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A work of friction? Drivers towards seamless securities settlement

A work of friction? Drivers towards seamless securities settlement

Securities,
7 December 2022 | 5 min read

In the second of three articles, Swift’s Head of Securities Strategy, Vikesh Patel, considers the building momentum for shorter settlement cycles and frictionless post-trade processes – and what this means for the current market structure.

Read article one in this series: More speed, less friction in securities settlement.

Despite the mixed reviews, I have to admit I am interested in the new prequel series to The Lord of the Rings. The plot holds perennial appeal to me, no matter how many iterations it goes through.

And while I hesitate to compare the pursuit of the One Ring to the mission for hyper-efficient post-trade settlement, there are similarities. The extended cast of players, their varied motivations, and the sheer scale of the task ahead, to name a few. Is the industry ready for the quest to handle volume and risk within very short settlement timescales?

The momentum for such a journey certainly exists, and is building on several fronts.

Vikesh Patel
A relatively simple step to tackle friction on an industry level would be the adoption of a unique transaction identifier (UTI), allowing firms to track transactions from end to end through the lifecycle of a transaction. This could reduce operational risk, improve traceability and transparency, and improve client service.
Vikesh Patel Head of Securities Strategy, Swift

Market reform

Digital transformation has raised customer expectations about speed and transparency of services. And several major markets are either on the journey or are pushing for T+1 or even T+0 settlement.

Following pressure from a number of market players, the US Securities and Exchange Commission has confirmed it will transition to T+1 by Q1 2024. Canada will follow suit, and the European Union is evaluating a move to T+1 as well. India is already phasing in T+1 for publicly traded equities, with the aim of covering all stocks by January 2023.

Other markets will surely follow. And assuming the anticipated benefits of reduced risk are achieved, calls for the ultimate compression of timescales will doubtless grow.

Revolution and regulation

One unintended effect is that the fragmentation of settlement cycle times across different territories and time zones will inevitably create further friction. More generally, while existing processes might just accommodate T+1, achieving T+0 will certainly require a new look at existing market structures. 

Market operations such as central counterparty clearing, which have taken on more cleared products since the financial crisis, must be carefully thought about. The capital buffers, reduction in counterparty risk and predictability and certainty of default management processes are hard won victories for the industry, and any future reform must not reduce the level of protection that the markets and end clients benefit from today.

Regulators are supporting market reform to reduce settlement cycle times, but their penalty-based systems – while providing an incentive to increase efficiency – aren’t a solution in themselves.

A squeeze on margins

Income trends are set to become another driver of market reform. While settlement volumes continue to rise, average transaction sizes for both equity and fixed income have been on a steady decline over the past two years.

For providers, the consequence is a further squeeze on margins. This will only be exacerbated by a challenging macroeconomic outlook, with most of the world set on a course of mounting inflation, higher interest rates and limited growth.

The role of tech

In this tough economic environment, banks and securities players will need to focus on core business and IT functions if they are to differentiate themselves and maintain a competitive advantage. Many are already building their capabilities to comply with shorter settlement cycles and tightening regulatory requirements.

Artificial intelligence and machine learning have potential to help reduce settlement friction and generate new revenue streams. The use of utility providers may be increased for activities that can be commoditised, with fintech and third-party services used to access specialist resources, skills and technologies when required.

Increasing transparency

A relatively simple step to tackle friction on an industry level would be the adoption of a unique transaction identifier (UTI), allowing firms to track transactions from end to end through the lifecycle of a transaction. This could reduce operational risk, improve traceability and transparency, and improve client service.

This is one area where the vision is within reach. A UTI already exists. The ISO 23897:2020 was created by the securities industry for over-the-counter derivatives reporting, but has the potential to be used in other types of transactions too.

At Swift, we’ve been working with a group of financial institutions and industry associations to roll out the UTI across various systems. We estimate it has the potential to halve the number of pre-settlement exceptions requiring investigation with a counterparty, and to reduce by 90% the number of matching or timing fails.

The choice we face

If achieved, this would be an important step in our quest for a frictionless future, with all it promises: flexible settlement options, including instant settlement; fewer interventions; more productivity; and less cost. However, the UTI illustrates a wider challenge. To be effective, tech solutions need to be used by a critical mass of players in the market – and collaboration is key.

That requires a conscious choice on the part of market participants. Change is inevitable and the clock is ticking. As Gandalf would say, “All we have to decide is what to do with the time that is given us.” How can we overcome fragmentation and achieve interoperability in the securities industry? This is the question I’ll explore further in my final article in this series.

Read article one in this series: More speed, less friction in securities settlement.

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