Back to 1875

The last time I wrote about settlement speed was back in 2017. In that article I published a chart of the history of U.S. securities settlement speed, which I only recently had the chance to update. 

Well, here it is:

You'll sometimes catch technologists making the claim that settlement speed is a function of societal advancement. That is, in the old backward days of yore, settlement used to proceed at horse-and-carriage like pace, but as technology improves we gain the capacity to quicken settlement up to hours, then minutes, seconds and finally zero.

But as the chart illustrates, the technological explanation of settlement speed isn't right. We're about to return to t+1 (or next-day settlement) in 2024, the same pace we had back in 1875. Settlement speed isn't dictated by technological advancement, folks, it's the end result of a conscious choice that takes other factors into consideration, such as efficiency.

I was going to write an article explaining this more clearly, but I was reminded of a post I wrote for AIER back in 2021, and hadn't yet re-published here, which already makes this point more than adequately. So without further ado, read on:

In Finance, Slow is Good

In an age of instant communications, a stock trade takes a leisurely two days to settle. That is, if you buy some shares of Tesla on Monday, your brokerage won’t receive the shares (or pay the cash) until Wednesday. In industry speak, this is called T+2.

This seems an achingly long time to settle a transaction. Indeed, last month, the CEO of Robinhood, a discount brokerage, went so far as to suggest that there is no reason why “the greatest financial system the world has ever seen cannot settle trades in real time.”

In fact, there is a very good reason to eschew real-time settlement. Going slowly is a way to capture one of the world’s great natural financial forces: netting. Go too fast and you lose out on it.

To understand the magic of netting, let’s consider a world without it. Imagine a world with real-time settlement, where if I buy Tesla on Monday at 10:49 it settles at 10:49.

Say that I buy $100 worth of Tesla shares from you. We each use a different brokerage. With settlement proceeding in real time, the moment after the trade is made your brokerage will transfer the Tesla shares to my brokerage. My brokerage will simultaneously wire your brokerage the $100.

That’s two transactions between the brokerages.

Now let’s say that thirty minutes later, Jill decides to buy $100 worth of Tesla from Tom. Tom and I are clients of the same broker, while you and Jill are clients of the second broker. As before, the brokerages will have to settle up immediately. Tom’s brokerage will have to transfer the Tesla shares to Jill’s brokerage, and Jill’s brokerage will have to wire Tom’s brokerage the $100.

The two brokers now have to do four transfers between each other.

But if settlement is slowed by just a little bit, then the participants to this trade get to enjoy the magic of netting.

Let’s repeat all those transactions, but wait an hour before settling up accounts. When the hour is up, the brokers have two trades to settle up. But instead of processing both separately, they can just cancel them out. In this example, the inter-brokerage flows perfectly counterbalance each other. Our $100 Tesla trade is offset by that of Jill and Tom. And so the two brokerages needn’t do any transactions with each other. The first brokerage simply balances Jack’s and my account while the second brokerage balances Jill’s and your account.

And that’s why netting is so powerful. By making everyone wait just a little, it cuts down on the amount of work the system must do, in this case reducing brokerage-to-brokerage transfers from four to zero.

The netting afforded by T+2 settlement is so efficient that it allows the National Securities Clearing Corporation, which processes all trades involving U.S. equities, to reduce average daily equity volume of around $1.7 trillion by about 98%, leaving just a tiny $38 billion to be settled.

Faster is often better. But, in finance, a bit of tardiness can be a good thing. That’s why we should be wary of Robinhood’s call for real-time settlement. It would put an end to netting.

In fact, we already have financial systems that have gone real time only to double back and reintroduce slowness. It’s an interesting story, one worth recounting if only to show why real-time stock settlement is no panacea.

In the 1990s, central banks around the world began to roll out a new type of large-value payment system: real-time gross settlement systems (RTGSs). People like you and I use banks to make payments. But banks in turn must make payments amongst each other––very large payments––and for that they use their national central bank’s large-value payments system. This bit of central bank infrastructure is one of the most important, unsung pieces of any nation’s plumbing.

For decades, large-value payment systems operated on a deferred net settlement basis. Settlement was slow by design. Throughout the day, banks initiated payments to each other using the central bank platform. When 5:00PM finally rolled around, all reciprocating debits and credits were netted off and then settled between banks. Deferring settlement to the end of the day allowed for the number of bank-to-bank payments to shrink to a tiny fraction of total business transacted. It was incredibly efficient, albeit slow.

With the arrival of RTGSs in the ’90s, large-value payments were settled instantly, rather than at the end of the day. When Wells Fargo pays Citibank $100 million at 9:52AM, this involves an immediate transfer of $100 million in settlement balances at the Federal Reserve.

The ability to make a real-time payment is valuable. Sometimes you really need to wire funds to someone by 2:31PM, not 2:45PM.

However, real-time settlement at the central bank meant doing without the benefits of netting. So RTGSs had to process a lot more transactions than the deferred net settlement systems that they replaced. To keep up with this payments firehose, banks had to maintain a much larger hoard of central bank money on hand.

In an effort to reduce this hoard, banks adopted a strategy of waiting for an incoming payment to arrive before making an outgoing payment. Unfortunately, with all banks adopting this strategy, the result has been that payments often get pushed towards the end of the day. Many payments experts worry that this pattern isn’t healthy, since it increases the banking system’s vulnerability to operational problems.

The solution that emerged in the mid-2000s was the introduction of a new piece of central bank architecture: liquidity savings mechanisms (LSM). Central banks still allowed banks to settle payments in real time via the RTGS, but they also provided the option of submitting payments to an LSM, or central bank queue. A payment might wait in the LSM for 1 minute, 10 minutes, or 1 hour, until offsetting payments from another bank arrived to cancel it out.

By slowing down settlement, LSMs reintroduced the wonders of netting. And as a result, banks no longer had to keep such a big hoard of central bank money on hand. The Bank of England, UK’s central bank, estimates that after installing its LSM in 2013, the amount of liquidity that UK commercial banks required to make payments fell by 20%. So the same amount of business was being conducted over the Bank of England’s large-value payments system, but much less work was being expended to conduct that business.

LSMs have made the financial system safer by encouraging banks to make payments earlier in the day. After all, the quicker that a bank submits a payment to the LSM, the more time it will have to be matched. This is a neat little paradox. Queues, notorious for causing delay, actually speed things up.

Having taken a detour through central bank large-value payments systems, let’s return to the original debate over two-day stock settlement. Sure, stock markets could follow Robinhood’s advice and introduce real-time settlement. But before long, we’d all start to miss the magic of netting. Just as central banks reintroduced delays by building LSMs, stock markets would likely take steps to bring back slow.

If anything, what the central bank RTGS/LSM two-step teaches us is that we need a good balance between fast and slow. Sure, real-time settlement is a nice feature. But let’s also have delayed settlement. If brokerages have a choice to use some combination of two-day and real-time settlement, we may arrive at a socially optimal stock settlement rate.