Prevention is better than cure
28 April 2021
CSDR SDR is set to improve settlement efficiency, but disparity remains among market participants in terms of readiness for the regulation. However, one thing is certain — prevention is better than cure
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Introduced in 2014, the Central Securities Depositories Regulation (CSDR) supplies a set of high and consistent standards across compliant CSDs.
This provides assurance from the regulators to investors that stringent measures are in place to ensure the security of their assets and the efficiency of transactions. The regulatory framework aims to bring risk and cost reduction benefits to financial markets as a whole.
In February 2022, the third phase of CSDR, the Settlement Discipline Regime (SDR), will be rolled out. SDR is set to provide common requirements for CSDs operating securities settlement systems across the EU, with the aim of harmonising aspects of the settlement cycle and mitigating settlement risks.
But with less than a year to go before the SDR go-live, confusion and concerns remain around the practical processes that will need to be followed for the buy-in regime.
DTCC’s director of institutional trade processing product management Matt Johnson suggests the level of preparedness varies considerably depending on the size of the firm.
“Large sell-side and buy-side firms seem to have made good progress with their preparations. However, some smaller regional brokers and buy-side firms appear to be lagging. With less than 10 months to go before implementation, this is concerning,” Johnson says.
Mandatory buy ins
Among the SDR measures to improve settlement efficiency is the provision for mandatory buy-ins. It has been argued that buy-ins, whether regulatory or contractual, should be discretionary and not mandatory.
A buy-in is a ‘contractual remedy’ available to a purchasing counterparty of financial securities in the event that the selling counterparty fails to deliver the securities. The aim is to restore the counterparties to the transaction to the economic position they would have been in had the original transaction settled.
Recent responses from the European Commission’s CSDR consultation found that 51 out of 91 respondents want the buy-in regime to change from a mandatory requirement to a voluntary one. Responses from the consultation, which ran from 8 December last year to 1 February this year, also showed that 14 respondents requested the buy-in regime be retained while 26 either did not respond or were neutral. Meanwhile, 69 respondents felt that a revision of the SDR, which the buy-ins fall under, is necessary. Only seven were in disagreement.
Discussing the opposition to the mandatory buy-in protocol, Matthew Pountain, head of product management, European post-trade, Broadridge Financial Solutions, says there are three main aspects to that.
“One is practical; at the moment it looks very difficult to implement, transactions often exist as part of a chain and many people will find themselves at the mercy of other parts of the full end-to-end asset flow. Another is cost; operationally it will require significant additional effort at a time when the industry is still not making its target returns. And then of course there are the service/relationship management aspects — invoking a buy-in against a key client is not really a conversation that account managers want to be having,” affirms Pountain.
Daniel Geddes, global head of product management, Torstone Technology, also highlights that it will cause problems with the chain, suggesting that the buy-in protocol is “problematic in many ways”.
Where a central clearing counterparty (CCP) is in a transaction chain between the buyer and seller, a buy-in notice cannot be passed through the chain as CCPs themselves cannot be bought-in, which Geddes explains is a concern to broker dealers exposing themselves to the risk of being bought-in by their customers, but not being able to pass this on down the chain to the ultimate failing party. Furthermore, where an order fails to settle over a long period of time this can often be attributed to a lack of sellers in the market and the unavailability of stock to borrow.
Geddes suggests that passing this responsibility onto another party will not bring new liquidity to the market, it will just move the problem to someone else at great administrative cost.
Prevention is better than a cure
In addition to the troubles and doubts around the buy-ins, some industry experts have argued that the CSDR itself has still not brought about any real changes in behaviour just yet.
Speaking during the panel at the DTCC CSDR Series 2021 in March, Martin Smith, head of Europe Middle East and Africa and Asia Pacific (APAC) trade support, BNY Mellon, said: “The industry would like to start seeing trade fails come down to the point where the industry’s investment into this space will kick in but I’m certainly not seeing this yet.”
