Today, the European Commission published its proposal for improving securities settlement and access to central securities depositories (CSDs), the entities that operate settlement systems. The proposed rules – which now go to the European Parliament and Council for discussion and negotiation – would require trades to be settled within two days of the trade date (T+2) and introduce financial penalties for trades which fail to settle on time.
Within the context of the current political agenda and the multitude of reforms affecting financial institutions, regulatory fatigue threatens to underplay the significance of the proposal. However, the proposal is significant, since it represents an important milestone towards a harmonised, single European market. **Assuming that this is still the intention for Europe**. Moreover, the creation of a single platform for securities settlement, known as Target2Securities (T2S), is also dependent on harmonised settlement cycles.
There are, at present, no standard procedures or guidelines in Europe relating to how national CSDs should communicate with each other, or how quickly a transaction should be settled after the trade has occurred. The same is true of the settlement cycles in the U.S., whereas in Asia, settlement efficiency is much higher due to a number of behavioural and regulatory reasons, including a T+2 settlement cycle.
Whilst most firms have become accustomed to divergent settlement cycles and regimes, there is evidence that non-harmonisation increases risk exposure on cross-border trades. The European Commission has acknowledged that the lack of harmonisation causes disruption and states in its proposal that while generally safe and efficient in national borders, CSDs combine and communicate less safely across borders, which means that an investor faces higher risks and costs when making a cross-border investment. Indeed, cross-border settlement costs are four times higher than domestic costs and the number of trade fails is also higher.
The mantra, if it aint broke, dont fix it, which has been applied to some areas of regulatory focus, does not apply to settlement. Settlement fails resulting from inefficient systems or incorrect data are a costly problem in the industry, and it is broadly agreed that efforts to reduce to the number of fails are overdue. That said, the scale of the undertaking and the level of regional coordination required to achieve better settlement efficiency means that a regulatory push is required to make it happen.
The question now is; how are the measures that allow for fines and shorter settlement cycles likely to be received by market participants? A T+2 cycle would be applicable in Europe as of 1 January 2015, and so it not likely that firms will perceive this as a measure of immediate concern. However, systems will need to be re-engineered for T+2 to happen, which includes the facilitation of faster trade confirmation. We anticipate that some firms will start to look at faster trade confirmation in the context of other systems upgrades, in order to avoid the upheaval of implementing changes that address one piece of regulation, only to be confronted by a requirement for further changes six to 12 months down the line.
Perhaps, surprisingly for some, but not for others, the markets largely agree with the concept of penalties for failure. The Commissions proposal states that the objective of ex post measures, including the introduction of financial penalties, is intended to reduce trails fails and to discourage competition on risk, for instance, between markets that may have different penalties systems in place. The question that remains is who will pay for the inefficiency; the broker/dealer, the investment manager or the underlying client? Further guidance and clarity will be needed around this over the coming months.
The proposal on securities settlement and CSDs shows a determination to improve settlement efficiency. It also demonstrates Europes leadership towards shorter settlement cycles compared to the U.S. That said, the deadline of 2015 in Europe does provide a three year timeline for the U.S. to catch up with Europe, thereby harmonising the settlement cycles of Europe, U.S. and Asia.
Finally but importantly, the proposal highlights the growing attention being given to the middle-office, and its role in making the financial systems safer.