that major work would be required due to significant behavioural and operational challenges.
However, the success of instant settlement in other markets, such as digital assets, shows that with the right infrastructure and technology it can work.
The spot FX market currently operates on two-day or T+2 settlement. This has been the case in the FX market since the 1980s – a time when capital controls were in place and technology wasn’t particularly sophisticated. Clunky telex machines were used for a lot of post-trade processing and back then the FX market had no centralised infrastructure, such as a clearinghouse. Manual processing took two days and so T+2 evolved as the norm. Since then, FX has been completely revolutionised by technology, particularly in the front office. Yet it still takes two days to settle an FX transaction.
Same day settlement
Same day settlement means that as soon as a trade is executed, it is recorded immediately, the money and securities move between the two parties and the trade is complete. The same day time settlement or T+0 debate was re-ignited earlier this year when Credit Suisse and Nomura-owned broker Instinet, settled some US equities trades using blockchain.
While blockchain has been used to settle many transactions, this was ‘a first’ because settlement occurred in just a couple of hours, not the 48 needed with America’s Depository Trust and Clearing Corporation (DTCC). The exercise demonstrated the ability for firms to execute and settle trades conducted throughout the day.
The progress has been described as ‘a financial version of moving from the snail mail of posts to zippy emails.’ This is because institutions currently use a third party, the DTCC, to transfer assets, net off balances and collect margin to protect against losses. However, Credit Suisse and Instinet cut out the middleman and dealt directly with each other by recording the trades on a shared ledger, and much faster. While this was a small trial with a few trades, it has made some senior people at key infrastructures rethink their approach because it has highlighted what new technology like blockchain can do.
This exercise has also shone a spotlight on the sheer inefficiency of two-day settlement. It requires siloed back-office operations to process deals which is costly and creates risks around agreement and transfer of collateral. It is estimated that $15bn to $30bn of industry capital and twice as much liquidity are tied up in DTCC systems.
Robinhood saw first-hand how costly the inefficiencies of T+2 can be when it had to suspend trading on stocks including Gamestop in order to post money with the Depository Trust & Clearing Corporation (DTCC) to collateralise trades during the two days it takes for them to settle, causing outrage amongst customers.
With T+0, no collateral would have been required. Logically, Robinhood CEO, Vladimir Tenev, has become one of the biggest advocates for the change. Furthermore, these longer settlement cycles leave participants susceptible to counterparty credit risk. This is particularly dangerous in periods of high market volatility where prices can change suddenly, and trading volumes can spike. For example, the unprecedented volatility resulting from the COVID-19 pandemic led to a 300% margin increase in March 2020 over historical averages.
In these circumstances, the longer the settlement cycle, the higher the risk that investors may incur significant losses and be unable to fund their transactions. It’s also worth noting that FX plays a vital role in underpinning the stability of other financial markets, including securities, and that same-day settlement will allow securities traders to use FX to fund their trades quickly and safely, as well as reduce their counterparty risk.
Meanwhile, with certain digital assets, settlement can occur within seconds and value can be moved fluidly. This decreases counterparty risk as it enables a more efficient settlement process. It’s proven in a growing market and has successfully mitigated concerns around capital requirements and counterparty risk.
Despite all of the excitement, such a step change would not be as simple and fast as your average software update. This type of move would require a complete overhaul on multiple levels, and the last such shift - from T+3 to T+2 - took 14 years.
That said, DTCC has recognised the need for shorter settlement cycles and proposed to cut settlement times to one day by 2023, if all its members approve. It released a paper which highlights the immediate benefits of moving to a T+1 settlement cycle, including cost savings, reduced market risk and lower margin requirements, and outlines the firm’s plans for garnering the necessary support for the project across a wide range of market participants.
While this is a step in the right direction, does this go far enough? Is there much point in doing it incrementally when the technology already exists to make settlement instantaneous? In order to do it properly, the market needs to be fully behind it. This is because to go to T+0, market participants have to be 100% accurate with no room for error so matching and credit need to be up front and other back-office functions such as aggregation and netting as well as compliance and risk checks still need to catch up.
