Europe’s CSDR: Fund Managers Monitor Settlement Fails

Operations managers at fund management firms are scrambling to improve how they monitor settlement fails and prevent penalties imposed by their custodian banks just around the corner as mandated under Europe’s Central Securities Depository Regulation (CSDR).

A dozen European fund management firms,who spoke with FinOps Report on condition of anonymity, say they are spending more time negotiating with counterparties and custodian banks to determine the cause of failed settlements, to verify whether the data is accurate, and to predict when failed settlements might occur. Their goal is to reduce the number of failed settlements which could spell extra fees on their March invoices. “Fund managers are likely receiving data on failed settlements on a daily basis, so they shouldn’t be too surprised if they do get hit with a penalty later this month,” says Daniel Carpenter, head of regulation at software firm Meritsoft, a Cognizant company focused on fails management, tax reclaims and data analytics.

Several custodian bank operations managers confirmed they have started to keep track of settlement fails and penalties with their fund manager clients. Talk by some fund managers of early delays in daily reporting of settlement fails and penalties from some of their custodian banks due to operational glitches at the outsourced Target 2-Securities settlement platform run by the European Central Bank could not be independently verified. “We have been calculating penalties since February 1, and reconciling all penalty reports received from issuer central securities depositories, subcustodians, and international securities depositories on a daily basis,” says Mariangela Fumagali, head of asset servicing global product and regulatory solutions for global custodian and subcustodian BNP Paribas Securities Services in a statement to FinOps Report. “We report such to our clients via the SWIFT network or our portal NeoLink. All clients are encouraged to review and reconcile their penalty reports.” She would not say how any discrepancies would be addressed. Clearstream owns an international securities depository in Luxembourg and Germany’s domestic securities depository while larger rival Euroclear owns an international securities depository in Brussels and several European national securities depositories.

Effective February 1, national and international European securities depositories must add two new twists to their practice of asking participants — custodian banks and broker-dealers– to pay fines if they are responsible for preventing a transaction from settling on time, otherwise known as a settlement fail. Each European securities depository must rely on the same methodology for how to calculate the penalty to be paid by the member at fault— otherwise known as a debit. The depository must also compensate the affected party in the form of a credit to its account representing the same amount as the debit.

Fund managers, which might gotten a free ride for failing to settle a trade on time or paid very little, will likely have to reimburse their custodian banks and broker-dealers for the full amount of the charge imposed on a monthly basis after debits and credits are netted. The most operationally efficient fund manager may end up ahead at the end of each month if their custodian banks or broker-dealers determines that the credits they earn from counterparties at fault for failed settlements offset the debits for the fund manager’s mistakes.

The CSDR’s penalty regime applies to any trades which are settled in a European securities depository or cleared by a European clearinghouse if the securities were not transferred in time to meet a settlement obligation; the other reason for a settlement fail– not delivering cash on time– is not affected. European equity and fixed-income trades typically settle within two days after the day of execution and the amount of the penalty will depend on the value of the transaction and the type of financial instrument involved. Trades involving liquid European government bonds will typically be charged the least while European corporate bonds will be charged the most; equities will in between the two extremes.  The European Commission has delayed the controversial buy-in provisions of CSDR to rectify failed settlements, also set to become effective on February 1, by at least two years.

Based on the European Securities and Market Authority’s latest report, the average fail rate for European equities in 2021 was eight percent. While that rate was far lower than the 14 percent rate at the height of the Covid pandemic in March 2020, it is still high enough to cause fund management firms with active trading desks plenty of angst. An eight percent fail rate could translate into more than 10,000 Euros a month in higher fees from custodian banks, predicts one European fund management operations director. Yet another operations manager at a different European fund management firm says that based on the average eight percent rate his firm’s monthly bill from its custodians would be 20,000 Euros higher than usual. Neither operations manager would specify his firm’s settlement fail rate.

