I was recently invited to moderate a panel around T+2 settlement cycle. My fellow panellists – Andreas Rudorfer from Vermeg, Gareth Bourne from HSBC and Jon Rout from Digital Asset – and I thought we had to find the right angle to cover what could be perceived as a dry topic. Due to the unfolding events in Hong Kong, the session was unfortunately cancelled. We are nevertheless sharing the outcome of our discussions as if they had taken place on that day.
Now that major markets across the region have moved to T+2, some voices are pushing for near real-time settlement cycles. While there are clear benefits to shorten the settlement cycles and to align them to internal standards and practices, going beyond the current T+2 and follow China’s example of T+0 will require the post-trade ecosystem to revamp its operational processes joining forces with new technologies to make it happen.
Shortening of settlement cycles is not a walk in the park, and although there are huge benefits to do so, the transition is far from easy. Today, there are nevertheless voices advocating for further reduction.
As we prepared for the panel, we discussed the benefits of shortened settlement cycles, if there is room for these cycles to be shortened further, and what challenges the industry would need to address if it wanted to go that route.
A brief history
Searching the literature for the origin and purpose of the length of settlement cycle, one can trace it to the eighteen century when the Amsterdam Stock Exchange and the London Stock Exchange were often listing each other’s stocks.
To allow the physical stock certificates and cash to move from Amsterdam to London and back, a standard settlement period of 14 days was agreed, which was about the time it took for a courier to make the journey on horseback and by ship. Most exchanges continued to use this 14 days settlement period until the late twentieth century.
Settlement procedures used to vary between domestic stock markets, with two main types of settlement periods leading the pack. Some countries used a fixed number of days after the transaction while others settled trades periodically on a fixed date.
In France, for example, all transactions settled once a month on the seventh business day preceding the end of the calendar month. Cash transfers were taking place on the last business day of the month. This actually lasted until September 2000 when all transactions settlement moved to a fixed settlement lag.
With the emergence of new technologies and progressive dematerialisation of securities from the mid 70s and early 80s onward, settlement times at most exchanges were reduced to seven days (T+7). Settlement cycles were later progressively shortened to five days (T+5), then three days (T+3).
Today, most stock exchanges have adopted T+2. From in India in 2003 and Japan in the summer of 2019, there are now over 18 markets in Asia Pacific that have joined the T+2 club.
The reduction in the settlement window brings many benefits, from reducing settlement risk to improving efficiency and boosting market liquidity.
If there is a clear correlation between settlement cycle and settlement risk, there is nevertheless a distinction to be made between CCP-cleared and OTC-uncleared transactions. Initial and variation margins address the market risk linked to potential counterparty failure.
This was definitely on the minds of regulators who have pushed for central clearing of OTC derivatives and bonds, a trend we expect to continue. But this risk mitigator is only as robust and adequate as the risk management system underlying the margin calls.
It is then not surprising that HKEX (Hong Kong Exchanges and Clearing) in its NextGen roadmap has committed to strengthening its risk infrastructure by introducing a VaR methodology which takes into account the liquidity and volatility of market participants’ portfolio.
Reducing settlement cycles would reduce the credit lines needed and allow investors and traders to more efficiently manage their cash, hence potentially also boosting markets’ volumes and liquidity. In a near zero interest rate environment, these benefits might not be that significant. Moreover, it is unclear if the indisputable positive impact on the credit line requirements has been measured in such an environment.
When it comes to aligning with international standards, it is important to note that most markets have historically been very efficient domestically because they were built and regulated for domestic participants. The frictions and inefficiencies have emerged with increases in cross-border flows.
The best example in Asia is China, with its T+0 settlement for equities, a process that is extremely efficient domestically but very cumbersome for foreign players accessing the market through Stock Connect or other channels. The alignment with international standards, although desirable and sought after, is closely dependant on the dynamics, priorities and development of each domestic market.
In August, China’s clearing and settlement infrastructure institutions issued a joint circular extending the settlement period for bond transactions involving foreign institutional investors, allowing up to T+3 settlement to ease market access for overseas firms.
How short could and should we go
The institutional and retail payments world is moving inexorably towards near real-time, with the dividing line becoming increasingly blurred. Australia’s NPP (New Payment Platform) for example did not set a ceiling on real-time payment amounts nor did it impose any restrictions on its users. With instant cash finality, one could argue that securities and cash settlement should converge.
In a different area, the Libor benchmarks are progressively being decommissioned in favour of overnight reference rates, moving the interest rate reference closer to the trade date.
Having said that, one will have to strike the right balance between the benefits and the operational constraints. Moving to T+0 will create headaches for the management of transaction failures, exceptions and repairs. In the case of Stock Connect, the pre-allocation process removes the advantages of omnibus accounts.
As mentioned earlier, the shorter the settlement cycle, the harder it gets for foreign players. It is interesting to note that in 2013, to attract international investors and to become “Euroclearable”, Russia extended its settlement cycle from T+0 to T+2. It provided huge benefits to Russia, with liquidity increasing manifold, foreign holdings jumping from 3% to 25% and a lowering of yields and credit spreads to historical lows.
The comparison with China might not be straightforward as the size of its economy and its domestic market has so far allowed the regulators to maintain their current practices with international players having to find, with their custodians and the HKEX, agile solutions to meet the tight settlement deadlines.
The inclusion of Chinese equities in the various key benchmarks will maintain that momentum, but one could argue that, in prevision of rainy days, aligning equity and cash settlement at T+1 – hence streamlining the operational processes for international investors – would significantly increase the attractiveness of the market in the long term.
Operational and technical challenges to reduce further
Should the decision be taken to further reduce the settlement period, a number of challenges will have to be overcome, such as improving operational processes to achieve zero-touch STP, upgrading internal technological architectures, and ensuring the readiness of vendors.
In itself, this is a lengthy process: most markets across the globe have taken 3-5 years to change their market practices and adapt their core infrastructure (e.g. the US moved from T+5 to T+3 in 1995 and to T+2 in 2017). There is also strong stickiness to existing practices in most markets. Convincing participants to go through another major project – beside all the other challenges they are facing – might be a difficult proposition.
It is nevertheless very clear, as mentioned by HKEX Head of Post Trade Roland Chai in his keynote at the conference, that sequential settlement is inadequate in a T+0 environment and that the adoption of DLT (distributed ledger technology) might be the only logical course of action.
Enabling new technologies would not only streamline processes for accessing China’s markets; it will also allow securities and cash settlement cycles to converge, offering retail and institutional investors all the benefits of reduced settlement risk, optimal use of their cash, and reductions in their credit line needs.
This could be facilitated by the emergence of tokenisation, alongside broader adoption of cryptocurrencies. But that is a debate for another day.
Philippe Dirckx is an international banking professional based in Hong Kong with broad experience in financial markets, including in the areas of trading, post-trade, technology, market infrastructure and strategic business development.