The settlement efficiency imperative

Even with the best will and the smartest technology in the world, settlement fails remain a feature of investment banking operations life, writes Daniel Carpenter, CEO of Meritsoft (a Cognizant company). But the incentives for doing something to improve settlement efficiency are changing fast.

Fail volumes are up

Every fail comes with a cost. The CSDR penalty regime, aimed at encouraging improvements in fail rates, has yet to manifest the intended effect. Some banks are reporting up to 5,000 fails per day and penalty charges more than three times the amount they budgeted for. According to analysis by fintech Ssimplebased on the ECB’s TARGET2-Securities Annual Report 2022 – some €1.7 billion was paid in penalties in 2022. Over the past 16 months there has also been a substantial increase in partial settlements as firms attempt to control their individual costs by paying penalties solely on the failing component of the trade.

Partial settlements have helped reduce penalty costs – but only up to a point. The total value of penalties may be suppressed, but consistent fail volumes are creating significant operational costs. The work needed to identify failing trades, determine which component has caused the fail, match it to the appropriate penalty, and then allocate that penalty to the right internal department or external client is considerable.

As ever, you cannot fix what you do not understand. And with relevant data sloshing around between various systems and workflows, understanding is often in short supply.

Interest claims are on the rise

Settlement inefficiency is a problem for institutions, their counterparties and eventually their clients. But until now, it has been seen as a broadly acceptable problem that IT and operations heads can de-prioritise in the face of the many challenges they face elsewhere.

Rising interest rates are changing that and turning this low-priority issue into a much more acute challenge. The unwritten agreement that prevailed until recently, in which a certain sum was set aside to pay for claims without any wilful wrongdoing, is no longer tenable. Anecdotally, at least, clients are telling us that they’ve seen a tenfold spike in interest claims or claims regularly exceeding their minimum thresholds.

The token claim of, say, €500 is now often wholly inadequate to cover the actual costs, putting paid to the working principle that it will all work out in the end.

T+1 is on the horizon

While all this is going on, the arrival of T+1 – to be followed by T-0 – is focusing minds. As settlement windows shorten, the costs of settlement inefficiency are only going to get worse.

Given this new settlement landscape, it is tempting to jump headlong into a solution that will simply process fails faster and deal with penalties more quickly. But that misses out a crucial step. Addressing T+1 is a front-middle-back-office issue around settlement processing. There is no single solution that will magically transform 36-hour batch processing into 1-hour batch processing, or re-tool operations to meet the new requirements.

Instead, the starting point for any improvement must be understanding what is failing and why. Is there a particular asset class that gums up your processes? A particular counterparty who simply cannot – or will not – settle on time? A specific day, week, or month where fails tend to pile up? This is the kind of information you need to improve the efficiency of your overall settlement operations.

Lessons learned

The experience many firms had with implementing their response to CSDR is illustrative. Understandably, much of the effort focused on demonstrating compliance with the immediate demand of the regulator and minimising potential penalties. But we also worked with firms whose response to CSDR was more wide-ranging. Those firms tended to look ahead at how they would create opportunities to improve their settlement efficiency overall.

Even before T+1 was announced, they saw that having data normalisation and transparency as a baseline would create the ideal foundations – not just for more efficient settlements, but for the later application of deep-dive analytics, machine learning and AI for greater operational improvements. They are now in position to use settlement efficiency as a source of competitive differentiation, with well-evidenced benchmarks to demonstrate their effectiveness to prospective clients.

Experience and efficiency

Some of those banks are now transferring their successful CSDR teams to preparing for T+1, and with good reason. Many of the same principles apply, as do the rules, the logic, and systems. The lessons learned from CSDR are invaluable in terms of driving process changes, technology changes and changes to client engagement.

They show that, if your systems are not talking to each other, if your data is not digitised, normalised and automated, if you don’t have STP of that data, then any perceived improvements in efficiency are superficial at best.

They also show that it doesn’t necessarily take an extensive root-and-branch overhaul of your current systems. The lesson we have learnt over the years is that the importance of efficiency isn’t just relevant to the end result – it’s also a necessary part of how you get there.