Operations, technology, legal and network managers at custodian banks and broker-dealers are starting to feel penalized when it comes to all the data collection, reconciliation and numbers crunching work they must do to pass along to their clients the new fines for settlement fails required by Europe’s Central Securities Depository Regulation (CSDR).
One of the CSDR’s goals — harmonizing the methodologies used by European securities depositories to calculate fines for firms that fail to settle their securities transactions on the intended day — will come at a hefty administrative, if not financial cost to member firms as well as the market infrastructures. No pain no gain is the CSDR’s mantra.
Dealing with new settlement penalties is one of the two critical tasks financial intermediaries will encounter in complying with the CSDR and the most difficult one.The other– reporting on trades which settle on time or fail to settle on time on their books outside of European securities depositories — is considered far easier to address as all the information is likely available. It will just be a matter of consolidating and reformatting.
Come January 2020, custodian banks and broker-dealers can breathe a sigh of relief that they will no longer have to deal with the different formulas European securities depositories use to calculate fines for settlement fails. Those discrepancies often require financial intermediaries to use a multitude of systems or even manual intervention to do their own math. They can only hope they used the correct figures for the right clients. In some cases, operations managers at custodian banks tell FinOps Report, clients can’t be fined because European securities depositories provide either insufficient or unclear information on the affected transaction.
Now comes the hard part. To benefit from the new uniform methodologies, penalties, custodian banks and broker-dealers must either tweak existing systems, build, or license new ones so they can collect the data on the settlement fails, interpret it, and correctly allocate the fines. It is expected that European securities depositories, who must also adapt their own systems, will inform their members about any settlement fails daily, but allocate any fines on a monthly basis.
The amount of the fine for a settlement fail will depend on the value of the 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 corporate bonds. Transactions involving government bons will incur the lowest fines.
Custodian banks and broker-dealers can’t take any data or fines at face value. They will have the extra burden of reconciling any discrepancies. It remains to be seen whether they will have sufficient information about the failed transaction and who is responsible to verify the accuracy of the fine and allocate it to the right client.
Global custodians, which rely on local agent banks to link to European securities depositories, must verify whatever information their agent banks provide with whatever data they have on hand. Those agent banks, in turn, will have to rely on data from European securities depositories. “Neither ESMA nor the European Central Securities Depositories Association have provided any specifications on what the penalty reports will look like,” says Mariangela Fumagalli, head of regulatory custody solutions for BNP Paribas Securities Services in London.
ECSDA, the trade group representing European securities depositories, is working with ESMA on clarifying the operational requirements for European securities depositories in implementing the CSDR.
Of course, at a minimum custodian banks and broker-dealers will need to explain any change in fines to their clients over the next few months and alter their contracts accordingly to explain the new obligations. Cients who were either never charged for settlement fails or charged far less than they will be under the new settlement fails regime will have plenty of questions, if not gripes to address with their front-line relationship managers. Legal counsels will be busy answering late night calls asking how to explain the new requirements without causing any relationship damage.
For the first time ever, custodian banks and broker-dealers will also need to inform clients that their “receiving trading parties” or parties which never got securities on time that their trade failed to settle on time. The receiving trading party would then be required to do a buy-in either four or seven days after the intended settlement date depending on the liquidity of the financial instrument involved.
Custodian banks and broker-dealers shouldn’t think that the deadline for implementing the new “settlement penalty regime gives them sufficient breathing room to make any tech changes. Not only do they lack the specifications on the fails reports they will receive, but some information from the pan-European securities watchdog European Securities and Markets Association on how European securities depositories should implement the legislation. That information from the organization responsible for establishing nitty-gritty rules on compliance rules with European regulations, is necessary for custodians to know whether a few tweaks or major overhaul of their middle and back office systems will be required.
“We are waiting on a number of open items which prevent us from finalizing our decisions on how to implement the new settlement fines regime,” says Fumagalli. Three uncertainties top the list of worries. One is whether the new settlement fines regime must be used for trades in non-European securities settled in domestic European or international securities depositories such as Euroclear Bank in Brussels and Clearstream in Luxembourg. The other concern, says Fumigalli, is whether European securities depositories, which are not using the T2S settlement system implemented by the European Central Bank can calculate fines using internal systems or must use the T2S platform to do so.
About twenty European securities depositories use the ECB’s single consolidated settlement platform T2S as their core settlement systems and the ECB is adjusting T2S to accommodate the CSDR’s new rules on settlement fail penalties. However, international securities depositories Euroclear Bank in Brussels and Clearstream in Luxembourg do not rely on T2S.
The most problematic unknown for financial intermediaries is whether European securities depositories, such as the National Bank of Belgium, which already implement fines for trades that settle late can maintain their own methodology as well as the CSDR’s. Allowing any accommodations would ease the stress those depositories would face in revamping their existing settlement fines process, but contradict the spirit of the CSDR. Custodian banks and broker-dealer would also retain the onus of handling multiple penalty methodologies.
