Europe’s T+2 Settlement: Bond Trades Hardest Hit?

With about thirty European countries moving to a two-day settlement cycle  next month, concern is starting to mount that the fixed-income market will trail its equities counterpart in meeting the shorter timetable, leaving fund managers and broker-dealers to pay a heftier cleanup bill than initially anticipated.

Securities depositories responsible for settling domestic and cross-boder transactions say that they aren’t worried about whether they can meet the expected higher volume of settlements come October 8, two days after the T+2 requirement comes into effect. They insist they have plenty of bandwidth to spare. However, their bank and brokerage participants might not be that lucky.

“It’s not an issue of whether we at the depository level can settle trades on time as we are already able to do so on a same day (T+0) basis, but whether we receive the necessary instructions from our members — the banks and broker-dealers who in turn must receive instructions from their underlying clients,” says Paul Symons, director of public affairs for Euroclear, the umbrella organization for international securities depository Euroclear Bank and national depositories of the UK and Ireland, France, Belgium, the Netherlands, Sweden and Finland. “The question is can banks and brokers complete the affirmation and confirmation process with fund managers on the same day the trade is executed and then get that information to the depository layer? That could become a challenge for some, particularly across global timezones.”

October 8 is the so-called double witching day when two days’ trades must be settled. The trades will include those executed on Friday, October 3, which would still be allowed to settle on the old T+3 schedule, and the trades of October 6, the first day of the mandatory T+2 schedule. The new T+2 timetable for European equities, government bonds, corporate bonds and Eurobonds reflects a voluntary decision on the part of European countries to meet the European Commission’s mandate that they settle trades on T+2 by January 1, 2015 at the latest. Most European markets — with the notable exception of Germany — settle their trades on a T+3 timeframe.

A spokesman for Clearstream, which operates Germany’s national depository and the Luxembourg-based international securities depository, says that in Germany, already working under a  T+2 schedule, no changes will be made. “Increased volumes can be handled smoothly at the domestic and international securities depository levels,” he adds. However, in recognizing the potential for higher settlement fails beginning October 8, Clearstream’s settlement, securities lending and financing units are bracing themselves for increased business and customer inquiries. Market players anticipate higher securities lending and repo activities to at least reduce — if not prevent –settlement fails

The shift to a shorter settlement cycle precedes another big step: European national securities depositories outsourcing their settlement functions to a new central operating platform called Target2 Securities (T2S). Operated by the European Central Bank, the system aims to reduce the costs of settling domestic and cross-border trades in Europe. It is set to be implemented in four stages between June 2015 and February 2017.

Although the new T2S platform handles both equities and fixed-income transactions, only securities traded on an electronic platform fall under the regulatory mandate to be settled on T+2. Those traded over-the-counter — that is, outside of an electronic platform — don’t. But with trade associations such as the International Capital Market Association (ICMA) urging its members — some of the world’s largest banks and brokerages — to settle on a two-day timetable for over-the-counter bond transactions, the practical effect could well be the same as if the EC had included them in its requirement.

Matching Discrepancy

None of the dozen European fund managers and broker-dealers contacted by FinOps Report were willing to quantify the difference between how the speed of matching fixed-income trades compares to equities trades. But they did offer a consistent message, as expressed by one UK fund management operations director: “It’s common knowledge there is a sizable gap between equities and fixed-income instruments in how quickly trade details are acknowledged.”

In matching, counterparties have to to acknowledge and agree upon the economic terms and place of settlement — the depository used — before they can settle a trade. If the details don’t match on first entry, there is increased chance the trade will miss the agreed-upon settlement date and neither side will receive the cash or assets promised. Right now, it appears that no one will be surprised if, on October 8, the percentage of fixed-income transactions which fail to settle on time spike and exceed the percentage of equity trades in the same boat. Even now, by industry estimates the percentage of failures in debt trades is slight higher than in European equity trades.

Although trading volumes are typically lower in the fixed-income market than in the equities arena — due to the buy and hold nature of investing in debt instruments– the financial values of transactions are typically far larger. As a result, it stands to reason that fund managers and broker-dealers could find themselves spending a lot more money cleaning up their fixed-income book of business than their equities. After all, they have to compensate each other for the lost use of  cash and assets, as well as paying whatever fines might be levied by depositories. While the executives that spoke with FinOps could not anticipate how much their costs might be, it is clear the problem is keeping some of them awake at night.

“We’re concerned, particularly about cross-Atlantic trades because of the time-zone differences,” says one operations manager at a UK buy-side shop. Compounding the problem is that there are so many varieties of fixed-income transactions with different associated information needed to match a trade.

A recent report issued by Trax, a subsidiary of fixed-income electronic trading platform MarketAxess, highlights the following post-trade communication gaps: late matching of trade details between broker-dealers, late matching of trade details between brokers and their fund managers, and last but not least the delayed matching of trade details between participants of European depositories which ultimately settle the trades. “Firms need to complete the trade verification process, including affirmation/confirmation of settlement details on T+0, ” recommends the London-based Trax. Such a scenario would allow mistakes to be corrected on T+1 so that settlement can take place on time on T+2. Too much of the current post-trade communications process is handled on a T+1 basis, simply because there is sufficient time under the current T+3 settlement timetable for any mistakes to be corrected on T+2.

