Beginning this month, securities transactions must be settled within three days. Custody banks, regulators, the Depository Trust Company and the Securities Industry Association have all strived to ensure that their institutional clients--from pension funds and mutual funds to broker/dealers, clearing firms, and transfer and paying agents--were prepared. Anyone who deals with corporate equities and debt, mutual funds, private label mortgage-backed securities, publicly listed limited partnerships or municipal bonds will be affected by T+3.
Is everybody ready? "I think there isn't any reason for any institution not knowing about the coming of T+3 at this late date," says Marshall Carter, chairman and chief executive at State Street Boston Corp., a leading asset manager and global custody bank.
"One significant reason is that the SEC, the Federal Reserve and all the other regulators have allowed the industry itself to drive the solution," Carter explains. Another reason is that many custody banks included the expense of preparing for T+3 in their ongoing systems upgrades, so the costs have been spread out.
A shortening of the settlement cycle, combined with a shift to same-day settlement of funds, takes a considerable amount of risk out of the system. It also offers significant opportunities for custody banks. "This is the biggest change in U.S. securities operations since DTC was formed in 1973," says Kenneth Landis, a partner in the financial services industry practice at Coopers & Lybrand.
Landis thinks T+3 gives custodial banks a great opportunity to gather assets that can then be leveraged into a whole range of increased fee revenues. He cautions, however, that Lit will require high-level strategic planning to exploit the operational advantages that T+3 brings. to the banks' custodian business."
Calls for operations reforms--including T+3--began shortly after the stock market crash in October 1987, when some foreign equities trades took a year to clear. A Group of Thirty steering committee, headed by Citicorp chairman John Reed, set up a series of working committees around the world to devise a solution. in March 1989, Reed's committee released a report that recommended a number of changes intended to make the world a safer place in which to invest and trade.
In the U.S., only two of those recommendations--T+3 and sameday funds settlement--posed a problem. Unlike the rest of the world, individual investors are still a major component of the U.S. market. In the early 1980s, fully 50% of all equities trades were executed for individuals. While the steady growth of mutual funds had absorbed half of these individual investors by 1990, many people still feared that changing the practice of mailing a check to cover securities purchased after a confirmation of the trade has been received by mad could alienate this important segment of the market.
Another important factor was possession of the securities themselves. T+3 was clearly a step toward dematerialization--that is, getting rid of physical certificates," says Jeremiah O'Leary, a senior vice president and member of the management committee of Geoserve, Chemical Banking Corp.'s transaction processing unit. Many fell that individual investors wouldn't give up the option of actually taking possession of their physical certificates even though, as O'Leary points out, many retail investors keep them with their brokers instead.
When the DTC was formed 23 years ago as a cooperative owned by some 2,500 financial institutions, it effectively began to immobilize securities by housing them in one location. This way, ownership could be transferred without sending the certificates themselves. Now, says Coopers & Lybrand's Landis, "The move to T+3 has compressed time, which is a sea change for the securities industry."
In all of the G30 discussions about clearance and settlement, the basic principle was: The shorter the settlement cycle, the lower the degree of risk in the settlement process. The systemic benefits of T+3 include the reduction of credit, market and liquidity risk. It also lowers financing costs and encourages greater operational efficiency among all market participants.
During times of market volatility, shortening the settlement cycle should reduce the likelihood of buyers reneging on transactions, thereby insuring greater safety and predictability of trades.
Were the banks diligent about educating their clients and customers about T+3? "Not just the banks," says State Street's Carter. "Everybody has been very diligent."
Most custody banks have worked closely with their customers in preparation for T+3. "We tried very hard to tell them that a failure to comply would mean they would be disadvantaged operationally, competitively and financially," says Chemical's O'Leary.
For example, some banks sent members of their custodial staffs to meet with customers and see if they could assist by providing interfaces with the DTC. "At the same time, we sent our relationship managers to DTC classes so they could field questions about this," says Citicorp vice president Curt Hudson, director of sales and management for cross-border custody. And in March 1995, the bank mailed a pamphlet entitled "T+3 Settlement" that tried to answer many customer questions.
There have been few complaints from custody banks about T+3 despite the obvious expense of training staff and customers, since it has been accepted as the price of playing the custody game. And as Carter points out, "Our regulators didn't slam dunk this on top of us with just six months to get it done."
Nor does it seem likely that a shorter settlement period will cost the banks much revenue. "Float went out of the business a long time ago," says Carter with a chuckle. "You can't believe how sharp people are as cash managers now."
Another Group of Thirty recommendation was same-day funds settlement--or SDFS--which is scheduled to take effect in February 1996. This requirement will apply to payments associated with dividends, interest redemptions and reorganizations, as well as securities transactions. SDFS also will reduce risks, simplify cash management and provide a single processing schedule for all security types.
A shorter settlement cycle offers an enormous competitive advantage to those custody banks that know how to use it. Brokers in the U.S. argue that customers should open money market accounts with them so that investing in stock will be easier. And yet shorter settlements make it more difficult to move cash and securities from one vendor to another. This creates an opportunity for any intermediary that can download confirmations from brokerage firms, print them locally and mail them to customers.
For institutional vendors, shorter settlements are a powerful argument for centralizing cash and securities with a single intermediary. Banks in the U.S. could use their technology prowess and understanding of payment systems to hold and transfer money and information. "Banks have a franchise in the payment system that the brokerage houses don't have," says Coopers & Lybrand's Landis. "They could potentially disintermediate the brokerage houses."
Will they? "Right now, T+3 isn't even on the radar screens of people who think about one-stop relationships, alternative distribution or fee income business," says Landis. Banks are only thinking operationally. But soon, banks will see T+3 as a powerful tool to accumulate client and customer assets, and begin to figure out ways to use it to their advantage.