Too much too soon?
While same day settlement is achievable, there is also a case for not going too fast and shooting for instant settlement. Blockchain plays a significant role in validating transactions and providing all parties with an irrefutable distributed ledger, but there is more of the settlement process to consider. For value to be deposited and withdrawn instantly from traders’ accounts, the whole back-office is required to work just as fast. This is unfeasible with current legacy systems.
Additionally, there is also the financial reality that not all trades are completed with the immediate availability of the buyer’s cash. Real-time settlement could require that transactions are funded on a transaction-by-transaction basis, eliminating the liquidity and risk-mitigating benefits of today’s netting features. Instantaneous settlement would require trades to be prefunded on an unsecured basis, which could limit market liquidity.
A substantial amount of work would also be required to settle each individual transaction, rather than netting them out at the end of each day. This is particularly relevant to high frequency traders and the volume of transactions they action in just milliseconds. It would be near impossible for them to settle these trades individually as the number of transactions to be settled would soar and the number of failed transactions could rise significantly.
As such, a different approach to T+0 may be needed. DTCC’s paper states that many of these issues apply solely to T+0 settlement, and a move to T+1 would not require large operational or technical changes by market participants, nor would it cause fragmentation and risk to the core clearance and settlement ecosystem. It argues that with a move to T+1, the industry can retain the core benefits of centralised netting and risk management, while moving to a shorter settlement time. The DTCC has also previously proposed the idea of a T-1.5 cycle whereby transactions are processed overnight. This would involve work through the night to ensure settlement by that morning’s margin call.
Another alternative is the introduction of various settlement windows throughout the day which could provide some slack in this transitionary period. This would then allow firms to net out a few times per day, while also settling on the same day. A number of central banks are exploring extending the connectivity and operating hours of their real-time gross settlement (RTGS) systems, which could have a positive impact on FX settlement times.
There is already a significant overlap between RTGS system operating hours around the world that opens the door for currency settlement to take place faster, including same-day settlement. If RTGS system operating hours were extended even further, this would allow for a greater number of same-day FX settlement cycles to take place during overlapping hours. In theory, real-time settlement is achievable, but the logistics of such are more complex. It may be more pragmatic to look at same day settlement, and even then, this journey may be longer than some would hope.
Watch this space
This debate is likely to rage on and it’s clear we can’t just transform one legacy back-office process and expect it to work. All of the other interlinked processes have to be brought up to speed at the same time. That said, there are huge potential savings for FX firms as tighter settlement cycles reduces collateral requirements, so the rewards could be significant, and the technology and processes clearly already exist in the digital assets market.
In short, we are seeing a coming together of the best of both digital and fiat worlds. In fiat, there are decades of regulation brought about by the correction of behaviour, so that trading and post-trade capabilities are much more scrutinised and a global code of conduct has come to the fore. Institutional operators need the same level of protection and control when trading digital assets. In digital markets the fact that a transaction is recorded on a shared and secure infrastructure in near real-time is a step change for the fiat trading community. The same should therefore be true of fiat settlement.
While T+0 is possible for fiat, a change in process needs to be adopted and this will likely start with those who are trading digital assets moving to trade digital fiat. We are seeing a move toward T+x hours in terms of settlement, so that any move to settlement provides sufficient time for error correction, trade offset and fee reduction before committing to ledger. We see that PvP may be possible in not just crypto assets but also between digital fiat assets. Collateral movements are also inextricably linked to settlement, so settlement confirmation will also adjust the collateral requirements. Speedier de-risking of portfolios is much better for balance sheet and credit limits and this derisking will aide trading, giving everyone much better, accurate and safe market access.
In a world where numerous fintechs have disrupted entire industries, the big incumbents involved in the settlement process should be listening to their customers views on settlement, otherwise, they could be left behind, alongside T+2.