Image Source: Unsplash

Market Efficiency and Personal Access to Cash Receipts Improve Dramatically

On May 28, 2024, a new rule went into effect that will affect almost every stock, bond, and ETF trade in U.S. markets. This new rule establishes the "T+1" settlement cycle, and it relates to how long it takes for securities transactions to clear and settle. These securities include all US exchange-traded stocks, corporate and municipal bonds, and exchange-traded limited partnerships.

To understand the importance of this, it is probably best to start with the rudiments of clearing and settlement. Clearing and settlement are processes that occur after a trade to facilitate payments and the transfer of securities. 

Clearing involves the exchange, validation, and reconciliation of transaction information across a payment network. Settlement is the irrevocable delivery of a security to the buyer in exchange for payment. Electronic national clearinghouses and stock certificates had yet to be invented. 

Brokers physically exchanged certificates, employing hundreds of messengers to carry certificates and checks. The mechanisms brokers used to transfer securities and keep records relied heavily on pen and paper. The exchange of physical stock certificates was difficult, inefficient, and increasingly expensive. Before 1946, when there were far fewer stocks traded on the exchanges and far fewer frequent stock market participants, the SEC had allowed for T+2 settlement (that is, settlement within two days of the trade date). 

As stock market listings exploded and ownership of stocks became more popular with institutional and retail investors going into the early 1960s, this deadline had been lengthened to four days and then five. In the late 1960s, with an unprecedented surge in trading leading to volumes of nearly 15 million shares a day on the NYSE in April 1968 (as opposed to 5 million a day just three years earlier, which at the time had been considered overwhelming), the paperwork burden became enormous. 

This led the New York Stock Exchange to establish the Central Certificate Service (CCS) in 1968 at 44 Broad Street in New York City.  The CCS transferred securities electronically, eliminating their physical handling for settlement purposes, and kept track of the total number of shares held by NYSE members. This relieved brokerage firms of the work of inspecting, counting, and storing certificates. NYSE Chairman Robert W. Haack labeled it "top priority", $5 million was spent on it.

As a result, the Depository Trust Company (DTC) was established in 1973 as the USA’s first securities depository. It was created to reduce costs and provide efficiencies by immobilizing securities and making "book-entry" changes to show ownership of the securities. DTC is a member of the U.S. Federal Reserve System and a registered clearing agency with the U. S. Securities and Exchange Commission.

Next, the National Securities Clearing Corporation (NSCC) was established in 1976 to serve as the central counterparty for trades in the U.S. securities markets. The new entity provided clearing, settlement, risk management, central counterparty services, and a guarantee of completion for certain transactions for virtually all broker-to-broker trades involving equities, corporate and municipal debt, American depositary receipts, and unit investment trusts. NSCC also nets trades and payments among its participants. When NSCC implements a net settlement, DTC simultaneously moves securities. Typically, the clearing and settlement processes involve transfers of securities, cash, and money market instruments between custodian banks and broker-dealers. 

The process of migrating to book-entry from physical delivery took some time. Meanwhile, the U. S. stock market really took off in the 1980s as technology became increasingly efficient. Eventually, the USA was able to gradually shorten its settlement cycles. In 1993, the NSCC changed the settlement period for most securities transactions from five to three business days following five years of diligent work. The new standard was known as T+3. Under the T+3 regulation, if you sold shares of stock on Monday, the transaction would settle on Thursday. 

In 1999, DTCC was established in 1999 as a holding company to combine The Depository Trust Company (DTC) and National Securities Clearing Corporation (NSCC). User-owned and directed, it automates, centralizes, standardizes, and streamlines processes in the capital markets. Through its subsidiaries, DTCC provides clearance, settlement, and information services for equities, ETFs, corporate and municipal bonds, unit investment trusts, government and mortgage-backed securities, money market instruments, and over-the-counter derivatives. It also manages transactions between mutual funds insurance carriers and their respective investors. Eventually, as technology took us well into the internet age and heretofore unfathomable processing speeds, the DTCC brought all parties up to speed by upgrading to t + 2 in 2017. Now, seven relatively short years later considering how long the prior changes took historically, t + 1 became the industry standard a little over a week ago.

Institutions have received background pieces from the largest custody banks such as State Street and BNY Mellon, recognizing the importance and improvements in efficiency and utility of this event. One major benefit for options users is it puts the options clearing and settlement processes in synch with the underlying options since options have enjoyed t+1 automated clearing and settlement for quite awhile. 

From a practical perspective for small investors, there is a major benefit that I believe has been greatly understated. This change means that individuals and small firms selling securities will have access to withdrawing their cash for other uses the next day without waiting an extra day. Morningstar, among others, hastened to point out that this also means that the funds are taken from investors’ cash balances one day earlier, which is certainly true. 

My point is that individual utility functions for access to cash are not symmetric. Once funds are committed to market investment, having the money depart the account one day earlier is relatively immaterial. Needing cash immediately for a personal crisis is a different matter altogether.

In my life, I have needed immediate cash three times and did not want to resort to expensive lending alternatives. In a crisis, having cash the next day after an emergency selling of securities is a potential lifesaver. 

Beyond these advantages for stocks, this enhances an already existing advantage for those who purchase ETFs in lieu of traditional mutual funds. When you sell traditional mutual fund shares back to the fund’s distributor, you receive your funds, minus any applicable redemption fees, on t+3; that is, three days later. In comparison with the next day for ETFs which was formerly t + 2. 

As the first portfolio manager in the US of ETFs, I grew to truly appreciate DTCC in 1996 or NSCC as it was known at that time. They developed what is known as the “bursting mechanism” for ETFs that assured that ETF issuers authorized basket creators and redeemers enjoyed guaranteed clearing and settlement for all US exchange-listed securities. This greatly increased efficiency and lowered operational costs. I daresay that without the bursting mechanism, the growing popularity of ETFs might never have taken off in the way it has.

Therefore, for personal and professional reasons, I thank the DTCC for the diligent efforts that have been required to make t+1 a reality and coordinating with major and minor players to ensure that the transition was seamless. I’d urge all those desiring more information to download this piece from the DTCC website here. 

In closing, I think of the DTCC crew as the “offensive linemen” of the industry. Their work is crucial on every single transaction, but no one notices them or even thinks about their existence until or unless something goes wrong.

More By This Author:

A Not-So-Brief History Of Quantitative Investing Since 1900
The Terrible Ten
Will 2024 See A Regime Shift To Value And Small Cap Or Will It Be Just More Of The Same?