Managing post-trade exceptions and settlement fails continues to be one of the biggest and most costly pain points for middle- and back-office operations and that is with a global failure rate of just 2%. However, that 2% is estimated to cost the industry $3 billion in operating expense and losses.
As an industry, we are an integrated community of market participants applying a variety of priorities and processes across the lifecycle of a trade, often leading to unnecessary inefficiency, risk, cost and ultimately settlement fails. Over time, efforts to reduce the volume and frequency of trade exceptions have seen success. But the need for greater attention to close the remaining gap is accelerating.
In the interest of mitigating systemic risk and ensuring financial stability, regulators are looking to reduce settlement timeframes and increase reporting requirements, including greater use of common data elements, such as legal entity identifiers (LEIs) and implementing cash penalties and mandatory buy-ins under the coming Central Securities Depository Regulation (CSDR) in the EU. While different jurisdictions are moving at varying speeds, the overall direction is clearly toward greater transparency and uniformity with lower tolerance for risk and market inefficiency. At a time of challenged margins, few firms can afford to take unnecessary penalties incurred by a trade fail resulting from incomplete or incorrect data, or inefficient processes.
For global broker-dealers, the operating expense and potential penalties are dwarfed by the financing costs for long inventory that failed to deliver. Analysing just the US market alone, these settlement failures estimated to cost brokers over $4 million annually. This does not even include the cost for stock borrow or impact of failed receives.
Successful trade settlement is dependent on three key factors: (i) agreement on trade economics, (ii) instructions on where to settle and (iii) adequate inventory
Inaccurate and incomplete standing settlement instructions (SSIs) are one of the most common and pervasive causes of settlement fails. SSIs are critical to the successful exchange of securities between counterparties. But agreeing SSIs are often separate to the economics of the transaction (i.e., direction, price, volume, value date, etc.), and therefore not exactly ‘front-of-mind’ for front-office staff focused on best execution.
‘Good’ trades will still fail if both parties are not aligned and agreed to where the trade should settle. Typically, a broker-dealer will seek the preference of its buy-side client, but the processes between the two can result in custodians and agents being incorrectly instructed, and fruitlessly searching for non-existent positions at CSDs. Agreement on place of settlement will become more and more important when the Target 2 Securities (T2S) Investor CSD model begins in earnest.
We need to evolve the post-trade lifecycle so when parties agree on a trade they can have full confidence in achieving settlement finality. We believe this will be done through adoption of industry-driven automation and standardised protocols including LEIs, centrally maintained SSIs and central trade matching solutions. The ability to access accurate, timely information and seamlessly instruct all parties to the trade throughout the process provides a path to successful settlement.
Ultimately, the goal for all market participants is simple – ensure cash and securities arrive at the same agreed place at the same agreed time.