Charles is the Head of Regulation at the Independent Investment Management Initiative.
Efforts to improve clearing and settlement processes inside the EU have been ongoing for two decades now as regulators look to facilitate better cross-border investment. A number of regulations have been introduced over the years to abet this, including the Central Securities Depositories Regulation (CSDR). Unveiled seven years ago, the CSDR established a standardised regulatory framework for EU central securities depositories (CSDs). It also sought to harmonise trade settlement practices across the bloc by forcing member states to adopt a T+2 rolling settlement cycle. So why is the CSDR – a piece of EU regulation that overwhelmingly applies to post-trade intermediaries – an issue for IIMI members?
An inefficient corner of the market
Existing settlement processes are woefully inefficient and manual intensive – increasing the likelihood of trade fails. Incidents of late and/or failed settlements as a result of manual processing are fairly ubiquitous in capital markets, and this is driving up industry costs. Data from the European Securities and Markets Authority (ESMA) found failed trades account for 3% of the trades’ value in corporate bonds and sovereign debt markets, rising to 6% for equities.1 During the worst of the COVID-19 volatility last year, there was a substantial spike in the number of trade fails. ESMA said that trade failures on government bonds and equities doubled to 6% and 12% respectively, while ICMA (International Capital Markets Authority) analysis found settlement failures in the European repo market jumped by 4-5 times in April 2020.2 The costs of these trade fails are non-trivial for the financial institutions involved with the DTCC estimating that a trade settlement fail rate of 2% equates to losses of $3 billion.3 Although CSDR came into force in 2014, certain components of the regulation are yet to go live, having been delayed because of COVID-19 . The Settlement Discipline Regime (SDR), a rather loaded provision designed explicitly to reduce the number of settlement fails, is one of them.
SDR and its impact on fund managers
IIMI members need to pay close attention to the SDR requirements for several reasons. Firstly, the rules apply across multiple asset classes and will impact any financial institution that trades inside the EU irrespective of where it is located. However, the UK Treasury has confirmed it will not implement the SDR. But what is the SDR? In order to promote better settlement discipline, market participants will be hit with penalties under SDR should a transaction not settle on T+2. If a financial institution responsible for a trade fail cannot deliver securities to the receiving participant within four days of the intended settlement date, then they will be hit with a mandatory buy-in. Although many within the industry accept that the threat of fines will encourage the market to improve its settlement discipline, buy-ins are more controversial. Industry groups point to COVID-19 as a case and point. With trade fails peaking during March and April 2020, experts argue the market would have taken a seismic hit had buy-ins been in place during COVID-19. Not only would managing the buy-in process have commanded enormous resources at a time when staff were stretched but any attempt to buy in illiquid securities in a chaotic market would have increased volatility, potentially resulting in heightened systemic risk.
Most asset managers have historically presumed that it is their custodians or brokers who are primarily responsible for ensuring trades settle on a timely basis. Not anymore. Under CSDR, CSDs will be entrusted with imposing fines for settlement fails on brokers/custodians – who unless they are themselves to blame – will in turn offload these costs to the underlying clients responsible for the fails, namely asset managers. As such, managers will now need to augment their settlement processes if they are to avoid CSDR penalties and mandatory buy-ins. While the rules have been delayed until February 2022 because of the pandemic, investment firms still need to make urgent improvements to their systems so as to ensure that trade settlements happen on time. Asset managers should also interrogate their custodian banks to ascertain the causes of any trade fails to establish if a third party is responsible, as this could potentially enable investment firms to make counter-claims. Now is the time for asset managers globally to start paying serious attention to CSDR and its wider implications.
1 Cognizant (July 18, 2020) Reduce the costs and burdens of trade settlement fails with predictive analytics
2 Global Custodian (May 29, 2020) Trade settlement fail spikes at height of COVID-19 crisis spark debate about CSDR
3 Cognizant (July 18, 2020) Reduce the costs and burdens of trade settlement fails with predictive analytics