What is T+1? Quick and Dirty: until last month, (5/28/2024), when stocks were sold on U.S. stock exchanges, they were processed on a T+2 settlement protocol. This means if you sold stock on a Monday, you had the day of the trade (T) + 2 more days to provide that stock to the buyer, and the buyer had those same 2 days to provide the money to the seller. On May 28th, 2024 this world shifted to T+1. Thus if you sold stock on Monday, you had to deliver it on Tuesday, same with the cash going to the seller.
This is boring stuff. However, the Money Stuff Podcast dove into what this change means to sophisticated financial institutions. Not only is that topic actually interesting, the tone of the conversation itself was fascinating. It turns out the more time between trade and settlement, the more shenanigans can be played with the underlying assets.
[I’m trying a new feature in this post where I’m cutting and pasting transcripts from the podcast itself at the bottom of this post for reference and broader context. I’ll be embedding the shorter relevant quotes in the regular post, but if you are curious for more context, scroll to the bottom of the post for lengthier transcripts. I did some light editing on the transcript provided by Apple’s podcasting app where there were obvious errors. I didn’t do a detailed proofread – so there could be some wonkiness in here that wasn’t in the original podcast.]
First the interesting bits. Large institutions who are actively trading large sums of money and stock often don’t have either the money or the stock when they commit to the trade. They used to have two days to figure it out, right? A couple of quotes:
“…big hedge funds want to buy don't have money just like sitting around in their account. They have to like go to their financing prime broker to like lend them the money the moment after they agree to the trade.”
“Sometimes you agree to the trade before you have the stock. All those sort of business processes happen after you agree to the trade.”
I love this. It’s just ‘sort of business processes’ to gain actual possession of something you just sold! In all fairness, this system appears to work fairly well. With the volume and frequency of trading occurring in U.S. capital markets, we’d hear about it if it didn’t. Still, this is the kind of stuff that main street is very skeptical of when they hear about it. Kind of like how the Federal Government can run perpetual and increasing deficits. ‘Hey – I can’t get away with that, why is this kosher for certain entities just because they are big?’ In fact, this podcast speculates early on that some of the reason for the switch to T+1 is the Gamestop fiasco from several years ago when there was some real market mayhem in that particular stock’s trading because retail traders were basically doing this exact same stuff. More quotes:
“…like you have to prefund trades, you have to have the money sitting in the account before you do the trade.”
“…it would mean that you'd need to have the money in your account before you did a trade, and so there'd be like weird stuff.”
“So between the minute you sell the stock, the minute you'd like your sell order executes on the stock exchange, and the settlement date, you have to get the stock right. Like you've loaned it out, you don't have it in your possession, so you have to call back the borrow. So you had two days to do that. Now you have one day to do it right. Now you call back the borrow but like you've loaned the stock out, probably through a broker who's loaned out to like a short seller. So you call your broker and you say call the intermediary and you say, I want the stock back in. The intermediary calls the hedge fund who borrowed it and said, we want the stock back and the hedge fund doesn't have it either. They've sold the stock, so they have to find it somewhere else right now,…”
This is where the ‘tone’ piece comes in. What struck me throughout this episode was how the hosts made this sound like a super annoying set of challenges to have to ‘prefund’ their trades. How all this re-hypothecation of assets would be challenged by the pesky rule change. Conversely, every quote I pulled here sounds to me like REASONS TO MAKE THE CHANGE! Just because there haven’t been major blow ups in markets from this activity doesn’t mean it is the correct way to run a railroad. A set of rules that include: ‘Don’t buy something unless you have the money in your account’ & ‘Don’t sell something you don’t have possession of’ sound a lot more stable to me than this mess.
The over-financialization of every aspect of our economy has an endless number of twists and turns that appear to make no sense outside of the context of ‘a bunch of financial engineers playing inside games with each other can extract unearned value from the regular processes needed to run a functioning economy’. It reminds me of the pictures you see from third world countries where everyone is stealing electricity from the regular power lines. At some point, no power can get through to the people actually paying for it. I’ve racked my brain for two weeks on this, and I can’t find any compelling reason that these financial practices provide value above the risk they embed in our economy. If this is how the sausage is made, I’ll have the chicken. T+0 anyone?
