Jack Rando is a managing director with the Investment Industry Association of Canada.
There’s a saying in the investment industry that nothing good can happen between trade date and settlement date. Investors face risks from the moment they execute a trade up to the time that cash or securities ultimately land in their accounts — typically two days later.
Operational glitches, failing counterparties and market crashes are some of the things that can prevent market participants from making good on their promise to buy or sell.
Industry measures mitigate these risks. Notably, the clearinghouse that guarantees trade completion collects collateral from the dealers that are party to the transaction. These collateral requirements reached unprecedented levels during the frenzied trading of 2020 when Canada’s central securities depository, CDS Clearing and Depository Services Inc., cleared 637 million trades — 31% more than in 2019.
A simpler defence against settlement risk is to shorten the settlement cycle itself, thereby narrowing the window of opportunity for default. In doing so, the industry would benefit, including through lower collateral needs, while further protecting investors.
For these reasons, in September 2017, Canada and the U.S. together reduced standard settlement from three days to two (T+2), a much-welcomed move given that over twenty years had passed since the settlement cycle was last reduced from five days to three.
Now, four years later, the U.S. industry has decided to accelerate settlement further — to next-day settlement (T+1) by mid-2024.
What prompted the move?
It was generally understood in 2017 that the move to T+2 would eventually need to be revisited, and the U.S. market volumes and volatility witnessed earlier this year expedited the review.
When the U.S. House Committee on Financial Services examined events of last January that prompted some U.S. dealers to curtail trading in GameStop and other meme stocks, the clearing and settlement process was a key area of focus. Embroiled U.S. industry executives who testified before the committee described a flawed settlement system and pointed to the billions of dollars in additional collateral that their firms needed to sustain customers’ trading. These witnesses suggested eliminating collateral requirements altogether by moving to real-time settlement.
However, the settlement system and the risk framework underpinning it performed as designed during the GameStop saga. The system held participants accountable for the risk they were introducing into the financial system, avoided default and prevented the threat of contagion. While real-time settlement was considered during the U.S.’s recent deliberations, it would have introduced many complications to current market structure, potentially reducing some of the efficiencies dealers and investors benefit from today. Hence the decision to move to T+1 instead.
The U.S. can autonomously amend its settlement cycle, having one of the world’s deepest, most liquid and efficient financial markets. Canadian markets are so interconnected with those south of the border that failing to align our settlement practices risks severe disruption and inefficiencies to Canadian investors and capital markets. Therefore, as in 2017, Canada will need to mirror the U.S. approach.
Securities regulators will be responsible for approving any shortening of Canada’s settlement cycle. However, accelerated settlement is a wholesale change that requires heavy lifting. The industry will have to carefully undertake required system, procedural and behavioural changes without introducing new risks to investors and markets.
As in 2017, the Canadian Capital Markets Association will assume the role of coordinating industry efforts in the move to T+1. The Investment Industry Association of Canada, whose members account for the majority of capital market activity, will play an important role through active participation in a series of industry working groups tasked with developing and executing Canada’s new settlement road map. It is only through this industrywide coordination that Canada can move lockstep with the U.S. and realize the benefits that accelerated settlement can bring to our investors and financial markets.