He warned that if the industry does not see this towards Q3 2021 then February next year could be a worry.
Broadridge’s Pountain says: “I think that’s true. While CSDR has certainly added focus to the need for improved processes to manage settlement, there has been a tendency to focus on dealing with the fines or the buy-in process rather than avoiding failures in the first place. Unfortunately the COVID-19 pandemic has really given firms a lot to deal with this past year, and that has probably left some of them addressing what they ‘must’ do rather than what they ‘could’ do.”
DTCC’s Johnson observes: “There seems to be a great disparity among market participants in terms of readiness for the regulation. However, one thing is certain — prevention is better than a cure. Therefore, firms would benefit from automating as much of their post-trade processes as possible ahead of the SDR implementation date in February 2022.”
This includes adopting automated solutions for the management of standing settlement instructions (SSIs), as inaccurate SSI data is often a primary reason for trade failures.
According to Johnson, focusing on improving same day matching and affirmation capabilities would also be beneficial, to ensure trades are instructed accurately on execution date, and to allow time for inventory management and exception resolution.
Challenges and benefits
Experts anticipate challenges in herding the entire industry in the right direction at the same time and momentum with the regulation.
In the short term, Karan Kapoor, head of regulatory change and regtech at Delta Capita, anticipates implementation of teething challenges around processing new penalty messages, new claims processes.
“The buy-in regime as it currently stands, if it goes live, will create confusion due to the lack of buy-in agent options in the market, likely impacts to the liquidity of low liquidity instruments — as the fear of buy-ins will deter the sell side to make markets in such instruments such as low liquidity debt instruments,” he says.
The time and effort spent on resolving unmatched and/or failing trades is costly and will require many firms to provide up-front investment in process improvements, according to Kapoor.
In terms of benefits, of CSDR’s SDR, experts say that the focus on the full settlement lifecycle, which really starts right from client-onboarding, will drive up straight-through processing (STP) rates and ultimately reduce costs.
DTCC’s Johnson adds: “Because of the threat of financial penalties for late settlement, market participants are taking a very close look at any inefficiencies in their post-trade processes, which have created operational costs and risks for many years. We anticipate that many firms will address long standing manual or operational challenges in advance of CSDR, bringing new levels of efficiency and risk reduction.”
The long-term view
While some of the immediate challenges and benefits of CSDR’s SDR seem clear, questions have been raised in regards to whether the industry is proactively building on what the long term view will be and whether tactical decisions are being made in this regard. Kappor believes industry participants definitely realise the benefits of long term strategic thinking while addressing the CSDR SDR challenge. However, as the industry is facing significant cost constraints, it is a case of striking a careful balance.
“We’d have to say that in our experience a hybrid approach is being taken. Tactical steps are definitely being pursued to get compliance ready in time but phased strategic initiatives are also being mobilised. As a firm that provides cutting edge technology solutions as well as consulting services — we are finding ourselves best placed to support clients with both approaches,” says Kapoor.
Johnson suggests that while a tactical approach to responding to regulatory change may be less daunting in the short-term, it will likely be more costly and onerous in the mid-to-long term.
He says: “Market participants should aim to respond to CSDR by building a post-trade infrastructure based on a medium-to-long-term view, which could ensure it is both future-proofed and scalable.”
Weighing in on this, Pountain notes that there is a risk that specific builds directly tied to regulatory compliance could prove to be ‘tactical’ or at least ‘sub-optimal’ given the current lack of clarity on how market practice will evolve to implement the regulations, but really any investment a firm is making to improve its settlement efficiency and STP rates should pay dividends anyway.
Faster settlement
With lots of hard work and effort going on in this space to ensure a smooth go-live date for CSDR’s SDR, some industry participants believe CSDR is going to work towards moving towards faster settlement times as well as greater risk elimination. DTCC has made it clear that it supports a move to T+1 for securities transactions due to the benefits it will deliver, such as significant risk reduction and a lowering of margin requirements, as well as capital and operational efficiencies.
