By William Watts
A little over 20 years ago it took stock trades a week to settle in a brokerage account — that money was out of your reach to make new investments. With several projects now in place, you might soon be able to put your money to work in two days, or fewer. That would be a boon to traders and investors of all sizes.
The settlement process, which entails the actual transfer of ownership of an asset, forms the hidden plumbing of the investment industry. But, like a busted pipe, if it fails, you can be in for a rude — and sometimes expensive — surprise.
That was the case earlier this year when online-trading app Robinhood, along with other trading platforms, temporarily shut down the purchase of popular meme stocks, including GameStop /zigman2/quotes/203755179/composite GME +1.15% , as it scrambled to meet billions of dollars in margin requirements. Those margin requirements would be smaller if the settlement process were faster.
The incident — which investors said robbed them of potential gains — prompted online outrage, sparked lawsuits and led to congressional hearings. It also triggered a plea by Robinhood CEO Vlad Tenev to shorten the settlement cycle.
“There is no reason why the greatest financial system the world has ever seen cannot settle trades in real time,” Tenev told the House Financial Services in prepared testimony at a February hearing.
Kenneth Griffin, the CEO of hedge fund Citadel, in the same hearing, said it was time to shorten the existing cycle by a day, settling trades one day after execution. Robinhood routes a large chunk of its trades to Citadel Securities, part of an arrangement known as payment for order flow, which allows online brokers to offer low or zero-commission trades but has attracted scrutiny from regulators and critics who contend it may put retail investors at a disadvantage.
The GameStop incident, meanwhile, put a spotlight on efforts already under way to speed the settlement process.
The Depository Trust Clearing Corp., which is owned by a consortium of financial-services firms, and its subsidiaries operate as the single clearinghouse and guarantor of all U.S. public stock trades. The DTCC is working with industry trade groups Sifma, which represents brokers, and the Investment Company Institute, which represents mutual fund companies, in an effort to shorten the settlement process by a day.
At the same time, a pilot project being run by crypto-services firm Paxos is attracting attention. That blockchain-based effort drew headlines earlier this year when project participants Credit Suisse and Nomura’s Instinet completed a same-day settlement of a securities transaction using Paxos’ ethereum-based blockchain technology.
ABN Amro, Bank of America, Société Générale and Wedbush have also participated in the two-year project, which was allowed by the Securities and Exchange Commission to proceed under what’s known as a “no-action” letter. The project expires on Oct. 29. Paxos has said it intends to follow up the project by filing an application with the SEC to become a clearing agency, setting up a potential challenge to DTCC’s monopoly on the clearing and settlement process.
Clearing is the process that takes place between when a trade is executed and settled. Settlement occurs when a security is officially transferred to the buyer’s account and cash to the seller’s account. In the stock market, settlement typically happens two business days after a trade is executed. So if you buy a stock on Monday, the trade will settle at the end of the day Wednesday. A trade made on Friday would settle on Tuesday.
In order to manage the risk that comes with effectively guaranteeing a trade before it actually settles, the DTCC requires brokers to post collateral.
The length of the settlement cycle, formerly dictated by how long it took to physically transfer stock certificates and cash, has grown shorter over the decades. In 1995, the process was shortened from five days after execution, known in industry jargon as T+5, to three days after settlement, or T+3.
It took until 2017 to further shorten the process to the current T+2 format.
Shortening the cycle requires significant work by exchanges, brokerage firms, clearinghouses, payment systems and other players, both in the U.S. and abroad, to ensure everything works smoothly.
But it’s an effort embraced by the industry. Part of that has to do with margin.
The National Securities Clearing Corp, a subsidiary of the Depository Trust Clearing Corp., maintains a large pool of cash ponied up by brokerage firms that can be tapped in case a firm somewhere in its system goes bust. Brokerages pay margin into the fund based on a formula designed to account for the risk of a possible default somewhere in the system. That formula takes volatility into account.