The Countdown to “Near Real-Time” Trading
In 1602 the Dutch East India Company officially became the world's first publicly traded company when it released shares on the Amsterdam Stock Exchange. For most of the last 400 years, the buy-sell process was done on paper (early stocks were actually handwritten). In the modern era, the settlement period shifted to five days (T+5), dictated by how long it took to physically move the stock certificates from the seller to the buyer. Imagine trying to reconcile accounts when the best mode of transportation (and ergo communication) was horseback!
In 1995, the settlement period was dramatically shortened to three days (T+3), thanks to advancements in technology. We were no longer physically moving stock certificates between transacting parties – the process had gone digital. The major market challenge during this time was, perhaps surprisingly, not the technology. Rather, some trades still took five days to settle, while others took three days. Significant manual effort was required to keep both physical and digital records accurate and up to date.
In September, the US is moving to T+2. State Street's Chief Data Scientist, David Saul, points out that the same fundamental recordkeeping challenge will continue. "I don’t really see moving to T+2 as drastically different from a process point of view. We're not moving to completely replace the infrastructure or database beneath the process. Some transactions will be settling in two days and some in thee days, so the challenge will continue to be keeping the books in order."
But it's that very recordkeeping process that might keep the financial services industry from the Holy Grail, an end state that experts refer to as "near real-time" reconciliation. That is unless something dramatically changes.
Assuming the industry and the regulators believe technology changes won't introduce unacceptable risk, operating at T+0 seems inevitable.
Our Chief Architect, Moiz Kohari, sees the pros and cons of moving from T+3 to T+0. On the one hand, shortening the reconciliation cycle puts a lot of pressure on the regulators. They have to move faster, yet still rely on a reasonable level of accuracy. As David added, "I believe regulators want visibility into market movements, patterns and trends. If everyting is operating at warp speed, regulators would have to be even more vigilant about detecting systemic market failures. We're talking about things that are fundamental to our economy."
On the other hand, Moiz emphasizes that shortening the trade cycle enables you to introduce additional liquidity to the marketplace. "This in turn helps with risk mitigation strategies, as the custodians aren’t carrying that risk for an extra day." Mitigating settlement and liquidity risk has been driving investor strategies since the days of the Dutch East India Company, and that is not likely to change anytime soon.
Assuming the industry and the regulators believe technology changes won’t introduce unacceptable risk, operating at T+0 seems inevitable. But getting there would require a fundamental shift in how the reconciliation and settlement process works. Moiz believes one of the ways to get there is with distributed ledgers, a fascinating concept that has been working its way through the financial industry in recent years. A distributed ledger is essentially replicated, shared and synchronized data spread across multiple sites, countries or institutions. There is no one central administrator or centralized data storage site. "With a distributed ledger, any ledger movement occurs only with the full consensus of all participants. And since the ledger is on top of a known network, only known people can participate. With this approach, 'near real-time' settlement capabilities are possible."
Why is being known so important for T+0? Well, in order to settle a trade you have to go to a clearing house that assumes responsibility for that trade. Then you have to go to a central depository. Sometimes there is a third custody or accounting partner that ensures the books are accurate. Different asset classes pose their own problems, slowing the process even more. Since the industry operates under the Know Your Customer model (KYC), essentially each person who touches the trade has to be known and verified and not every trade settles through the same hands. Thousands of people manage the reconciliation process on a daily basis.
But with a distributed ledger, all the players are known. And suddenly T+0 is actually possible. As Moiz said, "Everything from the trade order management system, all the way through to accounting and custody services, is within State Street's power. We can really lead this type of innovation across the industry." To support this work, State Street’s Office of Architecture and research and development teams have made a significant commitment to bringing in the industry's top engineers
It's important to note that distributed ledgers have not been tested at scale yet. We are talking about processing and transacting in volumes of data that could be unattainable with our current technology. Unlike going from T+5 to T+3 to T+2, going from T+2 to T+0 does require a total overhaul of the system. There are also concerns with fraud1 since not all distributed ledgers have known ownership right now. To counter that, State Street is committed to supporting approaches that are on top of a known network, where the KYC issues are tackled at the forefront.
To get to T+0, the forces at work are dealing with more than a complex, large-scale recordkeeping process. To achieve this across global markets, the changes required would amount to a total digital revolution.
1. Roberts, J. J. (2017, June 22). How Traders Got Burned In the Ethereum Flash Crash. Retrieved August 04, 2017, from http://fortune.com/2017/06/22/ethereum-crash/
Minnie Joung leads regulatory strategy for the Specialized Products Division of State Street’s investment services business. She is currently reading “My Early Life” by Winston Churchill.