Whether other markets follow suit remains to be seen but, as the saying goes, “nothing good happens between trade date and settlement”.
Johnson highlights that if settlement time can be reduced to T+1, there will be a number of benefits including a subsequent reduction in both operational risk and cost while freeing up capital.
Pountain concludes: “Bringing greater efficiency, improving STP rates for the settlement lifecycle should certainly enable the adoption of T+1 as standard settlement practice. Moving further to T+0 or beyond to real-time settlement brings very different challenges, not least in market liquidity, that will need to go beyond optimising current processes in order to resolve. I believe those changes are coming but on a much longer time horizon than moves to T+1.”
This provides assurance from the regulators to investors that stringent measures are in place to ensure the security of their assets and the efficiency of transactions. The regulatory framework aims to bring risk and cost reduction benefits to financial markets as a whole.
In February 2022, the third phase of CSDR, the Settlement Discipline Regime (SDR), will be rolled out. SDR is set to provide common requirements for CSDs operating securities settlement systems across the EU, with the aim of harmonising aspects of the settlement cycle and mitigating settlement risks.
But with less than a year to go before the SDR go-live, confusion and concerns remain around the practical processes that will need to be followed for the buy-in regime.
DTCC’s director of institutional trade processing product management Matt Johnson suggests the level of preparedness varies considerably depending on the size of the firm.
“Large sell-side and buy-side firms seem to have made good progress with their preparations. However, some smaller regional brokers and buy-side firms appear to be lagging. With less than 10 months to go before implementation, this is concerning,” Johnson says.
Mandatory buy ins
Among the SDR measures to improve settlement efficiency is the provision for mandatory buy-ins. It has been argued that buy-ins, whether regulatory or contractual, should be discretionary and not mandatory.
A buy-in is a ‘contractual remedy’ available to a purchasing counterparty of financial securities in the event that the selling counterparty fails to deliver the securities. The aim is to restore the counterparties to the transaction to the economic position they would have been in had the original transaction settled.
Recent responses from the European Commission’s CSDR consultation found that 51 out of 91 respondents want the buy-in regime to change from a mandatory requirement to a voluntary one. Responses from the consultation, which ran from 8 December last year to 1 February this year, also showed that 14 respondents requested the buy-in regime be retained while 26 either did not respond or were neutral. Meanwhile, 69 respondents felt that a revision of the SDR, which the buy-ins fall under, is necessary. Only seven were in disagreement.
Discussing the opposition to the mandatory buy-in protocol, Matthew Pountain, head of product management, European post-trade, Broadridge Financial Solutions, says there are three main aspects to that.
“One is practical; at the moment it looks very difficult to implement, transactions often exist as part of a chain and many people will find themselves at the mercy of other parts of the full end-to-end asset flow. Another is cost; operationally it will require significant additional effort at a time when the industry is still not making its target returns. And then of course there are the service/relationship management aspects — invoking a buy-in against a key client is not really a conversation that account managers want to be having,” affirms Pountain.
Daniel Geddes, global head of product management, Torstone Technology, also highlights that it will cause problems with the chain, suggesting that the buy-in protocol is “problematic in many ways”.
Where a central clearing counterparty (CCP) is in a transaction chain between the buyer and seller, a buy-in notice cannot be passed through the chain as CCPs themselves cannot be bought-in, which Geddes explains is a concern to broker dealers exposing themselves to the risk of being bought-in by their customers, but not being able to pass this on down the chain to the ultimate failing party. Furthermore, where an order fails to settle over a long period of time this can often be attributed to a lack of sellers in the market and the unavailability of stock to borrow.
Geddes suggests that passing this responsibility onto another party will not bring new liquidity to the market, it will just move the problem to someone else at great administrative cost.
Prevention is better than a cure
In addition to the troubles and doubts around the buy-ins, some industry experts have argued that the CSDR itself has still not brought about any real changes in behaviour just yet.
