Why stock, ETF, and bond trades are optimized to settle in less than a day, allowing investors quicker access to their cash and securities. What are the benefits and costs of optimization in the relentless drive for cheaper, faster, and more profitable.
Topics covered include:
- Why countries are moving to T+1 settlement from T+2 for security trades
- What will it take for security trades to settle immediately
- How BlackRock and Franklin have launched Treasury funds that are tokenized and trade on the Etherium network
- How optimization works and what are the tradeoffs
- How we can use satisficing and rules of thumb in order to cope with the complexity of the world
Show Notes
About the ‘T+1’ Rule Making US Stocks Settle in a Day by Lydia Beyoud and Greg Ritchie—Bloomberg
SEC Chair Gensler Statement on Upcoming Implementation of T+1 Settlement Cycle—SEC
Speedier Wall Street Trades Are Putting Global Finance On Edge by Greg Ritchie—Bloomberg
Krumme, Coco. Optimal Illusions: The False Promise of Optimization (p. 225). Penguin Publishing Group. Kindle Edition.
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Transcript
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 480. It’s titled “Beyond Faster T+1 Trade Settlements. The Hidden Costs of Optimization.”
T+1 Trading
Beginning today in the US trades for stocks, corporate bonds, exchange-traded funds, mutual funds, and options will settle in one day instead of two. And by “settle” we mean that the exchange of dollars for the particular security will clear, and the seller will receive the money they got, and the buyer will get the security they got. It will be reflected in their account.
SEC Commissioner Gary Gensler said “For everyday investors who sell their stock on a Monday, shortening the settlement cycle will allow them to get their money on Tuesday. Shortening the settlement cycle also will help the markets, because time is money, and time is risk. It will make our market plumbing more resilient, timely, and orderly.”
Back in the late 1960s stocks and other securities took a week or more to settle. We discussed this in episode 218. Because when you purchased a security, you received a stock certificate, and there was a paperwork crisis because trading volume went from 3 million stock shares a day in 1960 to 12 million in 1970.
And the paperwork would get so backed up, they would have to shut down trading, and take a day off so they could catch up with the paperwork. They solve that problem by depositing all these stock certificates in a central depository known as the Depository Trust Account. And then the stock certificates were held in the name of the brokers. So instead of having to trade paper certificates, there is bookkeeping entries as trades are made, and it dramatically increased the pace at which trades settle
In 1993 US exchanges went to T+3. So trades were settled in three days. In 2017 trades started settling in two days. And now it’s one day. This was some rules that the SEC put in place, and the reason comes out of what happened in 2020 and early 2021 with a lot of the meme stock trades; the volume got so high, many of those stock trades happened on Robin Hood. These brokers have to post collateral for trades in case there’s some type of trade fail, or the broker fails—which they don’t, they still have to put up collateral.
And the volume got so high, and because it took two days to settle, Robin Hood didn’t have enough capital to put up as collateral to settle the trade. And so they limited the ability of their customers to trade certain securities, which led to a congressional investigation, and ultimately, the move by the SEC to shorten the settlement window to one day. In fact, it’s not even one day in terms of 24 hours, but with the market closing at four o’clock, trade affirmations need to take place by 9 pm. So it’s really a five-hour window to settle these trades.
The brokers and other entities involved in trading are understandably worried about the transition, particularly because not every country is adopting T+1. There are international exchanges that still have T+2, which means that someone purchasing a security there doesn’t necessarily have to put up the money right away. Yet if it’s a US security, the brokerage might have to come up with money to settle the trade even before they get the money from their customer.
Eventually, all countries will move to T+1. India is already there. Canada, Mexico, and Argentina are moving to T+1 this month. UK in 2027. European Union’s been slower to adopt it.
Adam Watson, who is head of commercial products at BNY Mellon said the move to T+1 is the right thing to do. It reduces counterparty risk, reduces the risk of failures. But he also points out we will see short-term fails and increased funding costs.
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