Rationale for study
The aftermath of the 2008 financial crisis and more recent industry problems have brought into greater focus the risks and inefficiencies in post-trade processes, a portion of which may relate to the length of the settlement cycle. Since 1995, the settlement cycle has remained at trade date plus three business days (“T+3”) for U.S. equities, corporate bonds and municipal bonds, despite significant improvements in post-trade processes and underlying technology over the same period. Accordingly, in May 2012, the Depository Trust and Clearing Corporations (DTCC) commissioned an independent study to examine and evaluate the necessary investments and resulting benefits associated with a shortened settlement cycle (SSC) for US equities, corporate and municipal bonds. The purpose of this study was to examine three of the industry’s critical areas of concern: reducing risk; optimizing capital; and reducing costs by streamlining processes. To ensure the independence of the study’s findings, DTCC selected The Boston Consulting Group (BCG) to lead the analysis. The Securities Industry and Financial Markets Association (SIFMA) provided an advisory role on the project and helped assemble a Steering Committee to advise on the project. As BCG was asked only to share research findings so that the industry could determine to accelerate the settlement time period or remain at T+3, there is no recommendation contained in this report.
BCG took a three step approach in testing the preparedness of the industry, feasibility and desire to move to a shortened settlement cycle. The three steps were:
1. Extensive industry outreach;
2. Quantitative modeling of investments required and savings impact; and
3. Articulation of key findings and insights.
Industry outreach included over 70 in-depth, one-on-one interviews with firms of various sizes, including institutional and retail broker-dealers, buy side firms (asset managers, hedge funds and pension funds), registered investment advisors, custodian banks, transfer agents, service bureaus, exchanges and market utilities. A quantitative survey was also sent to over 260 firms, and the combined industry outreach covered 109 entities representing 94 different institutions. This outreach was further complemented by interviews and benchmarks with clearing utilities from various international markets, including Germany, the European Union, Hong Kong and Canada. Leveraging this outreach and several public and proprietary data sources and benchmarks, we developed a quantitative model of the investments and costs associated with shortening the settlement cycle to T+2 or T+1. Finally, we conducted several deep dive working sessions with 10 firms to validate the investments, cost savings, underlying assumptions and model outputs.
Initial industry outreach, conducted prior to the cost benefit analysis, showed that the majority of participants within each constituent segment are in favor of a SSC, with 68% of all participants supporting a move. Twenty-seven percent of participants considered a SSC a high priority prior to consideration of an industry-wide cost-benefit analysis and without confirmation of support by regulators. Furthermore, there was broad consensus on the risk reduction benefits of a shorter cycle, with 55-60% of firms indicating risk reduction to their firms (and 70-75% of firms indicating risk reduction to the industry) from shortening the cycle by one day. Beyond risk reduction, constituent groups indicated different benefits and challenges from transitioning to a shorter settlement cycle. The nature of the benefits and challenges vary by the constituent segment. For example, institutional broker-dealers, and to a lesser extent retail broker-dealers, cited the benefits from process efficiency and risk reduction. On the other hand, buy side firms and custodians with a significant amount of cross-border activity mentioned the benefits of improved international harmonization with T+2. Buy side firms cited reductions in loss exposure on in-process trades and faster issue resolution as the primary benefits, significantly higher than any operational cost savings. Custodian banks mentioned increased operational efficiency as a primary benefit, especially from process improvements at buy side firms. Finally, correspondent clearers and service bureaus cited risk reduction and improvements in process efficiency as key benefits.
Constituents broadly stated that competing priorities and other regulatory initiatives represent a potential challenge to shortening the settlement cycle at this time. Assuming a decision to shorten the settlement cycle is made, these competing priorities would limit how soon a transition might occur. Several institutional and retail broker-dealers stated that settlement of physical securities could present another potential challenge were the cycle to be shortened. A subset of broker-dealers, buy side firms and custodian banks also cited potential issues with securities lending and the timing of foreign exchange (F/X) transactions to support cross-border trades particularly in a T+1 environment. T+0 was ruled out as infeasible for the industry to accomplish at this time, given the exceptional changes required to achieve it and weak support across the industry.
