SEC’s New Shorter Settlement Cycle Aids Investors

Trimming clearance and settlement on trades to one day — referred to as T+1 — means clients selling securities now receive their cash sooner.

By Herbert Blank

On May 28, 2022, a new SEC rule went into effect that will affect almost every stock, bond and ETF trades in U.S. markets. This new rule establishes the “T+1” settlement cycle, which relates to how long it takes for securities transactions to clear and settle. These securities include all U.S. exchange-traded stocks, corporate and municipal bonds, and exchange-traded limited partnerships.

A major benefit from this change, that I believe has been greatly understated, is that individuals and small firms selling securities will have access to withdrawing their cash for other uses the next day without waiting an extra day. Morningstar, among others, hastened to point out that this also means that the funds are taken from investors’ cash balances one day earlier.

First Came ‘T+2’

To better understand the importance of this new change, let’s start with the rudiments of clearing and settlement. Both of these processes occur after a trade to facilitate payment and the transfer of securities.

Clearing involves the exchange, validation and reconciliation of transaction information across a payment network. Settlement is the irrevocable delivery of a security to the buyer in exchange for payment.

Before electronic national clearinghouses were invented, brokers physically exchanged certificates. They relied heavily on pen and paper to keep records and  employed hundreds of messengers to carry the certificates and checks between parties. Tthe exchange of physical stock certificates was difficult, inefficient and increasingly expensive. Before 1946, when there were far fewer stocks traded and far fewer frequent stock market participants, the SEC allowed for T+2 settlement (settlement within two days of the trade date).

Lightening the Paperwork Burden

As stock market listings exploded and stock ownership became more popular with institutional and retail investors in the early 1960s, the settlement deadline was lengthened to four days and then to five. The late 1960s brought an unprecedented surge in trading: Nearly 15 million shares a day traded on the New York Stock Exchange in April 1968 — three times the daily volume of 5 million shares just three years earlier (which at the time had also seemed overwhelming). The paperwork burden became enormous.

As a result, in 1968 the NYSE established the Central Certificate Service (CCS) at 44 Broad Street in New York City. The CCS transferred securities electronically, eliminating physical handling for settlement purposes. CSS also tracked the total number of shares held by members of the New York Stock Exchange. This relieved brokerage firms of the work of inspecting, counting and storing certificates. NYSE Chairman Robert W. Haack labeled it “top priority.”

Roughly $5 million was spent on this effort, which in 1973 established the Depository Trust Company (DTC), the U.S.’s first securities depository. DTC was created to reduce costs and provide efficiencies by immobilizing securities and making “book-entry” changes to show ownership of the securities. DTC is a member of the U.S. Federal Reserve System and a registered clearing agency with the U.S. Securities and Exchange Commission.

Greater Ease of Use

Next, in 1976, the National Securities Clearing Corporation (NSCC) was established to serve as the central counterparty for trades in the U.S. securities markets. The new entity provided clearing, settlement, risk management, central counterparty services, and a guarantee of completion for certain transactions. This included virtually all broker-to-broker trades involving equities, corporate and municipal debt, American depositary receipts (ADRs), and unit investment trusts.

NSCC also nets trades and payments among its participants. When NSCC implements a net settlement, DTC simultaneously moves securities. Typically, the clearing and settlement processes involve transfering securities, cash and money market instruments between custodian bank and broker-dealers.

Technology Enables Shorter Settlement Cycles

The process of migrating to book-entry from physical delivery took some time. Meanwhile, the U. S. stock market really took off in the 1980s as technology became increasingly efficient. Eventually, the U.S. was able to gradually shorten its settlement cycles.

In 1993, the NSCC, following five years of diligent work, changed the settlement period for most securities transactions from five to three business days. The new standard was known as T+3. Under the T+3 regulation, if you sold shares of stock on Monday, the transaction would settle on Thursday.

Additional Reading: Understanding So-called ‘Spot Bitcoin ETFs’

Then, in 1999, DTCC was established as a holding company that combined the Depository Trust Company (DTC) and the National Securities Clearing Corporation (NSCC). User-owned and directed, it automates, centralizes, standardizes and streamlines processes in the capital markets. Through its subsidiaries, DTCC provides clearance, settlement and information services for equities, ETFs, corporate and municipal bonds, unit investment trusts, government and mortgage-backed securities, money market instruments, and over-the-counter derivatives. DTCC also manages transactions between mutual funds and insurance carriers and their respective investors.

The settlement cycle was again shortened in 2017, to T+2, because by then technology had taken us well into the internet age, with unfathomable processing speeds. Now, seven relatively short years later, considering how long prior changes took, T+1 became the industry standard in late May.

Quicker Cash Can Be a Lifesaver

Institutions have received background pieces from the largest custody banks such as State Street and BNY Mellon, recognizing the importance and improvements in efficiency and utility of this event.  One major benefit for options users is it puts the options clearing and settlement processes in synch with the underlying options. Options have enjoyed T+1 automated clearing and settlement for quite awhile.

As mentioned early in this article, the new change brings quicker access cash to individuals and small firms selling securities. Funds are also taken from investors’ cash balances one day earlier. Once funds are committed to market investment, having the money depart the account one day earlier is typically relatively immaterial. But needing cash immediately for a personal crisis is a different matter altogether.

In my life, I have needed immediate cash three times and did not want to resort to expensive lending alternatives. In a crisis, it’s a potential lifesaver to have cash the day after selling securities.

Beyond these advantages for stocks, this enhances an already existing advantage for those who purchase ETFs in lieu of traditional mutual funds. When you sell traditional mutual fund shares back to the fund’s distributor, you received your funds, minus any applicable redemption fees, on T+3 (that is, three days later). In comparison for ETFs it was formerly T+2.

The ‘Offensive Linemen’ of the Industry

As the first portfolio manager in the U.S. for ETFs, I grew to truly appreciate DTCC in 1996 (or NSCC, as it was known at that time). They developed what is known as the “bursting mechanism” for ETFs that assured that ETF issuers and authorized basket creators and redeemers enjoyed guaranteed clearing and settlement for all U.S. exchange-listed securities. This greatly increased efficiency and lowered operational costs. I daresay that without the bursting mechanism, the growing popularity of ETFs might never have taken off in the way it has.

Therefore, for personal and professional reasons, I thank the DTCC for the diligent efforts required to make T+1 a reality and for coordinating with major and minor players to ensure that the transition was seamless. I’d urge all those desiring more information to download this piece from the DTCC website.

In closing, I think of the DTCC crew as the “offensive linemen” of the industry. Their work is crucial on every single transaction, but no one notices them or even thinks about their existence until or unless something goes wrong.

Herb Blank is a senior quantitative analyst at ValuEngine and senior consultant and practice leader in the Global Finesse Product Strategy and Implementations Consulting Practice. He has more than 30 years of experience in financial product innovation and quantitative analysis. Recognized as a pioneer in the exchange-traded fund (ETF) industry, Blank established the first family of ETFs to trade on the NYSE and was a portfolio manager for the fund. He is credited with the product development and launch of iShares, GLD and X Shares. He is also well known for his development of the construction and maintenance methodologies for Dow Jones Global Indexes.

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