How fast should trades settle?
Society for Financial Studies (SFS) Cavalcade, 2017
EFA 2017 Mannheim Meetings Paper
50 Pages Posted: 8 Dec 2016 Last revised: 13 Sep 2018
Date Written: September 12, 2018
Recent regulatory and industry initiatives aim to streamline post-trade infrastructures. Does faster settlement benefit markets? We build a model of intermediated trading with imperfectly competitive securities lending. Faster settlement reduces counterparty risk but increases borrowing needs. We find that flexible failure-to-deliver penalties reduce the tension between credit risk and liquidity, disciplining security lender competition and allowing for real-time settlement. Optimal penalties resemble put options on the lending market: They protect traders against high settlement costs, but do not eliminate failures-to-deliver. Mandating automatic security borrowing to prevent failures-to-deliver triggers a toxic settlement rat race to lock in low borrowing costs.
Keywords: Market design, trade settlement, security lending, counterparty risk
JEL Classification: D43, D47, G10, G20
Suggested Citation: Suggested Citation