Separate models were developed to quantify the required investments and savings impact of a move to T+2 or T+1. Overall, industry participants were keenly aware that T+2 could be accomplished through mere compression of timeframes and corresponding rule changes but that doing so would limit the amount of savings across the industry. Alternatively, implementing T+2 with certain building blocks/enablers would be more effective considering the fact that different changes have various levels of impact for different constituent groups. These enablers include trade data matching, match to settle, a cross-industry settlement instruction (SI) solution, dematerialization of physicals, “access equals delivery” for all products, and increased penalties for fails. T+1 could be built on the foregoing but would also require infrastructure for near-real time processing, transforming securities lending and foreign buyer processes, and accelerated retail funding.
Cost-benefit analysis showed material differences between the investments required for each model as well as across constituent groups. Moving to a T+2 environment would require approximately $550 Million (M) in incremental investments, whereas upgrading systems and processes across the market to support T+1 would require nearly $1.8B. Although these values are large in aggregate, the required investments are small on a per-firm basis. For example, large institutional broker-dealers would need to invest, on average, $4.5M for T+2 and about $20M for T+1, driven by various degrees of systems/platform enhancements and end-to-end testing and analysis. Similarly, large retail broker-dealers would need to invest, on average, $4M for T+2 and $15M for T+1 for a comparable set of changes. Custodian investments would involve enhancements to interfaces to increase automation and standardization of data formats, with average investments for large firms of $4M for T+2 and $16.5M for T+1. Average investments for large buy-side firms would be $1M for T+2 and $2M for T+1, driven primarily by automation and standardization to enhance interfaces with broker-dealers and custodians and enable compressed timeframes.
The benefits of each model vary by constituent group. The primary benefit to the buy side was attenuated loss exposure associated with market risk on in-process institutional trades, whereas it is operational cost for the other constituents. Broker-dealers would also gain from reduced Clearing Fund requirements, and significant additional cost reductions can be achieved in T+1 from full “trade date” adherence. T+2 would result in $170M in annual operational savings and $25M in annual return on reinvested capital from Clearing Fund reductions, whereas T+1 would result in $175M in operational savings and $35M in return on reinvested capital. The assumed cost of capital in the above numbers is 3.5% and assumes firms are investing the proceeds in Fed Funds. Three and a half percent was the average Fed Fund rate for the 10 year period prior to the 2008 financial crises. If these funds were invested in alternative ways to Fed Funds, that yielded a 5% or 10% return, annual returns would be $30M and $60M for T+2, and $50M and $100M for T+1, respectively. For institutional broker-dealers, buy side firms and custodian banks, key drivers of operational savings included streamlining of institutional trade processing and exceptions management. Retail broker-dealers and custodian banks also anticipated savings associated with a reduction in physical certificate processing. The below table summarizes the investments and economic benefits associated with each model.
For the whole industry, the implied payback period based on operational cost savings is ~3 years for the T+2 model and ~10 years for the T+1 model. The significantly longer payback period for T+1 reflects skepticism among participants that the industry would broadly change behaviors and adhere to a “trade date” environment to unlock a significant portion of the value of T+1. If, by contrast, significant behavior changes do accompany a move to T+1, reduction in manual processing across exceptions management, client data management, and institutional trade processing would lead to an additional $195M of operational cost reductions (corresponding to a ~5 year payback). Beyond the operational cost and Clearing Fund impacts considered in the calculation of payback periods, a material reduction in buy side risk was estimated at $200M for T+2 and $410M for T+1. The inclusion of these benefits would lead to a faster payback across the industry, but they were not included in the initially stated payback periods due to various values ascribed to risk reduction by different constituents.
The next step is to socialize the findings of this research with the financial services industry and have the industry decide the most appropriate path forward regarding a potential shortening of the settlement cycle. Should it be determined that a shortening of the cycle is the appropriate path forward, the industry should then clearly define a timeframe that accommodates current or planned regulatory initiatives, and involve regulators and rule-making bodies in the process of initiating change. Our research suggests that the industry could transition to T+2 within approximately 3 years once a clear direction for the industry is set. T+1 would be ‘aspirationally’ achievable within four to six years following a move to T+2 and require substantial investments for near-real time processing, major process redesign and tangible behavioral changes for “trade date” compliance. A direct move to T+1 is estimated to take seven to eight years.
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