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Page last updated
February 15, 2003




European capital markets Securities settlement what will it cost?


On 5 February 2001, UK and Irish equity settlement moved from a T+5 model (in which you pay for the securities you bought, or deliver those you sold, 5 business days after you struck the trade), to a T+3 model. This move will bring a certain elegance to the overall picture of securities settlement in the European capital markets, but will it deliver any tangible benefit to anyone? And what will it cost?

The benefit of reduced settlement times cannot be quantified. The main area of risk which is addressed by T+3 is known as replacement risk. This is universally regarded as "unwanted" by the market govemors and influencers, and T+3 is almost universally regarded as a reasonable step towards a cure. Nobody knows how much it is worth, in the same way that nobody knows how much premature death is caused by consumption of beef - it is simply accepted that T+3 is better than T+5 and the medicine is therefore worth taking.

On the cost side of the picture, we are a bit better off for information. The amount of money which is to be spent on new systems and procedures to support moving from T+5 to T+3, for the vast majority of investment firms, will, in the grand scheme of things, be negligible. CREST has been able to support T+0 (in fact, near real-time) settlement since inception.

Even those firms without direct CREST membership, inside or outside the European timezone, have no real trouble with T+3, however much the salespeople from OMGEO, axion4, SWIFT and countless software houses would like you to think otherwise. Of course, STP rates are still lamentably low and the cost of settlement in Europe is relatively high - but T+3 settlement is not really challenged by these factors. So - the costs of setting up T+3 should be relatively low.

There is an opinion, of course, that the real costs of the exercise are likely to make themselves known after, not before, implementation.

For example, in the US, when domestic equity settlement moved from T+5 to T+3 in 1994, the percentage of trades which settled on time reduced quite dramatically and stabilised, after a few weeks of "bedding down", at around 90% of all trades (as opposed to the 95% figure which had prevailed under T+5). This figure has now improved significantly - to the extent that T+3 is now as effective as T+5 used to be. It could be argued that the funding cost of the incremental trade failures during 1995-2000 in the US was the real cost of the exercise, and this is what is in store for the UK.

There are different dynamics in the UK, though. The majority of trades executed in the US which suffered delay in the immediate post-T+3 era were retail trades. In the UK, retail trades are so far from 95% settled on T+5 that nobody bothers counting... and the value at risk of a retail trade is very small. Overall, the costs of failed trades borne by the wholesale investment industry is unlikely to be significantly affected by T+3.

The real reason for the change to T+3 is that the major US and European investment banks, who are the major stakeholders in the industry, are moving their domestic infrastructures towards T+ 1. They are worried about huge and growing transaction volumes in the equity markets, and how to make them pay. They also have an eye on recent moves by central bankers (in the form of the Bank for International Settlements in Basle) to impose capital adequacy demands on trades executed but unsettled.

A settlements department's obligations regarding securities transactions only become fully discharged when full and irrevocable settlement of stock and cash has taken place - and the cost of providing capital to cover replacement risk for all transactions - even in a T+3 environment- would erode or eliminate the already thin margins on securities trading.

To prepare for a T+1 settlement environment, there is a great deal of money to be spent by everyone. The major problems are:
1. Liquidity management, defined as having the right stock and currency in the right place at the right time. The payments experts have lived through this for several decades - they know how difficult, and expensive, T+ 1 is, even when there is no contingent exchange of assets to deal with. One fundamental issue is that foreign exchange settles on a T+2 basis - meaning that the cost of borrowing currency overnight is likely to be a new cost component of every cross-currency deal in a T+ 1 environment.

2. Trade initiation and confirmation, making sure that all parties to a trade agree on its terms and its fine detail in a standard, electronic way that leaves no room for misinterpretation. This is, of course, what the GSTPA and its progeny regard as its main mission in life, and why Thomson embarked on its ITM concept. Whilst today's initiation and confirmation procedures (OASYS Global, Market Match and their ilk) demonstrably support T+3, they demonstrably fail to support T+ 1;

3. Managing the capital adequacy requirement for uncleared trades (which means buying or building yet another risk management system).

T+3 is but a small stepping stone to T+ 1, for which the building blocks are being put in place already. The smart securities firm is already getting with the program, or outsourcing the problem to someone who wants it.


Andrew Muir
Director of global securities solutions


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