The Sooner, the Better

Such advise isn’t new. Both Trax and the larger post-trade communications service provider Omgeo have repeatedly recommended fund managers and broker-dealers speed up their post-trade communications process, but the latest pronouncement from Trax may carry weight with fixed-income players because of Trax’s historic focus on the debt market. While Omgeo has long touted its Central Trade Matching (CTM) platform for central matching of equities and fixed-income trades between fund managers and broker-dealers, Trax is clearly competing with its post-trade matching service for European bonds. Trax says it does handle post-trade communications between fund managers and broker-dealers, but acknowledges its historic strength is in the dealer-to-dealer market.

“Broker-dealers shouldn’t be matching trade details at the end of the day or even later,” says Chris Smith, head of post-trade services for Trax. Instead, they could be doing so within fifteen minutes of trade execution using the Trax platform. So far about 200 broker-dealers and fund managers are on board.

European fund managers agree that the so-called same-day affirmation rate for fixed-income instruments trails those of equities by a long shot. Tony Freeman, executive director of European industry relations for Omgeo, says that fund managers and broker-dealers using its CTM will affirm 94 percent of European equities transactions and 84 percent of bond transactions on the day they are executed. That is because the central matching process whereby both fund managers and broker-dealers input trade details concurrently into a third-party platform, such as the CTM, results in the trade being affirmed automatically. Not so under electronic local matching where there is a sequential confirmation-affirmation process taking place between fund managers and broker-dealers.

Concerns about on-time settlement are bringing a lot of attention to potential sources of delay. Several European fund managers say the same-day affirmation rate could fall to as low as 50 percent for equities and 40 percent for fixed-income instruments should local matching be used and understandably lower should faxes and phone calls be used. There is naturally a lot of finger-pointing between fund management and broker-dealer operations managers  One operations manager at a European fund management shop says he isn’t receiving confirms on either equities or bond trades from his broker-dealers fast enough, while his counterpart at a European brokerage firm says he is receiving trade allocations too late on the day the transaction is executed — even after business hours.

Any delays in matching trade details between fund managers and broker-dealers will ultimately delay the so-called settlement matching, the final leg of the matching process . Under a T+2 timeframe, bank and broker-dealer members of depositories will have until T+1 to match up their information with each other instead of the current T+2 which was acceptable in  a T+3 settlement timeframe. There is talk of depositories handing out fines to members that don’t match their trades on time, in addition to fines for not settling on time. Those bank and brokerage members may well pass  along those fines to their fund manager customers.

So what should fund managers and broker-dealers be doing right now to prepare for the new European settlement landscape? Trax’s report didn’t hold out much hope they would all be ready in time for October 8, but suggested that for starters they could use automated trade matching platforms. However they do it, fund managers must inform their broker-dealers of their trade allocations the same day trades are executed, the earlier the better.

Of course, it would also help if the information which must be matched is accurate in the first place. One data field causing the most angst, says Smith, is the one naming the place of settlement. Insert the wrong depository into the data field and risk of the trade failing to settle on time goes through the roof. Such a scenario has historically taken place more often when it comes to fixed-income instruments because they could be settled in any of three depositories — a national European depository, Euroclear or Clearstream.

Dealing Scorecards

Are fund managers and broker-dealers getting their acts together? Although they won’t give FinOps specifics, fund managers acknowledge they are paying closer attention to the workflow process for fixed-income securities than ever before, and having serious talks among internal operations and IT staffers, as well as their broker-dealer counterparts. “We need to coordinate when we will be confirming, allocating and affirming trades as we don’t have time to correct mistakes,” one operations director at a UK fund management shop tells FinOps. “We are now reviewing our procedures on a product-by-product basis to determine what needs to be done.”

One approach being taken by some European fund managers and broker-dealers: handing out scorecards to each other on how quickly they are communicating the details of the trade for both European fixed-income and equity transactions. “The scorecards will tell us how badly or how well we are doing in the fixed-income products compared to equities and what corrective measures we need to take,” says one operations director at a UK brokerage.

Those measures could range from providing fund manager customers with advice on which matching platform or process to use, all the way to charging higher fees to firms that are slower or less efficient. Equally, fund managers could decide to concentrate their business on fewer but more operationally reliable broker-dealers. While Trax and Omgeo offer dedicated central matching engines, fund managers and broker-dealers preferring a local matching system could decide to use two newcomers — sending trade details through the network operated by global messaging giant SWIFT or using middle-office FIX message protocols developed by the FIX Trading Community.

Regardless of how fund managers and broker-dealers decide they want to handle the post-trade communications process, it’s clear they don’t have much time left to test their T+2 workflow. If they’re not ready, they could easily end up paying some hefty cleanup bills and even fines. Changing their operational standards might not be easy, but may ultimately be less painful than doing nothing.