By Matt Johnson, Director, ITP Product Management, DTCC.
It is just under ten months to go before the implementation of the Central Securities Depositories Regulation’s (CSDR) Settlement Discipline Regime (SDR), which will require firms to put in place measures to mitigate settlement delays, endorsing straight through processing (STP) to support high settlement rates. For trades that do fail, SDR will impose cash penalties or charges, as well as mandatory buy-ins. The latter refers to the process by which, after a trade has failed to settle for a specific amount of time, depending on asset class, the party being failed against will be legally obliged to initiate a buy-in, via a buy-in agent, against their failing counterparty.
While many firms have begun to prepare, ESMA’s recent Report on Trends, Risks and Vulnerabilities No.1, 2021, dated March 2021, highlighted some concerning data on settlement fails. The failed trade rates highlighted that market participants should make further improvements to lower trade fails before SDR is implemented in order to avoid repercussions in the form of potentially significant financial penalties for late settlement.
The report highlighted that, for equities, settlement fails are still more frequent than before the pandemic-induced market volatility in March and April 2020. On average, the settlement fail rate for equities in the second half of 2020 was 7.4%, compared to 8.6% in the first half of 2020. While the rate for the second half of the year improved, it is still higher than levels in the second half of 2019, which was 5.2%. This is concerning, particularly with SDR implementation coming up in less than a year.
The findings of the ESMA report are extremely timely, as high fail rates were one of the main concerns raised at a recent forum on CSDR held by DTCC with participation from an outsourcing firm, a broker-dealer and a global custodian. Market participants would need to devise their own blueprint as to how they can implement SDR, however the objective of the forum was to discuss outstanding issues and share insights on optimum approaches to ensure readiness.
The four big themes that emanated from the discussion in relation to SDR were:
- The status of preparedness for SDR is directly related to the size of market participant;
- SDR preparation requires collective action from the front and back-office;
- ‘You can’t manage what you can’t measure’: Analysing post-trade weaknesses and addressing them ahead of SDR implementation is essential;
- A strategic approach to improving post-trade processes is crucial if firms want to be well positioned for SDR.
The following steps were recommended to help market participants with their planning and implementation of SDR. On the first point, tiers of readiness for SDR are based on the size of market participant. Larger investment managers (IMs) that have considerable middle and back-office resources may have fail rates of 3-4%. Of those fails, 3-4% could result in buy-ins. For smaller IMs that do not have a comparable middle or back-office function, there may be fail rates of around 5%. However, of those, up to 18-20% may convert into buy-ins. The conclusion reached in the forum was that the smaller buy-side firms need to start to address these post-trade weaknesses ahead of SDR implementation. Otherwise, the potential financial penalties and expensive buy-ins could prove challenging for this size of market participant.
Second, there was consensus that SDR isn’t just an operations problem. SDR needs to be viewed as a front-to-back-office issue and therefore should be addressed collectively. To improve settlement accuracy and timeliness, increased communication between functions is imperative. This will drive the need for better communication between functions which have been traditionally siloed.
Third, ‘You can’t manage what you can’t measure’. For market participants to address their post-trade weaknesses ahead of SDR implementation, they would need to first analyze the causes of their failed trades. In particular, it is important to consider both the external and internal factors which are causing post-trade inefficiencies. Research that we have conducted amongst our clients identified that the most common reasons behind these fails are often missing or incomplete standing settlement instructions (SSIs), manual processing in trade matching, and post-trade processes being managed across different platforms. The good news is that market participants can address these issues by switching from manual to automated processes for trade matching and confirmation and by adopting an SSI utility. Automation adds efficiency and transparency, and available solutions can improve data management, reinforcing internal audit protocols and bolstering risk management.
Finally, the panellists suggested that market participants need to take a strategic approach to SDR preparations in order to be well placed for the mid-to-long term future. The first step market participants may want to consider would be to update legacy systems, addressing areas that create operational risk and cost with the aim of achieving fail rates that are more comparable to US and Asia, and are substantially lower than those in Europe. Consensus at the event was that there should be a reduction in failed trades from the middle to the end of 2021. If this is not the case, there is cause for concern.
The message underscored at DTCC’s CSDR Forum was loud and clear: for firms to be ready for SDR in February 2022, operational inefficiencies need to be addressed now. This will involve a change in behaviour, the adoption of automated solutions and continued engagement from both the buy and sell-side in order to be ready. The time to act is now.