“Often, we get sales notifications in batch or overnight, meaning, in this new environment we’ll be getting sales notifications on the day of settlement."
Pressure is growing on industry and government to respond to 2021’s extreme stock market volatility. Following on the controversy around the GameStop retail buy-side suspensions, one of the remedies being discussed is shortening of the settlement cycle and, perhaps, even a shift to real-time settlement in the US equity markets. Yet the practicality of the situation is that most of the banks and dealers in the securities financing sector just can’t operate real-time in today's environment. The timeline for financing activity, which underpins much of the trading by professionals in today's markets, as well as the lending of securities by institutional investors, cannot easily be compressed. For that reason, equity financing's capabilities are prime considerations for any change in the market infrastructure. Yes, trades can be executed in real-time, but trades are not the same as loans.
Trades don't have to be collateralized, marked to market nor returned by borrowers to their lenders. Trades are executed, cleared and settled. The same is true for securities loans, but the lifecycle of a loan can include distributions, corporate actions, and collateral substitutions. For that reason, "real-time" for securities finance is a far more complex operation. Only the most capable financial institutions can cope with that challenge. True, they operate behind the curtains, but without their support markets would not exist today. And so, to elevate and inform the public discussion, four of the most experienced members of the Securities Finance Operations & Technology Committee in the industry's Risk Management Association were tasked with describing those challenges and presenting possible solutions during a virtual panel on the morning of March 23rd, 2021.
"We operate at T+0 today,” explained Patrick Morrissey of Vanguard, since lent securities are delivered to borrowing counterparties on a same-day basis within the equity finance markets. But Mr. Morrissey also pointed out that the return of the securities is a different matter. To illustrate, legal satisfaction of the Notice of Recall, after legal delivery of the Notice, is subject to the T+2 equity settlement cycle in the USA, while SEC Rule 204 sets the S+4/T+6 buy-in rule for settlement fails. That sounds manageable. But, in reality, the sales notices are slow to arrive. As a result, fails to receive can create complex accounting problems because title is only passed on settlement date. The resulting financing delays will have to compressed if real-time settlement in good funds is the goal for the US equity markets.
“Often, we get sales notifications in batch or overnight,” said Matthew Puscar of Vanguard, "meaning, in this new environment we’ll be getting sales notifications on the day of settlement." Collapsing that process can create operational risks which may have consequences for the trustees and beneficial owners of lending funds. So any changes must be carefully thought through. No sooner had DTCC announced a plan to move to T+1 than the SEC threw down its own gauntlet by calling for a “robust public debate” on the need for improvements to the infrastructure.
How the Loan Recall Process Works in Equity Finance
After receipt by a lending agent of the Recall Notice from the lender's asset manager, a 'call is made' to the cashiering department for release of collateral, pending receipt of the securities. If there’s a record date involved with the securities, for instance in a voluntary corporate action, then that has to be considered along with the value of any optionality in the linked distributions. Complicated entries have to be made and corrected, sometimes on the fly. Ultimately, the interbank accounts have to be reconciled and credited with good funds at the central bank. All of these are interdependent actions which can result in reconcilement breaks, partly because not all participants are operating at the same speed.
Many experts believe that only an advanced technology can collapse the process to solve the recall problem. For example, a blockchain can create an infallible record of each transaction, allowing proof breaks to be reconciled against the “golden record" in the view of advocates for distributed ledger technologies (DLT).
That is, both the recall notice and the triggering sale notice, even though not reported to the bank until the morning of settlement date, create a causal chain to be recorded and then distributed in an encrypted shared ledger. Fails can still be recorded after market close. Of course, that doesn’t leave much margin for error resolution. As a result, the interim result will no doubt be a “more aggressive buy-in scenario,” says Thomas Veneziano of Citibank.
The legacy systems of the clearing banks, experts say, are among the main limiting factors in moving to realtime settlement. But, the same experts point out, the equity finance systems still work perfectly well in their initial and continuing use cases. Still, no warranty will ever cover the case of a 50% revamp of the market calendar. So critics are wondering if the regulatory costs to meet the promise are being underestimated. Again.
Skepticism is just realistic, says more than one expert. Mr. Morrissey of Vanguard asked rhetorically, “Where are we going to get systems that can handle that speed — and match it [accurately] to our legacy books? And what is the influence on workflows in this new environment, so that everyone knows what tasks are to be considered most important? This may be a problem that DLT can solve."
At a level higher, the new market system's architecture and reliability also has to be weighed. Considering the lattice of trading, collateral, and settlement systems, Nickolas Delikaris of State Street asks, "How will you get and keep all the systems online at once?”
New and emerging technologies such as Artificial Intelligence and Machine Learning may help the industry move forward, said Nic Roc of BlackRock. Many transactions will be controlled with self-executing utilities such as smart contracts, said Mr. Roc, and "human traders will be exception-based in the future." Nevertheless, relationships will always be fundamental to the operations workflow, he said, drawing agreement from the other panelists.
"How will automation affect our relationship with borrowers?" asked Mr. Morrissey, foreshadowing a key topic that will be covered in a future blog commentary.
[To be continued]