Accelerated settlement may represent considerable change across the post-trade landscape for the securities market, but it is by no means a novel concept. The intense interest in and scrutiny of this year’s T+1 rollout has surprised even market veterans, some who’ve had a front row seat witnessing a variety of dramatic changes in financial services over decades.
Collateral management has historically operated within a T (Trade Date) or T+1 settlement window, with a vast majority of collateral settling on T, it is easy to draw parallels between the securities market and collateral settlement. To do so, it is important to define T as the day of a margin call. Therefore, in order to settle on T, a margin call needs to maneuver through a series of interlinked steps that begin with calculating exposure or a margin requirement, a non-trivial task for certain types of transactions, notably, non-cleared OTC derivatives. After calculating a margin requirement, and if there is deficient collateral, a margin call is issued to a counterparty, that counterparty needs to compare it relative to their own exposure calculation(s), the amount and type of collateral is then proposed by the pledgor which may need to be sourced if there is insufficient inventory, this collateral must be checked for eligibility and value sufficiency by the recipient, and (most importantly) needs to be delivered or settled in the market.
Factoring in that full complexity, it is easy to argue that a margin call is by orders of magnitude more complex than the mechanisms to execute and settle a securities trade. So, why has T+1 in the securities markets received so much attention, what lessons can be learned by looking at collateral management, and what, if any, impacts does T+1 have on this space?
Accelerated transformation
Anyone that has spent some time in the securities industry has heard endless war stories about the settlement of physical securities, medallion stamps, the “paperwork crisis” in the 50s and 60s, and the formation of Central Securities Depositories (CSDs) and electronic trading. All of these were seminal moments leading into the 80s and 90s, but arguably not much has changed since. That does not mean the securities industry fully escaped post-2008 crisis regulation, but a majority of the regulatory efforts were squarely targeted at the derivatives market.
In particular, new requirements to clear certain OTC derivative transactions, starting in 2013, as well as the implementation of Uncleared Margin Rules (UMR) that started to go into effect in 2016 with a phased-in strategy for Initial Margin (IM) and a “big bang” approach to implementation for Variation Margin (VM). These regulatory efforts spurred major transformation of the derivatives markets, and more so than any of the requirements imposed on the securities market.
The publicity surrounding T+1 is therefore best explained by two key factors, that a majority of the derivatives reforms are now implemented and regulatory change for the securities industry has remained relatively benign for a considerable period.
Don’t overthink, automate
Additionally, friction in the process of settling a security and the size and scale of the securities market, has always led to a relatively large amount of fails and their related costs. With the size of the securities market growing, a fairly persistent level of fails eventually drove efforts to move to T+1 to reduce credit, market and liquidity risks. For some perspective, SWIFT business intelligence has shown that five out of every 100 securities transactions will not complete on their expected settlement date, noting that “while this might not seem like a lot, it translates to billions in operational costs and fees for the industry.” Therefore, greater automation, either through greater adoption of existing industry capabilities or by new innovation, will assuage lingering concerns that compressing the amount of time to settle would exacerbate settlement fails.
This automation is by no means novel and can easily be exemplified by looking at the collateral or margin call process. Taking a simple example, pre-financial crisis, one portfolio of non-cleared OTC derivatives was collateralized together, typically resulting in a max of one margin call per day: large thresholds and Minimum Transfer Amounts or loose requirements to collateralize may have further reduced the operational burden.
Post-financial crisis, the impacts associated with needing to clear certain clearable swaps and the implementation of UMR splits what was one margin call into at least four, and perhaps even more. To handle expected margin call volume increases, many financial firms hired or allocated more resources into collateral management organizations, but not at a 4x rate.
Acadia’s Margin Manager was initially developed along with a consortium of global banks as an event-based infrastructure/network to help automate an email-laden and unscalable margin call process. Today, it is the industry standard and has helped over 3,000 financial institutions automate margin call messaging with their trading counterparties and cope with an ever-growing number of margin calls. It’s currently helping to automate ~80% of all OTC margin calls.
The adoption of Acadia’s Margin Manager helped mute some of these regulatory impacts and enabled scale for the derivatives market. A comparable approach is equally necessary for T+1, in which the automation of trade capture through electronic trading, or matching and affirming trades electronically, is paramount. This is analogous to automating the margin call messaging process (e.g., capturing the ‘trade’).
Finally, switching from batch-based to event-based systems and processes enables a much easier transition to focusing operational effort on exceptions. T+1 does not have to be overthought. These tools exist in the market and firms just need to adopt them.
Collateral settlement fails
While there are parallels to be drawn, collateral management and T+1 also intersect at a very critical point when more collateral is needed. Higher funding rates and funding costs, along with UMR, which requires collateral segregation for IM, has led a growing use of securities as a form of collateral. It should be noted that securities are nearly always used for regulatory IM because cash cannot be adequately ring-fenced and segregated.
By analyzing collateral transfers across Margin Manager, the Acadia team observed that the mix of collateral, historically 80% cash and 20% securities, is closer to 70% cash and 30% securities today. The greater use of securities for collateral purposes has increased the need to either borrow or buy eligible collateral. Even though these securities trades now commonly fall into a T+1 settlement cycle instead of T+2, that is likely not sufficiently quick enough to meet a margin requirement on ‘T’. This can, and does, drive failures to post collateral in the market.
While this is never a good outcome, it is one that most firms accept as being a short-term operational issue. That is, until there is a credit risk concern for a specific counterpart or where there is a macro-economic event, or crisis, that quickly increases the sensitivity in the market to credit risk exposure, including any failed collateral settlement.
To combat this, firms may post cash on a temporary basis or opt to have an excess amount of securities collateral posted at all times, which they may choose to regularly model and stress. So, even though T+1 is a material shift for the securities industry, it is still not optimal. This is leading a wide variety of market participants to explore innovation that would have more real-time, or T, settlement capability. In a foreseeable future, this may even become a regulatory expectation.
It is unclear whether further efficiency will be created from the optimization of existing processes, using tokenized assets, creating natively digital assets, or something that markets and authorities have not even thought of yet. However, one thing is certain, financial markets will continue to innovate and T+1 is not going to be the finish line.
About the Author
Will Thomey joined Acadia in 2022 as Co-Head Business Development for its Workflow Suite. His remit is to set the strategic direction for Acadia’s agreement, margin and collateral business and drive new product innovation. Prior to joining Acadia, Will spent 19 years at JP Morgan in several roles across risk management, operational strategy and post trade transformation using industry market infrastructure. He has vast experience in Collateral Management across both Cleared and Non-Cleared OTC Derivatives.