In permitting partial settlement of securiies transactions to relieve financial penalties, the new European Central Securities Depository Regulation (CSDR) will unintentionally cause fund managers, broker-dealers and others more operational grief.
The CSDR is designed to harmonize the operating rules for all national European securities depositories, including using the same methodology to calculate fines when trades don’t settle on time. Dealing with settlement fails penalties is considered the most difficult of the two tasks financial intermediaries will face in complying with the CSDR. The other – reporting on internalized settlements or those settled on the books of a financial firm outside of a European securities depository — is easier because all of the data internalized settlements is likely readily available. The information just has to be consolidated and reformatted.
Bowing to industry requests, the pan-European securities watchdog European Securities and Markets Authority (ESMA) has postponed the settlement discipline regime portion of the CSDR and buy-in requirements by six months until February 1, 2021 to allow market players to adjust their operations for the coronavirus pandemic. Yet that delay might still not give financial firms enough time to prepare, particularly when it comes to partial settlement which applies only when some rather than all of the required number of shares are delivered by the seller to the buyer on settlement date. When only part of the cash payment is made by the buyer, the transaction is considered to have failed to settle on time. As of press time, ESMA had refused further pleas to change the timetable for the settlement discipline regime or alter the conditions for buy-ins.
Both the US and Europe operate under a two-day (T+2) settlement cycle which means that trades must be settled two days after they are executed. However, the US’ national securities depository Depository Trust Company does not allow for partial settlement and it does not fine bank and brokerage participants which fail to settle their trades on time. By contrast, the CSDR requires national securities depositories in Europe to not only impose financial penalties when trades don’t settle on time, but to also offer partial settlement as an alternative to settlement fails. Partial settlement is already an option, but is rarely used, say market players, because both counterparties must agree. “What was the exception to the norm and agreed upon between two counterparties could become more commonplace, because financial firms will now be obligated to accept partial settlement as a settlement option,” says Daniel Carpenter, director for regulation at regulatory technology firm Meritsoft, a Cognizant company focused on tax claims and data analytics.
A spokeswoman for Clearstream Banking in Frankfurt and Clearstream’s international depository says that the German securities depository already offers partial settlement and Clearstream in Luxembourg will do so by the required deadline for the settlement penalty phase of CSDR. Trades which settle “internally” between participants of the same depository or settle between participants of Clearstream and rival Euroclear Bank in Brussels will also be offered the partial settlement option. “Clearstream Banking will set the settlement instructions to PART [partial] by default and the setting can be overriden with NPAR for each instruction or by default to all instructions,” says Clearstream Banking’s spokeswoman in response to emailed questions from FinOps Report. Euroclear officials could not be reached for comment at press time.
Officials at the global messaging network giant SWIFT in La Hulpe, Belgium say that they will not have to make any changes to the current ISO-15022 compliant and equivalent ISO-20022 compliant message types to accommodate partial settlement. However, SWIFT will adapt messages to deal with settlement fails penalties and buy-in requirements. Those enhanced messages will be released in November 2020.
Here is how the penalties for settlement fails and buy-ins will be carried out under the new CSDR: natonal European securities depositories will be responsible for charging the fails penalties to their responsible banks or broker-dealer members as debits. Those participants must then pass along those fines to their underlying clients. Debits to a depository member’s account could either be partially or entirely offset by credits given as compensation for a failed settlement caused by a counterparty. Should a trade remain unsettled for too long after the intended settlement date, the buyer of the securities must implement a buy-in. The timetable for the buy-in is four days after the intended settlement date for a liquid instrument, such as a European equity, and seven days for a less liquid one, such as a corporate bond. In the case of a transaction that is processsed through a central clearinghouse, the clearinghouse will be responsible for the buy-in and for compensating the buyer. It is uncertain whether the UK will require financial firms to apply the buy-in requreiments for UK transactions when the country exits the European Union.
The amount of the fine for the settlement fail will depend on the value of the affected transaction and the liquidity of the financial instrument involved. As a rule of thumb,settlement fails for equity trades will incur a higher fine than for those in corporate bonds. Transactions involving government bonds will incur the lowest fines. “The criteria for knowing whether a financial instrument is liquid or illiquid parallels that which was set by ESMA under MiFID II,” explains Silvano Stagni, president of Perpetual Motion and Research Consulting, a London-headquartered regulatory compliance consultancy. The critiera are based on the number of trades over three rolling months and the number of days a financial instrument goes untraded. Based on those factors, a corporate bond which has 100,000 transactions for three weeks but no transactions for the remaining eight weeks is considered illiquid. By contrast, an equity could have only 2,000 over three months but as long as it doesn’t go untraded for more than two days it is considered liquid.
The buyer executing the buy-in will be compensated by the seller for the difference between the value of the shares at the time the sale was originally struck and the new price at the time of the buy-in. The compensation only applies if the share price has increased. In the case of a transaction that is processed through a central clearinghouse, the clearinghouse is responsible for the buy-in and for compensating the buyer. It is uncertain whether the UK will apply the buy-in requirement for UK transactions when it exits the European Union.
The penalty regime for partial settlement represents a twist on the regime for failed settlement, according to Stagni, who explains the process as follows: say an investor buys 100 shares of a European equity and the seller delivers 50 shares the day after the trade is executed and 50 shares two days later. The transaction would be considered settled on time because the full number of shares were delivered within the T+2 timeframe. However, if the seller only delivers 80 shares in total within the T+2 timeframe, the seller would have to immediately pay the buyer compensation based only on the 20 shares, not the full 100 shares. Should the buy-in have to occur either within four days because the remaining twenty shares were still not delivered, the buyer would only have to buy the twenty shares in the open market, not the full 100 shares. The seller would have to compensate the buyer for any price difference– should the shares increase in value– based on only twenty shares.
Despite the financial benefits of partial settlement, executing brokers and fund managers are none too happy they are stuck with accepting the alternative. They say they wil have a harder time tracking partial settlement than knowing whether a trade settles on time or not. Why? Because there are more moving parts to the equation. Financial firms have to know how many shares in total were delivered through multiple deliveries, when they were delivered to the buyer before the settlement date and within what timeframe the buy-in must kick in. Not all back-office systems are equipt to do so automatically so firms may have to use some manual intervention unless they make the necessary adaptations. Fnancial firms will also have to adjust their securities lending and borrowing systems to know just when and whether any have been borrowed or lent and when. They must then tie-in the result from the securities finance systems with their back-office systems. Last but not least, financial firms will have to reconcile any debits or credits imposed with their own calculations.
Despite having extra time to prepare for the new settlement penalty regime, fund managers and broker-dealers are praying that their predictions of a higher percentage of partially settled trades will be proven wrong. Operations managers at several European fund management firms and broker-dealers tell FinOps Report that instead of adjusting their back office systems to accommodate partial settlement, they are trying to reduce the number of fails by using electronic confirmation services and third-party standing settlement instructions. They are all in talks with their largest counterparties to ensure they are doing their part to reduce settlement fails and will discourage them from using the partial settlement option. “We dread dealing with partial settlement,” quips one operations manager at a European broker-dealer.
Whether financial firms will be able to avoid addressing partial settlement for too long is doubtful. At least one technology provider is preparing for the likelihood that financial firms will need to adjust their systems to handle a far higher number of partially-settled trades and rely on an external automated solution. Meritsoft’s Carpenter says that his firm’s platform for CSDR can reflect whether a partial settlement has occurred and hightlight where there are net settlement positions on the buy-in date, which indicates there is a potential for a buy-in to occur. Meritsoft’s platform can also calculate any penalty that must be made and reconcile any discrepancies with debits imposed by European securities depositories.