The first line of work for fund managers in dealing with the settlement penalty phase of CSDR will be to determine whether the additional charges levied by their custodian banks or broker-dealers are correct. Presumably, custodian banks and broker-dealers will be transparent about their methodology and data used, because fund managers aren’t members of securities depositories. Therefore, they will want to do their own calculations based on their own records. “We are reconciling the fees and data from custodian banks and broker-dealers with the data from our back-office platforms,” one European fund management operations director tells FinOps Report. When asked whether he expected there would be any discrepancies between his firm’s books and the custodian bank’s records, his response was a glib “Hope not.” Yet another fund management operations director says that his firm has set up procedures with custodian banks and broker-dealers for how to reconcile any penalties from settlement fails. “We are going over the data thoroughly to make certain the additional charges are accurate,” he says.

Discrepancies will likely be rare, because the books of the custodian bank or broker dealer which processed transactions should match those of its fund manager client. “All the fund manager has to do is verify that the trade actually failed to settle on time and was executed by the fund manager,” says Silvano Stagni, president of Perpetual Motion and Research Consulting, a regulatory consulting firm in London. However, mismatches between the records of the fund manager, its custodian bank or its broker-dealer can occur in the case of a securities lending transaction. Should the securities not be returned in time, the fund manager could  fail to settle the transaction by the designated date unless it acts quickly enough to borrow securities.” It  will be up to the custodian bank and fund manager to determine whether either of them is at fault for not recalling securities in time, Likewise, the borrower might be held accountable for not returning securities when asked.

If operations directors find that inefficiencies are too cost prohibitive, preventative measures will become the next course of action. One way to reduce settlement fails is to rely on automated platforms to quickly and accurately communicate the economics of the trade quickly, such as the US Depository Trust and Clearing Corporation’s Omgeo Central Trade Manager and smaller rival systems from Bloomberg and SS&C Technologies. Seven of the dozen European fund managers, who spoke with FinOps Report, say they are using CTM, while the remaining three say they are considering signing up. Yet another way to ensure that correct details are communicated about a transaction is to add automated standing settlement instructions (SSIs) involving the transfer of cash or securities. “The DTCC’s global SSI repository Alert increases the accuracy of trade data as the communication of account and settlement information is fully automated,” says a spokesman for DTCC in a statement to FinOps Report. “Data quality is increased as there are multiple levels of authorization which have been established for creating and updating settlement instructions within Alert.” DTCC would not specify how many fund managers are using the CTM or Alert, which has a slew of connectivity options to streamline the flow of information from custodian banks to Alert, prime brokers to their hedge fund clients, and non-Alert fund manager clients to Alert.

Predicting the possibility of a settlement fail can also go a long way. Meritsoft’s CSDR platform digitizes trade and settlement data across the bank and makes this available centrally so that analytics can be applied to identify where trades are failing to settle and why. So far, two undisclosed global custodians are using Meritsoft to communicate on potential European securities settlement fails with an unknown number of fund managers accessing the platform. Fund managers are also relying on their custodian banks as third-party service providers.

In 2018 BNP Paribas Securities Services launched a predictive analytics platform called Smart Chaser which uses a “Random Forest” algorithm to identify a subset of trades that might be in danger of failing to settle on time, to explain why, and to propose how to fix the problem. In 2020 the French headquartered bank told FinOps Report the platform was used by 80 fund managers which rely on the bank’s middle office services. BNP Paribas would not offer an updated figure by press time. BNP Paribas also uses Depository Trust & Clearing Corp’s predictive settlement fail analytics platform. The US market infrastructure for clearance and settlement, DTCC recently added a CSDR module to its Exception Manager platform which will calculate the potential fine for a failed settlement and prioritize operational work to prevent the fail based on the size of the fine. DTCC would not disclose how many firms are using the CSDR module of its Exception Manager platform.

For fund managers the settlement fails penalty phase of CSDR will mean a lot more work over the next few months if they haven’t prepared already. It is likely that all but the largest fund managers are behind their broker-dealers and custodian banks are making the necessary operational adjustments, so they are counting on their service providers to do the heavy lifting. Whether their new collective efforts will result in reducing settlement fails over the next few months remains to seen as trading volumes and volatility remain high. March invoices will either validate all their diligence or prove just how much more fund managers have to go before they can claim victory over the CSDR settlement fails penalty dragon,