Settlement is the backbone of financial market infrastructure. This critically important function until recently has been hidden in the background.
The recent GameStop debacle heralded calls from many—including founders of the platform at the center of it, Robinhood—for real-time settlement. This debate is valuable and important, and will likely be a top priority for the next SEC chairman, poised to be Gary Gensler, the former head of the Commodity Futures Trading Commission.
Real-time settlement, however, might not be a panacea for the entire market—in some asset classes or segments, next day, same day, or even multiple times per day settlement might be more appropriate. But whatever the regulatory community decides, they can act with the confidence that the technology already exists to offer more choice in the settlement options available to them.
The delay between execution and settlement has been a bugbear of financial market participants for years. In some asset classes the process has changed very little in generations, while other elements of markets infrastructure have modernized beyond recognition in the meantime.
The settlement of an equities trade happens two days after the transaction takes place, which means there’s a risk the broker won’t have the funds to pay for shares its clients bought by the time of settlement—especially with a stock experiencing high volatility, such as GameStop.
If the broker doesn’t have the funds, the clearing house has to step in. If there still isn’t enough collateral and the broker has collapsed, the clearing house’s member firms have to provide the cash. The central clearinghouse also plays a critical role in bolstering market certainty by ensuring quick, clean resolutions when a financial institution defaults.
Blockchain and Digital Assets
In recent years, however, the emergence of new digital technologies has prompted explorations into accelerated settlement to overcome these challenges. In particular, the Depository Trust & Clearing Corp. (DTCC) has been experimenting with blockchain and digital assets to enable T+1, T+1/2 and T+0 settlement cycles. Any regulatory decisions can be made safe in the knowledge that initiatives like this are already delivering the technology to enable greater settlement options.
Importantly, as an established and systemically critical part of the existing financial infrastructure, the DTCC understands equities clearing and settlement is part of a much larger ecosystem of interconnected financial markets. As such, speeding up the settlement cycle for equities would significantly impact other parts of market structure.
Conversely, calls from Robinhood and others to introduce real-time settlement feel like a knee-jerk reaction to a far more nuanced challenge. Regulators are more likely to opt for a considered, balanced solution that enables settlement to happen as close to the trade as possible—which could mean T+0 same day settlement—but without creating capital inefficiencies or introducing unintended risks, such as eliminating the benefits and cost savings of multilateral netting.
Currently, multiple market participants and the DTCC track their obligations to pay or deliver at settlement time in separate systems. Blockchain provides a single source of truth for trading records and eliminates the need for reconciliation across redundant systems. Digital representations of cash and securities, in a platform that traces and can audit the lifecycle of a trade, allows atomic delivery-versus-payment and an acceleration of its settlement window.
The technology, therefore, already exists to support faster and more flexible settlement, but any changes to such an important financial process must be given careful and detailed consideration, in close collaboration with the regulatory community in particular.
Potential Unintended Consequences of Real-Time Settlement
Consider a scenario, for example, where the U.S. equities market implements real-time bilateral gross settlement. All transactions would then need to be funded on a transaction-by-transaction basis, completely eradicating the liquidity and risk-mitigating benefits of the netting features that have become the norm in today’s equities market.
Real-time settlement makes it impossible to fund trading on a secured basis because it doesn’t allow traders to offer shares they have yet to transact as collateral. This scenario would require trades to be pre-funded and on an unsecured basis, which could have significant ramifications to overall market liquidity.
Currently, then, pre-funding is a major obstacle for real-time settlement. Shorter settlement windows are of course desirable—but how short? The answer: as short as is useful to the market.
Moving to a flexible model would accommodate the specific needs of different asset classes or segments, and the unique requirements of the particular market conditions at any given time. In turn, this would help strengthen the market during periods of significant volatility, reducing liquidity demands and lessening the amount of money that needs to be collected at any one time—such as during the GameStop event in January.
This would truly level the playing field for all investors, institutional or otherwise, modernizing equities settlement in a manner that benefits all participants without introducing new, unintended market risks.
The most advanced enterprise blockchain platforms are ready to support the settlement infrastructure of tomorrow—at whatever speed is necessary—with the ability to enable both netting and near-to-atomic settlement. The real task now is for regulators, the technology community and participants to work together to drive the evolution of the market forward in a rapid but responsible manner.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Charley Cooper is managing director at enterprise software firm R3 and former chief operating officer at the Commodity Futures Trading Commission. He began his law career at Kirkland & Ellis and has held roles at the Department of Defense and Deutsche Bank, acting as part of the latter’s legal, risk, and capital function.