February 27, 2020
In September 2017, the Security and Exchange Commission (SEC) shortened the standard settlement cycle for broker-dealer stock transactions from three days to two. This change was made to reduce risks to market participants, but it was unclear what the exact effects would be on financial markets. In this working paper, authors Stephen Breeze, Justin Cox, and Todd Griffith analyze the 2017 change and find that a shortened settlement cycle leads to increased liquidity, particularly for more difficult-to-borrow securities.
When the SEC initially proposed the shortened settlement cycle, it argued that it would increase liquidity by improving financial intermediaries’ access to funds, and decreasing their default risk. This, in turn, could decrease bid-ask spreads and increase trade volume. Some financial scholars disagreed, arguing that a shortened settlement cycle might hinder intermediaries’ borrowing capacity, leading to decreased liquidity.
The authors test these hypotheses using data from the Center for Research in Security Prices and the NYSE Daily Trade and Quote database. The authors find that in the 40 days following the change in the settlement cycle:
- Average trading costs decreased between 7.5 and 17.5 percent.
- The average daily dollar volume increased by 14.25 percentage points.
- The average number of daily trades increased by 11.25 percentage points.
These results suggest that the shortened settlement cycle significantly improved liquidity by lowering transaction costs and increasing trade activity. Importantly, these changes were driven by difficult-to-borrow securities, suggesting that a shortened settlement cycle effectively reduces inventory risk and default risk.
These findings are important as both domestic and global equity markets consider moving to shorter settlement cycles, including a one-day settlement cycle. This research shows that moving to a shorter settlement cycle can increase liquidity, especially for hard-to-borrow securities. This ultimately contributes to lower transaction costs and increased access to funds for investors and traders.