European securities depositories contacted by FinOps Report either declined to discuss their preparations for the CSDR’s settlement fail penalties or provided few details. Clearstream, which also owns Germany’s national depository offered the publication the following brief explanation: “Clearstream will make technological adjustments where necessary to allow for new processes such as penalty handling. For the T2S business, Clearstream will leverage the T2S solution where possible. Settlement fail reports provided by Clearstream to its clients will include various information such as failure time, the reason, amount and rate.”
As if custodian banks and broker-dealers didn’t have enough trouble dealing with new fines for settlement fails, they will also face an entirely new twist to the concept of fines. The damaged counterparty which didn’t receive cash or securities must be credited the settlement fine paid by the guilty counterparty. Because such a scenario differs from today’s practice where only the responsible member might be debited a fine, custodian banks and broker-dealers will have to do some new smart math. That means financial intemediaries must decide which netting methodology, if any, they will use to debit and credit the fines.
“We are evaluating three different methodologies for doing the calculations,” explains James Cunningham, senior advisor in BNY Mellon’s Office of Public Policy and Regulatory Affairs in London. Here is how each would work: under one methodology, the bank could net credits and debits for each fund manager or client from all its counterparties so that the fund manager would either be debited a payment or credited a payment each month. Yet another methodology would allow BNY Mellon to credit and debit each client each month. The third methodology would let BNY Mellon to debit and credit each fund manager or other client based on a counterparty by counterparty basis. Cunningham insists that the type of methodology would not affect the value of the debit or credit BNY Mellon allocates to clients.
Ultimately, custodian banks and broker-dealers will face the age-old challenge of whether to build their own systems to handle the new settlement fine regime or rely on third-party technology. Cunningham says that BNY Mellon will rely on a single platform to replace largely manual procedures while Fumagalli says that BNP Paribas has not decided whether to adjust its existing platforms used in different markets or create a new single one.
One UK-based software provider specializing in tax and claims technology says that it has come up with a quick seamless turnkey solution it is marketing to securities depositories, banks, broker-dealers and fund managers.
“Compliance with the CSDR’s settlement fines regime won’t be a differentiator and using a platform whose design leverages proven technology and broad client feedback will outweigh the risks and costs of building and maintaining in-house systems,” says Daniel Carpenter, a director at Meritsoft in London.
Meritsoft’s new CSDR Penalty Manager, which leverages its core FINBOS cash management tracking application, will receive fail notifications from settlement systems, validate fails and associated data and calculate any penalties on a daily or intraday basis. The penalties can then be communicated to any clients. Global custodians, broker-dealers and fund managers will be able to reconcile and correct any discrepancies in fines. A buy-in module of the new platform will notify the correct parties as to the need for a buy-in.
Calculating the fines correctly will depend largely on not only having the right data, but communicating it effectively. That’s where everyone affected– the European Central Bank, European securities depositories and their members– must be ready to deal with new message protocols or changes to existing ones. Paul Janssens, program director at SWIFT, says that the La Hulpe, Belgium-headquartered global network message provider is working with the ECB and other national central banks to create a new ISO 20022-compliant message for the ECB’s T2S platform to notify European securities depositories about failed trades and penalties. SWIFT will be adapting its current ISO 15022-compliant MT 537 statement of pending transactions and its MT 548 statement status and processing advice to allow users to add information about the failed trades and penalties. SWIFT is also changing other ISO 15022- compliant messages to harmonize the “qualifiers” or data on buy-ins.
Janssens says that all the changes to the ISO 15022 message types should be available in November 2019 as part of SWIFT’s standards release; therefore financial firms have some time to adapt their middle and back-office systems. European securities depositories and their member firms will likely need to do even more work to prepare to reformat any messages received in the ISO 20022 protocol from the European Central Bank’s T2S platform to ISO 15022 message types. Not all firms can process ISO 20022-compliant messages.
As is the case with calculating settlement fines, financial intermediaries will have to decide whether to rely on in-house resources or third-party systems to do any message reformatting. “Translating from ISO 20022 message types to ISO 15022 message types is difficult, because the ISO 20022 messages are often much richer in the type of information they can contain,” says Fiona Hamilton, the London-based research director and vice president of European and Asian operations for Volante Technologies, a message transformation and payments processing technology firm.
Volante’s message plug-ins will be ready to support changes to the ISO 15022 messages and the new ISO 20022 message necessary to comply with the CSDR’s new settlement fines regime. Volante’s message transformation system will also allow users to find information that might be lost in the translation between ISO 20022 and ISO 15022 message types through a dashboard, says Hamilton.
Given all the technological and messaging adaptations, European securities depositories, custodian banks and broker-dealers must make to accommodate the CSDR’s new settlement penalties regime, it stands to reason that all end investors will ultimately have to pay the bill. European securities depositories and their members could end up having to raise some of their own fees to compensate for IT development and potential higher fees from the European Central Bank’s T2S system.
The CSDR will certainly disincentivize any firms that consistently fail to settle on time from continuing their bad behavior. However, only time will tell whether the intended benefit of reducing the number of settlement fails outweighs the extra expense for the efficient as well as the inefficient market players.