Preventing Pesky US Treasury Settlement Fails

For US broker-dealer operations managers failing to settle a transaction in US Treasury securities might never have been all that problematic, but with the number of fails rising dramatically during the peak of the COVID-19 pandemic one megabank–BNY Mellon– has decided to offer a preventative service in a technology partnership with Google Cloud.

As the largest clearing agent for US Treasuries processing US$8.6 trillion worth of trades daily, BNY Mellon has come up with a way for its broker-dealer clients to avoid the costs of failing to settle a trade on time by predicting just when a settlement fail might occur. Knowing about the potential for a settlement fail also has multiple qualitative benefits as the US$20 trillion US treasury market is the largest and most liquid in the world used the basis for pricing and hedging other assets. “Reducing settlement fails in US Treasuries maintains the integrity and liquidity of the US government and agency securities market,” explains Brian Ruane, chief executive of clearance and collateral management business at BNY Mellon, Broker dealers can also improve their funding operations by avoiding the costs of an unexpected cash shortfalls and knowing when to invest excess cash.

Unlike US stock and corporate bond transactions which settle in a two-day cycle, trades in Treasuries settle on a T+0 timetable — or the same day a trade is executed. That is when the seller is required to deliver the securities to the buyer in exchange for payment. Because settlement for US Treasuries takes place on a gross settlement basis, the failure to receive cash payment on time does not constitute a failed settlement but failure to deliver securities does. Newly-issued Treasuries are more likely to fail to settle on time, according to BNY Mellon, because of higher trading volumes. The percentage of failed settlements also increases for trades executed in the early morning, at the end of the month, or calendar quarter. On average the percentage of failed settlements comes to two percent daily which doesn’t seem like a high figure, but the cost can add up for a broker-dealer or bank depending on the number of failed settlements. Trades in US Treasuries are typically done between broker-dealer and bank counterparties.

Settlement fails are nothing new, but until now much of the attention has focused on the European market and US equities and corporate debt markets where fail rates rose briefly during the early stages of the COVID 19 pandemic last year. The European Commission has postponed the implementation of Europe’s Central Securities Depository Regulation (CSDR) settlement discipline regime (SDR) to February 2022 and industry groups, such as the International Swaps and Derivatives Association and International Capital Markets Association, are calling for either the abolishment or voluntary application of buy-in requirements. The CSDR mandates European securities depositories use a uniform methodology for calculating penalties for failed settlements in European securities– after a two-day settlement cycle lapses. Market players will also be required to execute a buy-in within a few days after the settlement fail is left unresolved. The US umbrella organization for clearance and settlement, Depository Trust & Clearing Corp. (DTCCC), among others recently proposed a one-day settlement cycle for US bonds and equities amidst the controversy over a short squeeze in shares of Gamestop earlier this year that caused some brokerages, such as Robinhood, to restrict trading in certain securities. That idea has generated mixed response.

Figures compiled by BNY Mellon for broker-dealers using its government clearing services shows that settlement fails in US Treasuries tripled during the months of March, April and May of 2020 due to remote work, incorrect delivery instructions and higher trading volumes prompted by an increased demand for cash-like instruments. Although the fail rate has declined since then even one settlement fail could be one too many for broker-dealers which must pay fines imposed by counterparties. The methodology for calculating the penalty to be imposed by the broker-dealer which does not receive securities on time and paid by the guilty counterparty was set by the Treasury Markets Practice Group (TMPG) of the Federal Reserve Bank of New York back in 2009. The value of trades which failed to settle on time had reached a whopping US$16 trillion in October 2008 at the height of the global financial crisis.

The TMPG’s methodology, created by a group of primary dealers, received the Fed’s blessing and although voluntary the penalty has become industry practice. The formula works as follows: the annual rate of three percent (300 basis points), less the Target federal funds rate, calculated daily using the settlement value of the trade. What that means is that for a US$100 million trade in US Treasuries, a five-day failure to deliver the securities on time with a one percent reference rate would be US$5,555 per day or $27,777 for the five days. (Based on the current reference rate of zero the penalties are higher). The minimum fine that must be charged is US$500.

Broker-dealers trying to predict the potential for failed settlement in US Treasuries on their own could easily be wrong and they could source a Treasury security they don’t need, says BNY Mellon. Using Google Cloud’s data analytics, machine learning and artificial intelligence, BNY Mellon’s service can predict the ability for the trades to settle 40 percent of the time with a 90 percent rate of accuracy. The platform relies on an algorithm which incorporates factors such as the supply and demand of Treasuries, the velocity of the transaction, the number of trades settled per hour, and the user’s historic fail rate for the previous 10 months. The data collected by BNY Mellon’ government securities clearing system is stored by BNY Mellon and not Google.

If a broker-dealer were to take action each time there is an alert of the possibility of a potential fail, the number of fails would be reduced by the entire 40 percent. That means that the BNY Mellon system can prevent four out of 10 possible failed settlements at best. “A broker-dealer might not take action to prevent a settlement fail from occurring each time its back-office sees an alert on the screen,” says Ruane. “The possibility of failure is rated anywhere from 0 percent all the way to 100 percent and it is up to the broker-dealer using the BNY Mellon platform to decide at which percentage threshold it wants to take action and immediately deliver the Treasury securities to its counterparty.” The service predicts the potential for failed settlement three times a day at 1PM EST, 1:30PM EST and 2PM EST. The Fed closes market at 3PM EST and any pending instruction which have not been processed by then will result in a settlement fail.

So far, an undisclosed number of broker-dealer clients are pilot-testing BNY Mellon’s system and BNY Mellon won’t say when it will go live. Ruane could not estimate by what percentage the broker-dealers using the platform have reduced their number of settlement fails. However, he says that BNY Mellon hopes to increase the percentage of settlement fails it can predict as it finetunes the platform with pilot tester clients.

in the meantime, for broker-dealers still facing settlement fails in Treasuries the best chance of mitigating costs is quickly reducing the number of days in which the trade remains unsettled. The London-based Taskize, majority-owned by international securities depository Euroclear, provides an inter-firm workflow platform that allows the right individual at the right firm to resolve settlement fails. “The goal of the platform is to eliminate multiple time-consuming emails and phone calls needed to sort out why the fail occurred and how to correct it,” explains Taskize’s chief operating officer Philip Slavin. It could not be confirmed whether the service, which connects to DTCC’s Trade Exception Management (DXM) platform and Euroclear’s Easyway platform, has been used for US Treasuries, but Slavin says it is adaptable to multiple asset classes. DTCC’s (DXM) is used by buy and sell-side firms to standardize trade exceptions processing and more quickly resolve settlement fails. A June 2020 press release issued by DTCC listed 11 custodian banks as users, including BNY Mellon, Brown Brothers Harriman, Citi, HSBC, JP Morgan, Northern Trust and State Street. Easyway provides a web-based interface to Euroclear’s services. Over three hundred firms use the Taskize platform including fund management shop, custodians, securities depositories. and central banks.