*******************************************
TRANSCRIPT EXCERPTS
04:16 Speaker 2
…stock trading is like very efficient and very sort of just in time. And so when people want to buy stock, they don't have money sitting in their account. Most people do, but big hedge funds want to buy don't have money just like sitting around in their account. They have to like go to their financing prime broker to like lend them the money the moment after they agree to the trade. Right, there's a lot of like you agree to a trade before you have the money sitting in the account. Sometimes you agree to the trade before you have the stock. All those sort of business processes happen after you agree to the trade. And if you moved to like very fast settlement which I don't know exactly what very fast means, Like maybe T plus evening is still like slow enough.
06:13
Speaker 2
Yeah, if you move to like instantaneous settlement, then like everything changes, like you have to prefund trades, you have to have the money sitting in the account before you do the trade. And again, like in crypto, it kind of works that way. Like in crypto, you kind of prefund everything, and so people are there's like a model for that, but it's not really how the modern financial system works.
07:03
Speaker 2
… And similarly here it's yeah, like if everything moved instantaneously, like in some ways,that would look more efficient, but it would mean that you'd need to have the money in your account before you did a trade, and so there'd be like weird stuff. A lot of the problems that people worried about with T plus one were foreign investors having to convert currencies. If you're a foreign investor and you want to buy a US stock, you can just decide to do that and then figure out how to convert your euros into dollars later, not like much later, but like two minutes later, and an instantaneous settlement world, you wouldn't be able to do that. Now, maybe your FX transaction would also settle instantaneously and everything with like just in time workout, But it's like trickier.
09:38
Speaker 1
Yeah right, Well maybe that's computer entries, but that's the world we're rapidly hurtling towards her. Maybe we're already in Can we talk about the thing I won't really want to talk about? Okay? So I cover ETFs in my day job, and I think that a lot of etf issuers do is securities lending. They lend out the securities and their portfolio it gets them a few basis points for doing that. They make that, but you think about the expense ratios on a lot of these ETFs and they're like three basis points, So a couple of basis points is super meaningful. I don't really understand how securities lending is impacted by this move to T plus one. It seems like it would be a headache. Not just in ETFs, but mutual funds, etcetera.
10:21
Speaker 2
It's a huge headache, I think. So here's why it works. So, like you're a mutual fund or you're an ETF, you like lend out your stocks. You know on stocks, you lend them out, then you decide to sell them right because you have outflows or because you're your indexes rebalancing or whatever, you decide to sell your stocks. So between the minute you sell the stock, the minute you'd like your sell order executes on the stock exchange, and the settlement date, you have to get the stock right. Like you've loaned it out, you don't have it in your possession, so you have to call back the borrow. So you had two days to do that. Now you have one day to do it right. Now you call back the borrow by like you've loaned the stock out, probably through a broke who's loaned out to like a short cellar. So you call your broker and you say call the intermediary and you say, I want the stock back in. The intermediary calls the hedge fund who borrowed it and said, we want the stock pack and the hedge fund doesn't have it either. They've sold the stock, so they have to find it somewhere else right now, maybe they borrow it from some other mutual fund or some other lender, right and then they borrow it in like four hours and they deliver it to you within twenty-four hours, and then you deliver it to settle your sale. But another possibility is like they can't borrow it and they have to buy in their short but then that settles T plus one. So they're doing a trade after you that has to settle before you in order to give you the stocks that you can deliver it on your sell. So it's like very tricky, and I think that like one thing that mutual funds have been at least talking about doing to address this is calling in their borrow before they sell their stock. You know, you're having like an index rebalancing or whatever. Instead of hitting sell and then calling back your borrow, you call back your borrow the day before, so you make sure it settles, and then you hit sell. Larry Tabbo Bloomberg Intelligence that has written about likethe problems of that in terms of both you lose like a day of that lending income, but you also maybe tip your hand that you're going to be signing the stock because you're calling a sophisticated hedge fund and saying we need our borrow back. The hedge fund gets some information from that. They know you're selling. Yeah.
12:28
Speaker 1
Hey, that sounds pretty good. I mean, we're talking about razor thin margins on some of these ETFs. I'm wondering if it'll make securities lending a less appealing proposition for some of these companies.
And I love the picture of how electricity doesn’t work in third world countries
Amen. I’ll take the chicken 🐔 and t+0 👍