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How Wall Street Can Free Up Billions Of Dollars Per Day

Rich Daly discusses the benefits of faster trade settlement.

This article appears in the March 30, 2016 issue of Forbes.

Back in 1995, Wall Street made a huge leap forward, moving from taking five days to settle a bond trade to taking three days — a change hailed for strengthening markets to better withstand stress.

In the past 20 years, that three-day window has remained the standard. Since that time we’ve gotten iPhones, virtual reality and instant mobile payments, but it still takes three days to clear a bond trade. That makes little sense, and it doesn’t have to be that way.

There is a widely held view in the financial industry that the current three-day standard, referred to as T+3, is too slow. If trades cleared more quickly, it would free up capital in financial markets, allowing banks to deploy that money more efficiently.

According to PricewaterhouseCoopers, shorter settlement times would reduce counterparty risk, lower clearing capital requirements and reduce margin and liquidity demands. It’s a concept that’s been under consideration since the 2008 financial crisis and it is now widely accepted. Everyone from the Investment Company Institute to the Securities Industry and Financial Markets Association supports moving to T+2. Indeed, the industry now plans to move to T+2 settlement in the third quarter of 2017, pending final regulatory approval and the publication of final rule changes.

That’s a good start, but it doesn’t exactly put the U.S. on the cutting edge. The European Union, Hong Kong and South Korea have already moved to T+2, so just catching up with Europe really is not good enough.

I’ve seen firsthand how much more effective it can be to move more quickly than standards require. Back in 1987, when people first started discussing moving from T+5 to T+3, I was a senior vice present of operations at Thomson McKinnon. I remember a 2 a.m. call just after the October stock market crash from a colleague at Gruntal & Co. He had a South American customer with naked options that were to be called in the morning when the markets opened. To cover some of those options, my contact at Gruntal asked if, with his customer’s agreement, I could move his customer’s fully paid $35 million bond account at Thomson McKinnon by the time the markets opened the next day. Moving secured accounts is even more time-consuming than settling bond trades. It normally took six business days. But we got the job done by working together. In the morning when the markets opened, the $35 million was at Gruntal and the customer lost less than if Gruntal had liquidated his position by not having the collateral.

I tell that story as a reminder that we can control our own destiny. It’s something Wall Street firms can replicate by shortening settlement times for those firms that want it.

The imperative for faster settlements is clear, especially for institutional firms. Pressure from new regulations is intensifying, and that will make it difficult for capital markets and financial institutions to beat their cost of equity capital over the next five years. To close that gap, banks must restructure, find new and untraditional ways to cut costs and use their capital more efficiently. These themes emerge in our report “Restructuring for Profitability,” developed in collaboration with leading global equity analysts and Institutional Investor.

Given that capital markets and financial institutions face such challenges, it’s frustrating to wait until 2017 for faster settlement when the benefits are so clear and we are only just then catching up to Europe. Moving to T+2 settlement would reduce the average clearing fund requirement by 15-24%, according to a 2012 report by the Boston Consulting Group for the Depository Trust & Clearing Corporation.

Institutional firms had wanted to move to T+1 trading because it would have even more benefits than T+2 — other firms, though, felt that shift would be disruptive to their business. Regulators saw the value in T+1 settlement but felt T+2 settlement was a balanced compromise. However, those firms that want T+1 settlement can have it today. Wall Street firms could already be settling trades faster under rules of their own making because we already have the technology.

Firms interested in faster settlement could identify and join like-minded companies to set up a fixed-income utility, a members-only club to settle trades faster. Think of it as like setting up your own carpool lane to traverse the highway faster. Willing firms can use available technology to trade more quickly and efficiently today instead of waiting until late 2017, when settlement will still not be as fast as they want.

Today, capital is a real challenge on Wall Street. Faster trades will free up capital and, thanks to modern software and trade settlement tools, T+1 trades are possible today. Many firms on Wall Street want shorter settlement times and should not wait for a compromise that does not go as far as they had wanted. Waiting until 2017 for faster trading is like waiting until April 15 to file for your tax refund when you have all the information you need in January. When it comes to freeing up your own capital, now is always better than later.

From Forbes.com, March 30, 2016 © 2016 Forbes. All rights reserved.