Marut Khobtakhob
Introduction
Clearing and settlement must have a higher priority than transactions.
To calm the securities markets, clearing and settlement must become the main event. T+1 leaves safety second to volume in the markets’ priorities. It spends more resources on a failed clearing system instead of changing the priority of clearing to assure market health. Thus, T+1 will only increase the cost of failure. It may even unintentionally increase market instability.
Market instability is growing because the faster pace of modernity has exposed the error of the securities markets’ attitude toward risk. The pace of world events inevitably quickens. The appropriate response to the resulting market instability is to prepare – to assure safety before transactions – instead of spending more money playing catch up with halfway measures such as T+1.
Settlement is an afterthought in financial markets today. Pouring more resources into the poorly conceived settlement process without raising its priority will fail to stabilize the markets. The financial markets must prepare clearing and transfer mechanisms for changes in valuation in advance of price changes.
The limit to the time between trade and settlement is zero. However, safety in a world of unlimited speed is about preparation, not reaction. And preparation will only happen when the securities market puts safety first.
T+0 settlement has been the rule in futures trading for decades where far fewer resources are spent on clearing and settlement with far greater success. Success is not the result of futures markets’ superior technology. Instead, futures exchanges decided to make safe settlements their priority at the beginning.
What Is The T+1 Challenge?
At the end of May, the US securities markets are moving to T+1 settlement – trades will be settled one day sooner than they are now. This has been in the cards for years but was only moved forward because of the Meme Disaster when Robinhood blew up the stock market in January 2021.
That T+1 is difficult in an era where corporations can move millions out of a bank account instantly is prima facie evidence of the continuing global disregard for market safety. Financial market stability gets abundant lip service. The pace of legislation supposedly creating safer financial markets is exceeded only by the increasing pace of events of market instability.
Lipstick cures like T+1 will never reduce instability because they ignore the fundamental issue – the priority of volume must be subordinated to that of safety. If transactions are more important to securities markets than safety on a moment-to-moment basis, transactions will be conducted before there is a certainty that their implied transfers of wealth are accounted for. No system built on this priority can survive modernity. A secure system will ensure that trades will clear before they are made.
Is Preparation For Clearing Difficult Or New?
No. The problem was resolved decades ago, in the case of one risky market that accommodates high trading volume with scarce collateral protection. This situation is what Chicago’s futures markets were designed to manage.
How do futures markets reach the ideal of much greater stability than securities markets with substantially less collateral protection?
The Chicago exchanges put safety first.
They do that by making the clearinghouse the arbiter of trading access. The clearinghouse is the seller to every buyer and buyer to every seller. The clearinghouse requires clearing members to limit new position-taking to something less than positions covered by existing customer excess margin funds. Thus, a sufficient margin is posted before new positions are entered. A second effect of an exchange-controlled clearinghouse is that there is far less possibility of transaction error. If you buy or sell, ancillary issues are not part of the trade and cannot impact the transaction. Put another way, the clearinghouse guarantees only the exchange transaction. Ancillary issues such as changing the currency of margin funds must be managed before the trade is entered.
Another issue that futures exchanges have managed differently than securities exchanges is transfer of ownership. Futures exchanges do not directly participate in ownership transfer. This is an important difference since ownership transfer is the most expensive and time-consuming part of settlement. More generally, the specs of the transaction are limited by customer interest. If a customer does not seek ownership, it is not part of the settlement.
The most fundamental distinction between futures trading and securities trading is that futures exchanges make clearing the centerpiece of their identity. Securities exchanges, on the other hand, make new corporate issues the centerpiece of theirs.
The Markets’ Well-Founded Concerns About T+1
A recent article in the Financial Times described the markets’ concerns about the effects of the move to T+1. As the article reported, the move to a shorter period between trade and settlement alone should theoretically reduce the risk of subsequent market failure because prices will change less between trade and settlement.
But the article catalogs the several possible reasons the change could increase instability.
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Work schedules will be compressed. The steps must be done in less time.
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Funds transferred must happen sooner.
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Systems that are inherently slow (faxed wire instructions?) must be replaced.
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Failure rates will inevitably increase.
But all this only clarifies the inadequacy of a plan that leaves payment of margin associated with transactions as an afterthought. If the money is there before the trade, the whole process is a single transfer by the single bank that clears the exchange itself.
Changing priorities instead of spending more money will not only work but it will also be cheaper.
Is Putting Safety First Going To Reduce Transaction Volume?
The reason that trades have higher priority than clearing and settlement is that trades can happen even before an exchange is involved. Exchanges exist to facilitate transactions in the high-volume US securities markets. As a market matures in a competitive environment, market practice accommodates added participants by increasing the assurance that participants can meet their obligations. But when the incentive to add new transactions comes first the seeds of instability are sown.
Because of the unhappy mistake that securities exchanges never took direct responsibility for the safety of their own transactions, clearing and settlement became a kind of market utility – the same system for all exchanges, leaving traders without an opportunity to pick stable exchange venues over unstable ones. Predictably all venues have become equally unstable.
If an exchange were to take responsibility for clearing and settlement of its trades, investors would choose safety first, especially when they find that exchange-provided safety is cheaper than the current expensive afterthought clearing process.
In the end, volume will migrate to cheaper, safer venues and stability will increase volume.
Conclusion
The uproar over T+1 is understandable. It will cost investors more to trade after the change. Moreover, there is no assurance that T+1 will meet its intended goal of market stability. This article identifies reasons for believing market stability may even decline.
The face of clearing and settlement in US securities markets is ugly, especially in comparison to the cheaper, lower-margin, safer futures version of the same financial markets. T+1 is lipstick on a pig.
The difference between the stable futures markets and the unstable securities markets is simple. Futures exchanges prioritize safety. Securities exchanges consider safety to be the problem of the rest of the trading system. While settlement and clearing are an afterthought in securities markets, no amount of overspending on settlement will improve market stability.
