European Regulators Tell Market: Failure Not an Option

Failing to settle or even match the details of European securities trades on time could become a lot more expensive and reputationally risky for banks, broker-dealers, and their fund manager customers, if European regulators have their way.

Just how much more they will have to spend beyond the hefty internal administrative costs, and current fines imposed by European securities depositories for failing to settle a trade on time is unknown. What is clear, based on new technical rules just proposed by the European Securities and Markets Authority (ESMA), is that European regulators want sell-side market players to do their best to settle trades on time when a far shorter schedule become effective. They will be financially penalized if they don’t, and it stands to reason they will pass along any additional fees to institutional and even retail investors.

Although the settlement fail rate in Europe is low — under three percent of all trades by industry estimates — European regulators are worried it will spike when the settlement cycle is cut from the current prevalent three days after a trade is executed to two days, or T+2. The European Commission has advocated a January 2015 timetable for T+2 for European equities, but over ten European countries — including the UK, Ireland, Luxembourg, Norway, Austria, Belgium, France, Netherlands and Switzerland –say they will do so voluntarily in October 2014. Germany, Slovenia, and Bulgaria already require domestic equity trades to be settled on T+2.

The US operates on a T+3 settlement timetable for domestic equities, but could eventually shorten that schedule to T+2 as market infrastructure Depository Trust & Clearing Corp. (DTCC) and industry trade groups, such as the buy-side association Investment Company Institute, advocate. However, as indicated in an article posted on FinOps Report on February 26, such a change would be market-driven in a voluntary way, not mandated by the Securities and Exchange Commission.

Still, the SEC would need to approve operational changes required needed by DTCC to meet a T+2 timetable. Given the lack of a regulatory edict and the preliminary nature of industry talks, the US could well lag behind Europe in implementing a two-day cycle.

Settlement Matching Deadline

The matching timetable that the ESMA wants to impose — by the end of T+1  — relates to banks and broker dealer participants acknowledging settlement details for their trades through European depositories, so they can exchange cash and securities on T+2. This follows a separate process of matching– or affirmation–between fund managers and broker-dealers or banks which must also be sped up to ideally take place on same day a trade is executed, instead of the next day. Any delays in that affirmation process — outside the control of European securities depositories — could easily delay the subsequent matching of settlement details through the local European settlement houses.

The eleven data fields that ESMA is proposing European depositories use go beyond voluntary standards the trade group European Central Securities Depository Association (ESDA) developed with members and market players in 2006. Still, not all European depositories use the same data fields to match trades in all markets and mandating specific ones, some fear, wouldn’t allow for any flexibility to address local needs and requirements.

The ESMA’s new technical draft enforces the new “settlement regime” outlined in the proposed CSD-R legislation, which sets uniform operating and financial stability standards for depositories. Feedback on the proposals must be submitted by May 22 on the ESMA website under the heading Consultation. The ESMA, the European Union’s regulatory body specializing in securities legislation, will forward the feedback to the European Commission to incorporate into the new legislation.

Getting Ready for T2S

Such harmonization, says the ESMA, is necessary to migrate the entire European continent to a T+2 settlement cycle before a new Target2-Securities (T2S) platform operated by the European Central Bank goes live. Over two dozen European depositories have already agreed to outsource their settlement functions to T2S, which the ECB claims will reduce the costs of settling domestic and cross-border European trades.

Most of the CSD-R’s provisions focus on ensuring the operational and financial soundness of depositories, creating little if any impact on participants, insist depository specialists. Not so for the new settlement regime.

Eager to promote business as usual, most depositories in Europe are hesitant to comment on the potential impact of the proposed rules on their participants. Although not joining the T2S bandwagon, Russia’s National Settlement Depository (NSD) says will review the ESMA’s technical draft and CSD-R legislation to determine whether it will follow any of the new rules. As a member of the European Central Securities Depository Association (ECSDA) and electronically linked to international depositories Euroclear Bank and Clearstream Banking Luxembourg as of early 2013 , the NSD needs to meet rigorous operating standards to attract more international investors to the Russian market. 

Russia already follows a T+2 settlement cycle for the most liquid exchange-traded securities, but the NSD does not fine bank and broker-dealer members which either fail to match settlement instructions quickly or don’t settle their transactions on time. The bank and broker-dealer participants can match trade settlement details with each other as late as settlement date — similar to what most European depositories currently permit.

