In the 10 years since the financial crisis the middle-office has been significantly affected by a swathe of new regulation. This has led to significant adjustments to their post-trade processes, brought about by regulations such as the European Markets Infrastructure Regulation (EMIR) and the Markets in Financial Instruments Directive (MiFID) II. But just when firms thought the tide of regulatory change might abate, further regulations are on the horizon, in the form of the Settlement Discipline Regime (SDR). The SDR, a much delayed element of the Central Securities Depositories Regulation (CSDR), will enter into force in September 2020, is an effort to increase settlement efficiency across European markets. An official settlement efficiency rate for the European Union doesn’t exist but it is generally thought to be between 97% and 98%. It has remained quite static for many years and the aim of SDR is to raise the rate to well above 99%.
Compliance with the SDR presents numerous challenges for firms including, but not limited to, the factors below, all of which serve to highlight the importance they should place on automating their middle and back-offices with the over-arching objective of reducing the number of failed trades.
While the regulation was conceived in Europe, its impact will be felt by any market participant, buy-side and sell-side, who invests in the European market, regardless of where they are domiciled. That is to say that the scope is determined by where the settlement of the stock takes place – if a stock is bought within any EU 28 country and it settles in an EU 28 central securities depository (CSD), the regulation will apply.
This can be compared to issues that arose in relation to compliance with MiFID II when many financial institutions remained unaware, even up until just one day before the regulation entered into force, that it was also applicable to their trading activities given that they traded European instruments. What was also apparent was that even for those buy-side firms who were aware of the need to comply with various aspects of MiFID II, there was an assumption that their brokers and custodians would take care of compliance on their behalf. Similarly, firms should not assume that SDR is “someone else’s’ problem”. It isn’t.
Penalties for failed trades
Market participants will be liable to pay penalties or charges against each transaction which fails to settle under the mandated T+2 timeframe – an earlier component of CSDR which entered into force in October 2014. A penalty will be charged daily based on the asset class/security type and notional value of the transaction up until the buy-in process is initiated. Further, SDR has no thresholds so every failed trade, even a trade that fails to settle for just one day with a €1 penalty will be enforced.
This can be a frustrating process for firms, particularly for sales desks whose commissions could be wiped out very quickly if a trade fails. For example, if a cash equities trade, with a daily fine of one basis point on the notional value of the trade, fails to settle for four days, the commission on the trade, which is an average of five basis points of the value, would be almost negligible and hence financially disadvantageous.
The buy-in regime
A mandatory buy-in process will take place for any financial instrument which has not been delivered within a specified period of the intended settlement date in order to fulfil settlement. Illiquid securities will be required to be bought-in within seven business days of the intended settlement date while liquid equities and bonds will be required to be delivered within four days. Small to medium size enterprise (SME) stocks will be subject to buy-in 15 days after intended settlement date. Although this seems more flexible, as these types of stocks are illiquid and difficult to borrow, firms could potentially be hit with 15 days of failed trade penalties, which could be very expensive.
In order to deal with the additional workload required to comply with SDR, firms will likely need to augment their workforces. To give an example, one of DTCC’s large broker dealer clients estimates that, because of very high trade volume and the current number of fails, it may need as many as 50 staff across its middle office department to process the penalties and manage the buy-in process. This is a cost they cannot absorb. To avoid having to pass the extra costs on to their clients they have no choice but to proactively act – now – to address the causes of failed trades.
While the above serve to highlight some of the key issues that firms need to consider when complying with SDR, a great irony is that the regulation continues to allow for ‘non-electronic’ or manual confirmation of trades.
This component of the regulation, contained within the level three guidelines of the Regulatory Technical Standards, which are currently being consulted on by the European Securities and Markets Authority (ESMA), and expected to be finalised in the summer of 2019, allows for confirmation in written form, including fax and email. The use of manual processing is undoubtedly detrimental to the efficiency of the market and costs considerably more to undertake and correct when errors occur. To explain, if there are discrepancies between market participants with regards to the trade confirmation details, due to the fact that manual processing is extremely error prone, this could delay the settlement of the trade which will then incur a penalty. Hence, firms should definitively agree the terms of the trade in an automated and standardised fashion, before the trade flows further downstream for settlement.
Another point to consider is that brokers and custodians may well start to think twice about incurring the costs of failed trades imposed by the CSD, due to the inefficiencies on the part of their buy-side client as a result of choosing manual processing. Furthermore, the SDR might lead to a “name and shame” policy whereby CSDs and CCPs publish lists of their custodian clients who have the highest failed-trade rate. At this point, the custodian will then need to decide whether to pass the cost on to their clients: clients who cause persistent failures and costs should anticipate difficult conversations with their custodians about why they are causing failed-trades and how they can improve their processes.
With a deadline of September 2020, firms may believe they have ample time to prepare, however if they are to realise the benefits of automation, change must start taking place sooner rather than later. While it is acknowledged that non-electronic forms of processing will be tolerated across the industry, if the rate of settlement efficiency in Europe is to be improved, firms must recognise that higher levels of automation are essential and act now.