T+1 ?

Old calendarShould US stocks settle T+1? The current T+2 settlement date is considered antiquated, and the Robinhood affair (gee, them again???) has relaunched the debate.

The DTCC has pushed forward a new outline on the eventual implementation of a T+1 settlement cycle.

What T+1 means

Here are the whereabouts of the transition to T+1, in the DTCC’s opinion:

  • The US stock market migrated to a settlement on T+2 (after market hours), in September 2017. from a T+3 Settlement. It used to be T+5, which was already an innovation from when when stocks where still physical (delivery of cash vs stacks of stock ownership certificates).
  • The DTCC started the debate about an even shorter period just four months later, with this report DTCC January 2018 – US equity market modernization. It envisioned settlement on T+1, as well as pre-open on T+2 (aka saving a full day of funding/collateral).
  • The existence of a settlement cycle implies that two parties of a trade have counterparty risks until the trade is settled. The DTCC’s clearing house requires collateral to reduce this risk.
  • A shorter cycle to T+1 would reduce this margin requirements, but by 41% only.
  • Because the amount of collateral is based on market volatility, and the social media stocks were highly volatile and high in unrealized profits, Robinhood had to raise $3.4 billion of capital in 72 hours to match its margin call requirements.
  • Robinhood’s CEO blamed the DTCC’s T+2 settlement cycle for its issues during the GameStop mania.
  • The DTCC systems can handle T+1 and even T+0, but the difficulty will be at the financial firms who may not be able to handle the change. So an industry-wide coordination effort is needed.
  • The DTCC is also considering the implementation of the distributed ledger technology (aka blockchain). This avenue has to match security and resiliency standards, which need to be fully asserted beforehand.
  • A T+0 settlement will not solve the margin issue: companies would have to be pre-funded on an unsecured basis, which would be expensive for the users.

Trading note:

Here is a derivatives / options trading consequence around this issue.

  • The day count in the calculation of a fair value is not TradeDate-to-TradeDate, but SettlementDate-to-SettlementDate.
  • If the cycle reduces from T+2 to T+1, all existing forwards will lose one day of funding. That is huge $$$$.
  • So don’t be long the long-dated forwards but short forwards instead. We don’t know when this would happen, but an implementation would probably take 1 or 2 years, so anything longer would be impacted.
  • Best forwards would be those expiring on a Thursday, so that the 1 business day change amounts to 3 calendar days.
  • If you don’t hedge the dividend risk, you will be long dividends, which would not be too bad of a risk considering how rates are increasing – the trend is likely for a rally in dividend yields rather than a reduction.
  • New forwards should not be impacted too much after the change. The calculation will be T+1 to T+1, which is usually the same as T+2 to T+2 (holidays excepted). Only the old forwards (T+2 to now T+1) will be impacted.
  • Same for the forward forwards, which will be impacted on both ends, unless the implementation date falls in the middle after the trade is taken.
  • Equity swaps should not be impacted either, but check your clauses.

By the way:

A few more points about settlement in the US financial markets:

  • It is already possible to settle stock early already, by asking for a special settlement in your trade. Some brokers are offering it, essentially for tax & option exercise reasons.
  • Other instruments settle at different times: CDs and Commercial paper settle spot, like the O/N Libor. Futures & options settle T+1. Most bonds and FX settle T+2.
  • The legal ownership actually changes with the settlement date. You become “Shareholder of record” on the settlement date.

 

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Written by Gontran de Quillacq

Gontran de Quillacq is an expert witness and a legal consultant. He is a recognized authority in options, trading, derivatives, structured products, portfolio management, hedge funds, mathematical finance, quantitative investment, strategy research and financial markets in general.

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