For now, the NSD has decided to promote earlier matching on a voluntary basis, says a spokesman, by giving its participants reports on their matching activity. The depository will also be ready to report laggards — those who don’t settle trades on time — to the Bank of Russia, if the Russian central bank requests the information.

Naming Laggards

Should the ESMA’s rules become effective, depositories would have common standards for reporting to regulatory bodies, breaking out the number of trades which fail to settle on time, the percentage of trades successfully settled, and which participants are responsible for the fails. “Today, the great majority of European securities depositories already report settlement fails data to regulators, but the contents and frequency of such reports are not harmonized,” explains Soraya Belghazi, secretary general of the ECSDA in Brussels. “A single European methodology would mean that depositories in the future collect settlement fails data the same way and report this data to regulators using a broadly similar template.” The benefit: regulators could compare data on settlement fails and aggregate it on a European level.

While securities depositories would never decide to toss out a repetitive laggard on their own without clear justification, they could have far more ammunition to do so with the support of securities watchdogs, an operations specialist at a European fund management shop tells FinOps Report. The reason: all European regulators will be constantly updated — as frequently as daily — about which bank and broker dealers failed to settle trades on time. Currently, some regulators only receive such information sporadically upon request because most European central depositories do not identify specific participants that fail to settle trades on time on a regular basis.

For their part, European depositories say that suspending a participant with repeated settlement fails is a drastic last resort and likely to be used sparingly by any depository. The reason: the securities depository won’t want to trigger the bank or broker-dealer being suspended from all relevant trading venues and clearinghouses. “Suspending a participant in a central securities depository will almost never be a reasonable response to repeated settlement failures and there are more efficient ways for the CSD to penalize repeated bad behavior,” insists Belghazi.

Clearinghouses, not depositories, would implement buy-ins in case a trade processed through a clearinghouse fails to settle on time. Alternatively, an electronic trading platform would do so, if the trade is not centrally cleared. Buy-ins related to settlement fails for trades executed bilaterally over-the-counter  will still have to be sorted out between the two counterparties.

Disincentives for Lateness

The ESMA’s proposal did not specify the value of any fines or “disincentives” that depositories could levy for trades not matched or settled on time, saying it will address the matter in a future document.

“The ESMA suggests that European securities depositories could charge participants for trades not matched on time and this [approach] would be new for most central securities depositories in the European Union,” says Paul Symons, head of public affairs for the Euroclear family of depositories headquartered in Brussels. The Euroclear UK & Ireland depository is a notable exception in bucking the status quo. The depositories that do levy fines on participants which don’t settle trades on time use various methodologies to determine how much to charge , which participants to charge and when to apply the charges.

Five operations directors at UK and continental European fund management shops tell FinOps Report that they have been warned by their custodians and broker-dealers of potential new charges for trades which fail to match or settle on time, but so far have few specifics on how they would be implemented. “We don’t know if they will pass along the full amount of any fines charged by European securities depositories or any buy-in costs charged by clearinghouses and how often they will calculate and report the fines to us,” says one London-based fund management operations director.

Another possibility being proposed by some custodians, according to other operations specialists at European fund management shops, is financial incentives –in the form of lower safekeeping and settlement fees — for fund managers who match and send settlement instructions early. European custodian banks contacted by FinOps declined to comment on the proposal or their plans.

As with most new rules, there will be technology investments involved. If fines are to be passed on to to fund manager customers, making them ante up for their own post-trade inefficiencies, custodians and broker-dealers will need to adapt their middle- and back-office accounting, safekeeping, settlement, reconciliation and reporting applications to tabulate the amounts correctly and inform clients. The depositories, in turn, must keep track of late matching instructions and adapt their systems for new fines for settlement fails.

With the deadline for a shorter settlement cycle just around the corner for many European countries, European depositories, their bank and brokerage members and their fund manager clients have little time to get ready. Not knowing when the new fines must be imposed will make such preparations even harder.

The European Commission has yet to indicate whether the new settlement regime will become effective before T2S is implemented, during the three-wave implementation between June 2015 and June 2017, or after June 2017. European depositories and financial firms prefer the latter. They don’t want to have to make any IT and operational changes to accommodate the new settlement regime during a transitional period. In fact, European securities depositories are urging the ECB to make T2S, not the depositories themselves, responsible for calculating and imposing fines for failing to match trades on time.

“It’s all up in the air, and we are resentful about having to handle the potential new settlement matching fines and changes to settlement fail fines while preparing for T2S,” one custodian bank operations specialist privately tells FinOps. “The last thing we need is to have confused and annoyed fund management clients on our hands.”