Managing $1.7 trillion of risk

The move to T+1 settlement

A huge shakeup to investing infrastructure is happening, you just don’t know it! Come May 2024 US Cash Equities are moving from T+2 to T+1 Settlement. 

What does that even mean?

For the first 400-plus years of investing history, when you bought a stock you received a physical stock certificate to prove your ownership. That’s right, a piece of paper. It would include information such as the number of shares owned, the date of purchase, an identification number, usually a corporate seal of the company, and signatures.

The first stock certificate was issued way back in 1606 by the Dutch East India Company. 

When an investor wanted to sell their stock they would have to turn in their stock certificate to their broker or transfer agent. They would then verify the certificate's authenticity and facilitate the trade settlement. This could take weeks! Just imagine trying to complete a trade internationally and having to wait on physical mail.  

Fast forward to 2023 and stock ownership records are now digital and trades are settled on what’s called a T+2 settlement basis.  “T” is the trade date, which is when your order is executed in the market. The “+2” is the settlement date which is usually two business days after the trade date. 

Here’s an example:

On Monday you buy Tesla shares. This becomes ‘T’ or the trade date and ‘+2’ is two business days later, so Wednesday. On Wednesday the trade is expected to settle, meaning the buyer and seller complete the trade by exchanging the cash and Tesla shares. 

However, the buyer and seller don’t directly exchange with one another. Settlement is normally done through an intermediary known as a clearing house. This is a central counterparty that becomes the middleman for each trade that happens in a market. They become the buyer to every seller and the seller to every buyer involved in a trade. This process, known as novation, helps mitigate counterparty risk. The clearing house becomes the guarantor of the transaction, reducing the risk of default.

Clearing houses are essential to the smooth functioning of financial markets.

If this is news to you, don’t worry! Most brokers offer instant settlement nowadays.  This means you get the shares or cash from a trade instantly while your broker takes on the responsibility and risk of settling a trade with the clearing house two days later. Often there will be restrictions around this, like being unable to withdraw unsettled funds, as your broker doesn’t yet have the cash for your sale.

What about the change to T+1? 

The Securities and Exchange Commission (SEC) has agreed to shorten the standard settlement cycle for US securities transactions from two business days (T+2) to one business day (T+1) following the trade date. 

This is a significant change for US securities markets. It will reduce the time it takes for investors to receive their cash or shares from a trade, which will help reduce systemic risk, improve market efficiency and reduce cost. It has been driven by huge stresses seen in US markets across 2020-2022.

The US stock market has around $1.7 trillion in equities transactions happening daily. The process of netting buys and sells reduces that number by about 98%, so the total value settled is around $38 billion. 

This process allows brokerages to transfer that $38 billion between parties only once at the end of the day. Much less risky than $1.7 trillion! 

A settlement value of $38bn also requires an average of $13.4 billion to be held in margin every day to manage counterparty default risk in the system. This is the risk that one side of a trade doesn’t deliver the cash or shares they are supposed to. 

The value of the securities awaiting settlement can fluctuate over the 2-day time gap between the trade date and the settlement date. By posting margin, brokerages offer collateral to cover potential losses in case the counterparty fails to fulfill its obligations. It acts as a safety net, reducing the risk of default and ensuring that trades are settled smoothly.

Why does T+1 matter?

Margin levels reflect volatility. Markets that are more volatile require more margin.

Imagine I’m Robinhood during the Gamestop phenomenon. My clearing house would have assigned a margin requirement per stock calculated using an algorithm that measures volatility. Before Gamestop went crazy, the margin requirement might have been around 10%. Meaning that for every dollar of net buy from customers, Robinhood would have to front up $0.10 of its own money to the clearing house to prove it could settle the trades. However, when Gamestop rocketed, the margin percentage went to something like 50-60%. All of a sudden Robinhood was effectively in default and needed to raise billions of dollars to cover the enormous net buy position they were waiting for T+2 to settle. 

A move to T+1 will reduce the volatility component of margin calculations by about 40%. This is going to reduce risk in the system and free up billions of dollars of margin that brokers are currently required to have across the two-day settlement cycle. This is good for everyone, clearing houses, brokers, and investors! 

This is a complex change. There’s a huge amount of infrastructure, risk management, and regulatory oversight that has to be seamlessly switched overnight. It cannot go wrong! Accelerating settlement requires careful consideration and a balanced approach so settlement can be achieved as close to the trade as possible, without creating capital inefficiencies and introducing new, unintended market risks.  

The new settlement cycle will go into effect on May 28, 2024. So set a reminder in your calendar to place a trade for that date and be part of history!