(March 14, 2021) – Buried deep within the drama surrounding GameStop’s January trading frenzy was the determinant factor behind Robinhood Markets’ January 28, 2021 decision to restrict purchases in the stock: a staggering $3 billion margin call to the online broker from its clearinghouse.
Nearly one month later, the Depository Trust and Clearing Corporation (DTCC), a post-trade financial services company providing clearing and settlement services to global financial markets, published a white paper urging an overhaul of the stock market’s clearing structure that could reduce the risk of such a scenario repeating. In an effort to reduce volatility and speed up the time it takes to settle equity trades, the clearinghouse proposed that settlement times be cut in half—from two days to one—by 2023.
The Role of a Clearinghouse
Owned by a financial-industry consortium, the DTCC is virtually unknown to the average investor despite processing an average of $1.77 trillion of securities per day in 2020.[1] After every stock trade, DTCC ensures that shares are delivered to the buyer and cash is delivered to the seller. That clearing and settlement process takes two business days, better known in the industry as T+2.
“The immediate benefits of moving to a T+1 settlement cycle could mean cost savings, reduced market risk, and lower margin requirements.” – DTCC White Paper
To protect against the risk that either a buyer or a seller will default on its obligation, the National Securities Clearing Corporation (NSCC), a DTCC subsidiary, was formed and presently maintains a multibillion-dollar fund to be tapped in case of such a failure. The NSCC fund is supported by deposits from brokerages including units of many Wall Street banks as well as some online brokerages such as Robinhood.
When trading volumes rise or markets become more volatile, the DTCC can demand additional deposits from brokerages to reduce its risk exposure. This is precisely what happened with Robinhood on Thursday, January 28. From the standpoint of the NSCC, the soaring price of GameStop created fears the clearinghouse could be left in the lurch if the stock price suddenly cratered. Robinhood might not have the capital to cover a potential collapse in prices between when shares were purchased on Wednesday, January 27 and when they cleared two days later. In the same way a brokerage can ask an individual investor to pony up more cash to cover a margin call, the NSCC wanted Robinhood to plunk down more money to avert risk.
Unable to come up with the $3 billion immediately, Robinhood acted to limit the number of GameStop shares that could be purchased by customers using its platform. According to NSCC formulas, that decision made Robinhood less risky and ultimately reduced the size of the margin call. Nonetheless, in the days that followed, Robinhood was able to raise $3.4 billion from its venture backers to meet its margin call.[2]
According to their risk simulations, the risk volatility component of NSCC’s margin could potentially be reduced by 41% by moving to T+1.
The Move to T+1
In a white paper published February 24 titled, “Advancing Together: Leading the Industry to Accelerated Settlement,” the DTCC claims that based on extensive industry engagement conducted throughout 2020, “early indications suggest that market participants increasingly favor the move to T+1 to take advantage of capital and operational efficiencies, and benefit from significant risk reduction and a lowering of margin requirements, especially during times of high volatility and stressed markets.” Moreover, according to their risk model simulations, the volatility component of NSCC’s margin could potentially be reduced by 41% by moving to T+1, assuming current processing and without any other changes in client or market behavior.[3]
Industry support for moving from T+2 to T+1 also grew after the onset of the coronavirus pandemic, when a surge in volatility and trading volumes resulted in brokers being forced to post more margin at the NSCC. For example, in 2018 and 2019, the size of the NSCC clearing fund averaged around $7 billion. In 2020, that level rose to $13 billion. According to the DTCC, the size of the fund hit a record $36.4 billion in December when Tesla was added to the S&P 500, resulting in enormous trading volumes as index funds snapped up shares of the electric-car maker.[4]
“Time to settlement equals counterparty risk, and margin requirements, which are designed to mitigate those risks, represent a cost to members,” says Mike McClain, Managing Director and General Manager of Equity Clearing and DTC Settlement Services. “The immediate benefits of moving to a T+1 settlement cycle could mean cost savings, reduced market risk, and lower margin requirements.”[5]
The Goal: Achieve T+1 by 2023
The DTCC would not be able to unilaterally move to T+1 settlement. DTCC does not have the regulatory or legal authority to unilaterally change the settlement cycle. Such a shift to T+1 would need the blessing of the Securities and Exchange Commission, and hundreds of firms would need to update their systems and take part in coordinated industry tests to ensure a smooth transition. Despite this, DTCC continues to advocate for shortening the settlement cycle to T+1, similar to the role it played in 2017 to move to T+2 from T+3. Before that, the last shortening of the process was in 1995, when the industry moved to T+3 from T+5 settlement.
“The hardest thing to do when trying to make a change like this in the industry is to get consensus and get the whole industry to coalesce around the date,” said Murray Pozmanter, Head of Clearing Agency Services at DTCC. “So, 2023 at this point seems to be the date that we can get the industry to agree to move forward.”
[1] “Clearinghouse Urges Faster Trade Settlement Amid GameStop Scrutiny,” Wall Street Journal, Feb. 24, 2021.
[2] “U.S. Stock Trades to Clear in a Day Under Clearinghouse Proposal,” Bloomberg, Feb. 24, 2021.
[3] “DTCC Proposes Approach to Shortening U.S. Settlement Cycle to T+1 Within Two Years,” DTCC Press Release, Feb. 24, 2021.
[4] “DTCC Proposes Approach to Shortening U.S. Settlement Cycle to T+1 Within Two Years,” DTCC Press Release, Feb. 24, 2021.
[5] “Clearinghouse Urges Faster Trade Settlement Amid GameStop Scrutiny,” Wall Street Journal, Feb. 24, 2021.
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