The securities industry is working to reduce the time it takes to complete payment on a stock transaction amid a call to lower the risk from events such as the GameStop Corp. trading frenzy in January.
The issue of faster completion for trades has been simmering behind the scenes for years, but it became more prominent after a popular app halted buying of GameStop stock, blaming what’s known as the settlement process.
GameStop experienced heavy trading in January driven by social media, in particular Robinhood Markets Inc.’s mobile app. The stock’s wild swings prompted financial market utilities known as clearinghouses to demand much higher collateral to protect the financial system from that volatility.
Robinhood, faced with having to put up 10 times the normal cash to protect against severe stock price movements over the two-day settlement period, halted purchases of GameStop and several other stocks. Major changes in a stock’s price before settlement add risk, which in turn requires brokers to hold more funds against the risk. That prompted fresh calls for faster settlement under the theory that it will reduce risk.
Two efforts, one from major securities organizations and another from a financial technology firm, are underway to reduce the settlement time from two days to one. For some, that’s not enough.
Robinhood CEO Vladimir Tenev told the House Financial Services Committee at a hearing that he supports real-time settlement, also called instant. Real-time settlement would have reduced the risk, Tenev said.
“Accomplishing this won’t be without its well-documented challenges, but it is the right thing to do and Robinhood is eager to drive this critical effort on behalf of all investors,” he told the committee in February.
The problem is that many in the industry say instant settlement isn’t possible because of technological limitations.
Three big industry players are preparing recommendations to move to one-day settlement though. They are the Securities Industry and Financial Markets Association, which represents brokers; the Investment Company Institute, which represents mutual funds; and the Depository Trust & Clearing Corp., which is owned by banks and brokers.
Separately, financial technology company Paxos Trust Co. LLC is working to gain approval as a clearinghouse that would settle trades within one day. The Securities and Exchange Commission is expected to formally publish the company’s proposal as soon as next month. Paxos is seeking to become the alternative to Depository Trust’s subsidiary, the National Securities Clearing Corp., which has a monopoly on the settlement of equities.
Experts contacted by CQ Roll Call say a move to quicker settlement is likely, although they do not expect it to be instantaneous. For one thing, instant settlement isn’t possible with a large segment of the market: mutual funds, where the price is only determined at the end of the day, no matter what time during that day the investor buys or sells the shares.
“I think eventually, as systems continue to improve, at some point it is T+0,” the Investment Company Institute’s chief operating officer, Marty Burns, told CQ Roll Call, referring to a same-day, but not instantaneous, time frame. He said risk would actually rise with instant settlement because of the massive amounts of cash continually moving back and forth, as well as the possibility of errors.
Paxos has already done some same-day settlement with clients under the limited authority granted to it by the SEC. It is currently working with Bank of America Corp., Credit Suisse Group AG, Instinet Inc., Societe Generale Group and Wedbush Securities Inc.
Greg Lee, Paxos’ managing director for securities, told CQ Roll Call the company has submitted a proposal to the SEC to become the first new clearing agency since 1976.
“Our utopian view for U.S. equities is T+0 net settlement,” he said.
Importance of netting
Settlement, much like a poker game in which players track their winnings but don’t have to exchange cash after every hand, allows for “netting.”
The key advantage of netting is that it greatly reduces the amount of cash that changes hands, especially for big brokers handling the bulk of the billions of shares bought and sold every day in the United States. Many in the industry have older systems unable to handle instant settlement, in which money would have to exchange hands with every trade.
Settlement also allows traders to cancel and reverse errors before the securities and cash change hands.
Lee anticipates T+1, or one-day settlement, as the first step. Going to same-day settlement faces obstacles, such as the different banking hours in Europe and the United States.
“You’ve got to be able to move cash freely and efficiently across time zones,” he said.
Digital currency may be the answer, according to Lee. That might take the form of a central bank digital currency, a Paxos stablecoin or others being proposed by the likes of JPMorgan Chase & Co.
“Any of the different variants … we think are important steppingstones to getting down that settlement cycle,” Lee said.
Tom Price, the Securities Industry and Financial Markets Association’s managing director of technology, operations and business continuity, said the march to faster settlement will happen in phases. “It’s more of an evolution versus a revolution,” he said in an interview. Blockchain technology would be a revolution, and the markets are not ready to fully employ the technology, he said.
“What you don’t want to do is create something so fast that the cash and securities get delivered and there is no way to validate and reconcile,” Price said. He noted that 48 rule changes were needed when the securities industry moved from three-day settlement to two days in 2017.
“It’s easy to say, ‘Let’s go to real-time,’” Price said. “The complication is, the devil is in the details. How do we really do it?”
A blockchain company called tZero, owned by trading site overstock.com Inc., anticipates that innovation will happen with the securities of privately held companies, which don’t trade on public exchanges and face less regulation than the public markets.
“You’re going to see the most innovation in the private space before you’ll see it in the public space,” Alan Konevsky, chief legal officer of tZero, told CQ Roll Call. But even that transition will be “incremental,” he said, heading first to same-day, and then settlement several times a day. His company is working with a regulated exchange, the BOX Exchange LLC, on a securities token exchange offering same-day settlement as an option.
Steven Lofchie, a partner at Cadwalader, Wickersham & Taft LLP, said the settlement issue is much bigger than GameStop. Instead, it is a matter of reducing systemic risk. The longer the time needed to settle, the greater the risk, he said.
“The general reason that you want to shorten the settlement cycle is to reduce the level of marketwide systemic risk,” he told CQ Roll Call. “On the flip side of why you don’t want to do that, among other reasons, you have operation issues.”
SEC Commissioner Hester Peirce supports quicker settlement but warns against going too far too quickly. Widespread adoption of real-time, or at least near real-time, settlement “would require a major overhaul in the way equity markets work and could harm liquidity by raising the cost of making markets,” she said in February.