On April 1, 2003, India moved from T+3 (three business days after transaction) to T+2 (two business days after transaction) settlement in the securities markets. Europe did that in 2014, and the US migrated to T+2 in 2017. Even though India took almost two decades to reduce the settlement period to T+1 (January 27, 2023), it is still ahead of the developed economies. On February 15, 2023, the US SEC (Securities and exchange commission) finally adopted a resolution to shorten the settlement cycle from T+2 to T+1 w.e.f. May 28, 2024. The UK and Europe are expected to follow suit.
Global markets are closely watching and analysing the execution of India’s shortened settlement period. Indian regulators had adopted a phased approach to make T+1 settlement a reality. T+1 settlement in India started with the bottom 100 stocks by market cap, and was gradually extended to the next 500 stocks, and then all stocks by January 27, 2023. Now, the Indian markets are contemplating to move to one-hour settlement, and subsequently, to instantaneous settlement, also referred to as atomic settlement.
Global concerns
Some global market associations had apprehended hiccups in the T+1 execution, and there was major resistance from FPIs (foreign portfolio investors). They said the transition would impose humungous costs and operational complexities, as substantial technological enhancements would be required to support the processing capabilities.
Their major concern was that different stakeholders (custodians, foreign exchange brokers, bankers, etc.) working in different time zones would have to align their operations with the reduced settlement period. The industry said that settlement cannot be a silo; it needs to be seen along with margin requirements, funding requirements, securities borrowing and lending scenarios, etc.
Impact assessment
Impact assessment by the US clearing and settlement agency — the Depository Trust & Clearing Corporation (DTCC) — for T+1 settlement confirms the benefits of reduced settlement latency: lower costs, decreased risk, improved liquidity, and operational efficiency. In fact, moving to a reduced settlement cycle was one of the prescribed measures to reduce the risks resulting from the meme stock events of 2021, when retail traders pushed GameStop’s price from $20 to $480, causing hedge funds that had bet against it to lose billions.
However, the DTCC report explains that moving beyond T+1 in the short-run would require comprehensive overhaul of the current clearance and settlement infrastructure, changes to business models, revisions to regulatory frameworks, etc. This perhaps is making certain market participants jittery even in the Indian scenario.
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Benefits of reduced settlement
It’s time to decode some of the myths around the apprehensions of reduced settlement periods.
For brokers, it will lead to reduced margin and collateral requirements, especially during volatile periods. In the long run, it will lead to increased market resilience as systemic risk, operational risk, and liquidity needs will reduce, even during stressed market scenarios. Investors will benefit from reduced risk exposure, and quicker access to their cash and securities, leading to more efficient resource utilisation.
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What’s the worry about T+0 settlement
Some experts worry that T+0 could eliminate the much needed “netting” process, where multiple financial obligations (receipts, payments) are aggregated to arrive at the net obligation. Industry participants argue that T+1 still provides brokers with sufficient time to arrange for margin requirements, which would be nearly impossible under T+0 settlement. This means that market participants would be required to have funds and securities ready before settling each transaction. Foreign brokers / investors will need to arrange for forex much in advance to fund the trade.
Few concerns also relate to the trades undertaken by high-frequency traders (HFTs) / algo traders, and the frequency at which their transactions are executed. However, in practice, HFTs often have prior arrangements with brokerages to facilitate settlement within the required time frame.
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Atomic settlement
Research has shown the need for two essential elements to make atomic settlement a reality. One is the availability of sophisticated distributed ledger technology (DLT), or blockchain, through which smart contracts (programmed self-executing agreements) can speed up the settlement process. The DLT enables securities to be issued in the form of digital tokens or assets. In short, blockchain verifies and closes transactions in an expeditious manner.
The second essential element is the central bank digital currency (CBDC). These two components can eliminate traditional clearing and settlement processes and enable instantaneous and secure settlement of securities transactions.
In May 2020, the DTCC announced “Project Ion,” to explore if digitisation of assets and application of DLT can accelerate settlement and reduce cost and risk for the industry. Thus, efforts are underway in this area. In fact, the Depository Trust Company (subsidiary of DTCC and a major securities depository in the US) has always been a T+0 platform, and can support settlement of transactions on a near-instantaneous basis. Nevertheless, DTCC supports a two-year transition for the US market due to the massive trade volumes.
Another tool being contemplated by global clearing corporations for facilitating seamless reduced settlement cycles, is the universal transaction identifier (UTI). This, perhaps, could enable all parties (broker, custodian, investment manager, etc.) in a transaction to track the status of any given trade at any given time. This would help the counterparties and their agents reduce operational risks arising from post-trade issues such as incorrect transactions, thereby resulting in greater risk mitigation for the financial services industry.
India’s capabilities
India has the technological capabilities and is contemplating implementation of ASBA (Application supported by blocked amount) in the secondary market. This, along with the unified payments interface (UPI), can perhaps help India fast forward to atomic settlements without having to wait for the CBDC.
It is acknowledged that reduced settlement implies a big shift in the affirmation process and entails substantial tweaking of the workflow for various post-trade operations. Certainly, re-engineering of market microstructures and revisiting various operational issues such as trade processing and margin requirements are essential. As far as HFTs are concerned, they are tech aficionados and will embrace instantaneous settlement.
The question is: should we adopt atomic settlement sooner rather than later?
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