Settling down: T+2 settlement cycle and liquidity

• Published date: 01 November 2022
• Author: Ahmed Baig,Stephen Breeze,Justin Cox,Todd Griffith
• Date: 01 November 2022
• DOI: http://doi.org/10.1111/eufm.12344

DOI: 10.1111/eufm.12344

ORIGINAL ARTICLE

Settling down: T+2 settlement cycle and

liquidity

Ahmed Baig

1

|Stephen Breeze

2

|Justin Cox

3

|Todd Griffith

4

1

Department of Finance, College of

Business and Economics, Boise State

University, Boise, Idaho, USA

2

Master of Data Analytics Program, Jon

M. Huntsman School of Business, Utah

State University, Logan, Utah, USA

3

Department of Finance, Banking, and

Insurance, Walker College of Business,

Appalachian State University, Boone,

North Carolina, USA

4

Department of Economics and Finance,

Jon M. Huntsman School of Business,

Utah State University, Logan, Utah, USA

Correspondence

Todd Griffith, Department of Economics

and Finance, Jon M. Huntsman School of

Business, Utah State University, 3565 Old

Main Hill, Logan, UT 84322, USA.

Email: todd.griffith@usu.edu

Abstract

We examine the effects of a shortened settlement

cycle on liquidity. Our difference‐in‐difference re-

sults show that securities listed on US stock ex-

changes become more liquid, relative to similarly

matched securities listed on the London Stock Ex-

change, after the standard settlement cycle in the

United States was reduced from T+3 to T+2. These

results hold across various low‐and high‐frequency

measures of liquidity and empirical model specifi-

cations. Furthermore, we find that securities that

are more difficult‐to‐borrow experience the greatest

gains in liquidity. Our findings might provide in-

sights to regulators and exchange officials con-

sidering the adoption of a shortened settlement

cycle.

KEYWORDS

borrowing constraints, failures‐to‐deliver, liquidity, trade

settlement

JEL CLASSIFICATION

D47, G10, G14, G20

Eur Financ Manag. 2022;28:1260–1282.wileyonlinelibrary.com/journal/eufm1260

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© 2021 John Wiley & Sons Ltd.

EUROPEAN

FINANCIAL MANAGEMENT

We would like to thank the anonymous referee, Editor John Doukas, and The Center for Growth and Opportunity for

their valuable comments and suggestions, which have substantially improved the quality of this paper. The authors are

listed in alphabetical order.

1|INTRODUCTION

In financial markets, settlement refers to the seller's obligation to produce a certificate and

executed share‐transfer form to exchange with the buyer for a corresponding payment.

1

The

settlement cycle, or period, is the time between the transaction date and the settlement date.

2

The Securities and Exchange Commission (SEC) dictates the allowable time within which to

settle a transaction in US financial markets. The settlement cycle is widely referred to as T+x,

representing the trade date (T) plus the number of business days (x). For most of the 20th

century, securities markets in the United States had a T+5 settlement timeframe. In 1995, the

SEC approved the move a T+3 settlement period, which lasted for over two decades. However,

the global credit‐and‐liquidity crisis of the late 2000s led the SEC and the Depository Trust and

Clearing Corporation (DTCC) to revisit the risks and costs associated with a prolonged set-

tlement cycle. On 5 September 2017, the SEC adopted Rule 15c6‐1(a), which shortened the

standard settlement cycle for nearly all broker‐dealer equity transactions from T+3 to T+2.

In this paper, we examine the effects of a shortened standard settlement cycle on firm‐level

liquidity. Most equity security transactions involve the services of specialized financial inter-

mediaries, such as broker‐dealers or central‐counterparty members. These intermediaries essen-

tially conduct a two‐sided auction, as they stand ready to trade on the buy (long) or sell (short) side

of the market (O'Hara & Oldfield, 1986). Facilitating such trade requires capital.

3

When inter-

mediaries buy a security, they can service the trade using their own capital or borrow in the lending

market using the security as collateral. However, intermediaries cannot borrow the entire value of

the position. The difference between the security's value and collateral value, also known as

margin, must be financed with the intermediaries' own capital. Similarly, when intermediaries sell

a security, they can float the transaction with their own inventory or short sell by borrowing the

shares. Short selling, however, requires capital in the form of margin; it does not free up capital.

Since intermediaries do not typically carry large long positions in inventory, they must sell short to

meet sudden buying demands of market participants. Thus, financial intermediaries can face

borrowing constraints on both long and short positions.

Brunnermeier and Pedersen (2009) construct a theoretical model that links an asset's

market liquidity to intermediaries' funding constraints. The authors argue that the ease with

which funding can be obtained by traders affects market liquidity. If funding is tight, inter-

mediaries become reluctant to take on positions in high‐margin securities, and as a result,

market depth declines for those securities. Furthermore, an intermediary's risk from holding a

security is a determinant of the bid‐ask spread (Branch & Freed, 1977; Hamilton, 1978;

Tinic, 1972; Tinic & West, 1972; Stoll, 1978), which measures the size of the transaction cost. A

natural hedge for intermediaries is to incorporate the costs associated with default and in-

ventory risks into transaction fees (Glosten & Harris, 1988; Glosten & Milgrom, 1985;

Stoll, 1989).

4

Based on these arguments, we contend that the economic avenue through which

the settlement cycle affects security liquidity is the intermediaries' financing constraints.

1

Settlement cycles have evolved from delivering physical security certificates to delivering electronic share‐transfer

forms via an electronic settlement system. Clearing a transaction occurs between the trade date and settlement date,

which involves any modifications needed to facilitate settlement.

2

The transaction date marks the date that the buyer and seller agree to trade, whereas the settlement date marks the

date the seller delivers the security's certificate and the buyer transfers the appropriate funds.

3

https://www.sec.gov/rules/concept/s72499/broy1.htm.

4

Comerton‐Forde et al. (2010) argue that when intermediaries hold large positions or lose money, they widen the

spread between their quoted bid and ask prices.

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