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With just over six months to go before the implementation of CSDR, market participants are still at very different levels of readiness. Generally, the larger the market participant, the further along they are in their preparations. Therefore, the types of conversations we are having with clients vary greatly. However, one common theme amongst all market participants is around the efforts being spent on predicting the impact of SDR’s settlement penalties and buy-ins.
The purpose of SDR’s failed trade penalties and mandatory buy-ins is to incentivise market participants to achieve accurate and timely settlement. The failed trade penalty will be charged for each transaction failing to settle under the mandated T+2 timeframe. A penalty will be applied each day the transaction fails, up until buy-in date. The penalty is calculated using the CSD’s daily reference price and asset class. The buy-in regime, which is mandatory, will take place for any financial instrument which has not been delivered for settlement fulfilment within a specified period after the intended settlement date – which for cash equities is four days.
Recently, I spoke to one of our custodian partners, Derek Coyle, vice president and custody product manager, Brown Brothers Harriman (BBH), to better understand the types of concerns that clients have about SDR and, unsurprisingly, similar themes are surfacing. To help their clients understand what level of late settlement penalties they may face for failed trades, and of those, which will lead to buy-ins, BBH recently analysed historical data on cash equities transaction trade fails. The results provide some useful insights, particularly for mid-tier and smaller asset management firms.
Historical data analysis findings
Looking at trade fail data covering 2019 and 2020, BBH found that if SDR were in force over those years, penalty values for their clients could have exceeded €1 million of both penalty credits and debits per month. Of the trades analysed, 8% of these would have required a buy-in. When BBH analysed the data by size of buy-side client, the results varied significantly with a larger impact for mid-tier and smaller investment managers than larger firms, who are more likely to have the resources to process this activity.
For mid-tier firms, the level of estimated buy-ins per month was around 6.5% of trades, which would result in five buy-ins per month, although each of these could be of considerable value, ranging from €1.75 – €2 million of delivers and €500,000 of receives. Given the size of the value of the transactions requiring buy-ins, mid-tier firms could face an impact on their liquidity which may require moving assets around to support the buy-ins.
For smaller asset managers, it was estimated that there would be an average of 30 trades failing every month of which five to six trades would require buy-ins. The issue for this size of firm is that typically, there is considerably less operational resource to deal with the buy-in process. As a result, these firms may be required to make significant investments in their middle and back-office functions to handle late settlement fines and to process buy-ins.
Recommendations after analysis
When it comes to SDR preparations, market participants are encouraged to focus on prevention rather than cure by automating as many post-trade processes as possible to support timely settlement. In particular, BBH and DTCC recommend that market participants adopt post-trade tools which are currently available to make the pre-settlement process as efficient as possible. Exception processing, where market participants have early insight of problematic trades which are not matching up, was an area that Coyle highlighted to enable speedy resolution and to prevent late settlement. The importance of testing ahead of implementation was another area that Coyle raised. For market participants using a third-party provider, BBH would recommend at least six months of testing ahead of SDR going live, which would mean that testing should start to take place as early as August 2021.
The countdown to SDR has begun. Thanks to the analysis that has been conducted by BBH, buy-side firms of all sizes should have a better understanding of how they will be affected by the new regulation. Having a clearer understanding of this will hopefully prompt market participants to press ahead with their preparations and allow ample time for testing. By doing so, they will be well prepared when the regulation comes into effect.
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