With one year remaining until the settlement discipline regime (SDR) component of the Central Securities Depositories Regulation (CSDR) comes into force, some of the remaining challenges may feel familiar to firms that were bearing down on the revised Markets in Financial Instruments Directive (MiFID II) deadline two years ago. It’s not surprising that CSDR would follow in the footsteps of MiFID II, given that both regulations are part of wider EU regulatory reforms adopted following the financial crisis, aiming to improve transparency and mitigate risk in the financial markets.
The European Securities and Markets Authority (Esma) last month issued final guidelines on how firms should comply with SDR, CSDR’s final and most significant phase, which is poised to have tremendous impact on the industry due to its penalties and buy-ins for trades that fail to settle on time. In order to avoid such burdens, it is imperative that market participants have the necessary processes in place ahead of the compliance deadline. Like MiFID II, there is a communications component to those preparations, especially with regards to building regional awareness and global collaboration between counterparties.
With one year remaining until SDR’s implementation deadline, it is concerning that while some non-European firms are fully informed about the regulation, many are not. Just like MiFID II, SDR is extra-territorial in nature, meaning that any buy-side or sell-side firm that invests in the European market, regardless of where they are domiciled, will be in scope. Specifically, the regulation applies to any stock bought within any EU28 country and settled in an EU28 central securities depository (CSD). The lack of awareness of SDR’s global reach in the Americas and Asia-Pacific is both alarming and highly reminiscent of MiFID II, when some financial institutions remained unaware that they were in-scope, even up until the day of MiFID II implementation.
Firms that are unaware and under-prepared may pay a hefty price. Under SDR, market participants are liable to pay a penalty for each transaction which fails to settle on the mandated T+2 settlement timeframe. The penalty will be charged on a daily basis according to the asset class/security-type and notional value of the transaction, up until a buy-in process is initiated. Any financial instrument which has not been delivered within a specified period of the intended settlement date triggers this mandatory buy-in process: seven business days from the intended settlement date for illiquid securities and four days for liquid equities and bonds. While the penalties issued for failed trades might not be large in value, they will carry a significant administrative burden. Some market participants anticipate they will need to add considerable resources to their middle- and back-office teams in order to handle the buy-in process and manage late settlement penalties.
Preparing for the buy-in process creates an additional communications challenge related to the effect on relationships between market participants, as SDR mandates that participants must determine who is to blame for failed trades. Clients, brokers and custodians will need to agree who should shoulder the cost of a failed trade, which is unlikely to be an easy process.
As the MiFID II compliance process revealed, firms do have options to alleviate these challenges. Although the recent guidelines issued for SDR still allow for trade confirmation in written form, including fax and email, automation and standardised trade confirmation enable firms to mitigate failed trades. Manual processing is notoriously inefficient, as any discrepancies between market participants with regard to trade confirmation details will likely delay settlement. The benefits of automation go beyond mitigating trade failures, as an automated approach delivers wider operational efficiencies through enabling processes such as exception management. In addition, the buy-side could consider consolidating the number of brokers they trade with, as conducting a higher volume of trades with a smaller number of counterparties increases efficiency and reduces opportunities for trade failures.
With exactly one year to prepare for SDR implementation, market participants should be analysing the reason for their failed trades; address these issues through the adoption of a best practice approach to middle and back office trade processing; and test new systems and processes which have been put in place. It is a sizeable to-do list, but firms who cross off those items will not only be well-placed to comply with SDR, they will also benefit from the wider operational efficiencies which post trade automation delivers.