Settlement inefficiencies are on the rise, despite the passage of the Central Securities Depositories Regulation’s (CSDR) Settlement Discipline Regime (SDR) earlier this year. European Union regulators had hoped that SDR’s cash penalties against counterparties responsible for failed trades would help reduce the volume of settlement fails. However, it is still early days and various factors, including challenging market conditions, have meant that this has yet to materialise.
“When CSDR went live at the beginning, settlement rates got better, but now we’re seeing rates drop to the levels they used to be before CSDR,” said David Wouters, product manager at BNY Mellon, speaking on a panel at Sibos 2022 in Amsterdam. According to a European Securities and Markets Authority (ESMA) study of 30 European jurisdictions, an average of 2-4% of all bond trades failed to settle between 2020-2022, rising to 7-8% for equities.
Recent Swift analysis confirms this trend too. Based on data from our network, we see that about 1 out of every 20 transactions ends up failing.
Identifying the causes behind trade settlement fails
There are a number of reasons why trades sometimes fail to settle on time. One of the biggest factors is the lack of transparency and traceability in the trading lifecycle, a point made by Paul Baybutt, global product head, middle-office, at HSBC. “We don’t always know where a trade might be failing, or what the root cause of the fail is,” said Baybutt. Without accurate information detailing why or where trades may be failing, it becomes very difficult for market participants to fix the underlying problems, making it harder to prevent future fails.
Inventory management constraints are another impediment hindering trade settlements. “The most commonly reported reason for fails by the CSDs is because there is a lack of securities available,” said Emma Johnson, executive director and global product manager at JP Morgan. She added that this is compounded by process fragmentation post-execution, with processes sitting across different teams and even systems, which makes end-to-end lifecycle management a challenge.
A new sense of urgency
With a potential tightening up of CSDR and looming market changes elsewhere, settlement inefficiencies do need to be addressed, and quickly. Although mandatory buy-ins under SDR were put on hold, the provision could still reappear, especially if EU regulators don’t believe that cash penalties are having their intended effect of improving settlement efficiency rates.
“CSDR is currently under review by the European Commission. The CSDR Refit Proposal has been published and mandatory buy-ins have been proposed to be retained in the regulation. There is a lot of debate about what would trigger the introduction of mandatory buy-ins, but it’s a trigger that will be based on metrics. If cash penalties are not leading to a reduction in settlement fails, or if settlement fails are not reaching appropriate levels compared to third countries, or if settlement fails pose a threat to financial stability, then mandatory buy-ins could be triggered,” said Johnson.
The urgency around improving settlement efficiency has also been given fresh impetus by the global shift that is happening towards a T+1 settlement cycle for equities. India is already phasing in T+1 for equities, while the US Securities and Exchange Commission (SEC) is looking to implement T+1 in 2024, with Canada in lockstep. Other markets are bound to follow, with some reports suggesting the EU and UK are actively discussing the feasibility of such a move.
If market participants are to effectively navigate T+1, they may need to make changes to their operational models. So how can these changes be achieved?
Delivering settlement efficiency
HSBC’s Baybutt suggested that automated partial settlement (‘auto-partials’) – namely the automatic partial settlement of matched instructions that do not settle on their settlement date – could help mitigate the number of trade fails.
Transparency will also play a crucial role in driving up settlement completion rates. In order to rein in settlement fails, investors and intermediaries must improve the visibility they have into the securities transaction lifecycle. The Unique Transaction Identifier (UTI), an industry recognised standard – the ISO 23897:2020 – which was first used to support derivative trade reporting under the Dodd-Frank Act, is one mechanism that could be used to solve some of the deficiencies around traceability in the trade lifecycle.
Indeed, greater industry adoption of the UTI would help automate the exchange of data between counterparties, enabling them to identify and spot potential problems in the trade lifecycle sooner. By remedying these issues in good time, the likelihood of trade settlement fails happening will be curtailed. This will help all participants throughout the investment chain to both obtain cost synergies and reduce their operational risks.