Credit, market, and liquidity risks are forms of financial risks that market participants can typically manage through their trading activities. However, questions related to the need for law based risk management mechanisms arise when the financial positions in a given financial market become of systemic relevance. A systemic risk management mechanism that policymakers have employed to transfer financial risks from market participants to clearing agencies is the centralized clearing and settlement system in relation to the post-trading activities of stocks, bonds and other securities. One consequence of this mechanism has been the concentration of credit, market, and liquidity risks onto clearing agencies. This phenomenon has created significant concerns, especially after the financial crisis of 2008. In the attempt to reduce those risks “inherent in the clearance and settlement process for all clearing agencies,” the SEC has amended Rule 15c6-1 to shorten the standard settlement cycle from three days (T+3) to two days (T+2).
The settlement of a security transaction consists in the delivery of the security by the seller and in the payment of the price of the security by the buyer. When broker-dealers execute investors’ orders on a registered securities exchange, they are generally required by the exchange rules to clear the executed security transaction through a registered clearing agency. When a clearing agency clears a security transaction, that agency, operating as a central counterparty (“CCP”), assumes the seller’s delivery obligation and the buyer’s payment obligation. As explained by the SEC, the clearing agency assumes the original parties’ contractual obligations to each other through novation. The effect of novation is that the original contract between the buyer and the seller is discharged and replaced by two new contracts: one between the clearing agency and the buyer and the other between the clearing agency and the seller.
The amended Exchange Act Rule 15c6-1 (whose compliance date was September 5, 2017) provides that “a broker or dealer shall not effect or enter into a contract for the purchase or sale of a security … that provides for payment of funds and delivery of securities later than the second business day after the date of the contract unless otherwise expressly agreed to by the parties at the time of the transaction.” This is often referred to as the T+2 settlement rule. Applying the amended rule to a security transaction cleared by a broker-dealer through a clearing agency shortens the duration of the CCP’s exposure to the credit, market, and liquidity risk of the original counterparties.
The T+2 settlement rule must be considered in the context of the designation of some financial market utilities (“FMUs”) as systematically important entities under Title VIII of the Dodd-Frank Act. Note that clearing agencies providing central counterparties services and registered under the Clearing Supervision Act qualify as FMUs. Under Section 804 of the Dodd-Frank Act, the Financial Stability Oversight Council (FSOC) has the power to designate FMUs as “systemically important” entities based on factors like the “value of transactions processed by” the FMU; “the relationship, interdependencies, or other interactions” of the FMU with “other financial market utilities or payment, clearing, or settlement activities;” and “the effect that the failure of or a disruption to” the FMU “would have on critical markets, financial institutions, or the broader financial system.” Based on these factors, the FSOC designated a number of clearing agencies as “systemically important” FMUs, including National Securities Clearing Corporation (NSCC). As observed by the FSOC, NSCC is involved in “nearly all broker-to-broker equity and corporate and municipal debt trades executed on major U.S. exchanges and other equities trading venues.” Therefore, if NSCC experiences financial problems, the ripple effect could ultimately lead to instability of the financial system of the United States. Importantly, under Section 805 of Dodd-Frank, once an FMU is designated as “systemically important” their operations must comply with the risk management standards prescribed by the oversight authority.
Risk management can be divided into two categories: private risk management and public risk management. Private risk management includes activities designed to manage risks that could impede the achievement of an organization’s goals, such as, trading activities and investment decisions implemented to hedge financial risks. Public risk management refers to rules adopted to mitigate “systemic” financial risk by prescribing requirements related to the structure and the functioning of an organization or to the transactions that take place in the marketplace. The T+2 settlement rule falls in the second category. Indeed, shortening the settlement cycle would reduce the time that unsettled transactions are guaranteed by the clearing agency, thereby reducing the clearing agency’s exposure to the counterparties credit, market, and liquidity risks. The amendment is expected to produce additional benefits: a reduction in the amount of resources needed to meet the margin requirements; faster access by market participants to the securities and the proceeds related to security transactions; and a further step toward the harmonization of market infrastructures among the American and main foreign markets. Many observers, however, consider the amendment just an intermediate step toward a T+1 standard, which the evolution of the distributed ledger technology (i.e., the blockchain) could accelerate.
In summary, clearing agencies represent one of the most important piece of the infrastructure of modern financial markets. The centralized clearing and settlement system, however, has shifted the majority of credit, market, and liquidity risks onto clearing agencies. After the financial crisis of 2008 revealed the vulnerability of financial markets, the Dodd-Frank Act introduced a variety of systemic financial risk management tools to mitigate the risks associated with the activities of clearing agencies. The T+2 settlement rule can be considered as an additional public risk management tool to ensure the financial stability of clearing agencies and the safety of our financial markets.
Giovanni Patti serves as a graduate editor of the NYU Journal of Law & Business. He is an LLM candidate in Corporation Law (Dean’s Graduate Awards) and a research assistant at the NYU Pollack Center for Law & Business. He holds a PhD in Corporate Law from the University of Roma Tor Vergata. Prior to attending NYU, he was an associate in an Italian-based law firm, where he practiced corporate and banking law. He also worked as a research assistant at the University of Roma Tre.