In recent years, an important development which has taken place in stock markets around the world is the shift to reduced settlement cycles. Initially, the rolling settlement was taking place on the T+5 basis.

That is, if you buy shares today, you have to make payment and take the delivery on the fifth day. Later most exchanges shifted to the T+3, that is you settle on the third day, two days earlier compared to the T+5. Some are now working towards the T+1 settlement, reducing another two days. We wish to look into the reasons behind this trend of reducing the settlement cycle and its implications.

There are three key reasons that had led to the shift from the T+5 to the T+3.

1. The shift to the T+3 was the need to reduce the systemic risk. This is the risk of a default spilling over to the market. Such defaults not only hurt the immediate participants but also shake the investor confidence, thus hurting the overall economy. The systemic risk arises because there is a time lag between the transaction and its settlement. The longer is the time to settlement, there are more trades outstanding, and larger is the systemic risk. Exchanges use a variety of measures to reduce or manage systemic risk such as the margin deposits, the capital adequacy norms, the clearing house protection fund, etc,. But in an environment of increasing trading volumes, the most important measure to reduce the systemic risk is to reduce the time lag between the transaction and the settlement. In a T+5 system, at any point in time there would be five days worth of trades outstanding. By moving from the T+5 to the T+3, the exchanges have managed to reduce two days worth of outstanding exposure.

2. The information technology enabled the exchanges, brokers, and investors to reduce the risk and still move faster. The automated trading, immobile digital securities, and the electronic banking have substantially reduced the slow manual work that was done at the exchange and the brokerage houses. Thanks to the technology, traders don’t have to cry their throats hoarse in trading halls, the paper securities don’t have to change hands, and the clearing houses do not have to give or take cheques. While the need to reduce the systemic risk made reducing the settlement cycle desirable, it was the information technology that made it possible.

3. Investors prefer faster and cheaper operations. Once the larger exchanges had moved to the T+3, others had to follow suit to retain or to attract the business. Where companies were listed on more than one exchanges and the trading was happening internationally, the exchange that offered the faster operations was better placed to gain volumes. Competition, the ultimate driving force in any business, drove the exchanges forward to the T+3.

The exchanges have not been able to stop on the T+3. The reasons that took exchanges from T+5 to T+3 are now leading them to T+1. However, the road to T+1 is even more difficult than the one to T+3.

Problems in the way of T+1

The problems in implementing the T+1 include:

i. Manual processing and the lack of automation even after the T+3;

ii. Lack of real time functionality where the technology is employed;

iii. Lack of standard interfaces and the inter-operability;

iv. Lack of data integrity and standards; Table

Removing these obstacles means introducing the Straight Through Processing;

The Straight Through Processing (STP) is an overall business and technology strategy to reduce the risk, cut costs, improve the customer services, handle larger volumes, and have greater ability to introduce new products. It is best described as the seamless integration of systems, and the processes to automate the trade process from end to end. That is from the trade execution, to confirmation, to settlement without the manual interventions and the redundant processing. The benefits of the STP go beyond introducing the T+1, but primarily it is the desire to move to the T+1 that is behind introducing the STP.

Well established business ideas underline the STP, such as the “Time is risk”, “Nothing good happens between the trade and the settlement”, “Eliminate the process that does not add value”, and “Get it right the first time.”

The STP requires (i) standardization of the software and the hardware in brokerage houses and other places; (ii) real time information flows to all participants; and (iii) reliable and flexible technology infrastructure.

Bringing in the STP and the T+1 requires a lot of groundwork and involve substantial costs. The target for implementing the T+1 in the US is by 2005, while the work was started in 2000. The Securities Industry Association of America (SIA) has estimated the cost of T+1 at $8 billion, but with a payback period of only 3 years. By taking out two days of outstanding trades, the exposures of the clearing houses of the stock exchanges would be reduced by 67 per cent.

Conclusion: The T+5, T+3, and T+1 are the past, present, and future of the stock exchange settlement cycles. It was the need to reduce the systemic risk to safeguard the investor-confidence, the ability to reduce the risk by improved technology, and competitive pressures to protect the businesses that are causing the stock exchanges to reduce the time to settlement. The leading exchanges are already working on the STP and the T+1, which means that the future investor shall be able to trade more volumes and trade across the countries but in a shorter time and probably at a lesser cost.