Speaking during the panel at the DTCC CSDR Series 2021 in March, Martin Smith, head of Europe Middle East and Africa and Asia Pacific (APAC) trade support, BNY Mellon, said: “The industry would like to start seeing trade fails come down to the point where the industry’s investment into this space will kick in but I’m certainly not seeing this yet.”
He warned that if the industry does not see this towards Q3 2021 then February next year could be a worry.
Broadridge’s Pountain says: “I think that’s true. While CSDR has certainly added focus to the need for improved processes to manage settlement, there has been a tendency to focus on dealing with the fines or the buy-in process rather than avoiding failures in the first place. Unfortunately the COVID-19 pandemic has really given firms a lot to deal with this past year, and that has probably left some of them addressing what they ‘must’ do rather than what they ‘could’ do.”
DTCC’s Johnson observes: “There seems to be a great disparity among market participants in terms of readiness for the regulation. However, one thing is certain — prevention is better than a cure. Therefore, firms would benefit from automating as much of their post-trade processes as possible ahead of the SDR implementation date in February 2022.”
This includes adopting automated solutions for the management of standing settlement instructions (SSIs), as inaccurate SSI data is often a primary reason for trade failures.
According to Johnson, focusing on improving same day matching and affirmation capabilities would also be beneficial, to ensure trades are instructed accurately on execution date, and to allow time for inventory management and exception resolution.
Challenges and benefits
Experts anticipate challenges in herding the entire industry in the right direction at the same time and momentum with the regulation.
In the short term, Karan Kapoor, head of regulatory change and regtech at Delta Capita, anticipates implementation of teething challenges around processing new penalty messages, new claims processes.
“The buy-in regime as it currently stands, if it goes live, will create confusion due to the lack of buy-in agent options in the market, likely impacts to the liquidity of low liquidity instruments — as the fear of buy-ins will deter the sell side to make markets in such instruments such as low liquidity debt instruments,” he says.
The time and effort spent on resolving unmatched and/or failing trades is costly and will require many firms to provide up-front investment in process improvements, according to Kapoor.
In terms of benefits, of CSDR’s SDR, experts say that the focus on the full settlement lifecycle, which really starts right from client-onboarding, will drive up straight-through processing (STP) rates and ultimately reduce costs.
DTCC’s Johnson adds: “Because of the threat of financial penalties for late settlement, market participants are taking a very close look at any inefficiencies in their post-trade processes, which have created operational costs and risks for many years. We anticipate that many firms will address long standing manual or operational challenges in advance of CSDR, bringing new levels of efficiency and risk reduction.”
The long-term view
While some of the immediate challenges and benefits of CSDR’s SDR seem clear, questions have been raised in regards to whether the industry is proactively building on what the long term view will be and whether tactical decisions are being made in this regard. Kappor believes industry participants definitely realise the benefits of long term strategic thinking while addressing the CSDR SDR challenge. However, as the industry is facing significant cost constraints, it is a case of striking a careful balance.
“We’d have to say that in our experience a hybrid approach is being taken. Tactical steps are definitely being pursued to get compliance ready in time but phased strategic initiatives are also being mobilised. As a firm that provides cutting edge technology solutions as well as consulting services — we are finding ourselves best placed to support clients with both approaches,” says Kapoor.
Johnson suggests that while a tactical approach to responding to regulatory change may be less daunting in the short-term, it will likely be more costly and onerous in the mid-to-long term.
He says: “Market participants should aim to respond to CSDR by building a post-trade infrastructure based on a medium-to-long-term view, which could ensure it is both future-proofed and scalable.”
Weighing in on this, Pountain notes that there is a risk that specific builds directly tied to regulatory compliance could prove to be ‘tactical’ or at least ‘sub-optimal’ given the current lack of clarity on how market practice will evolve to implement the regulations, but really any investment a firm is making to improve its settlement efficiency and STP rates should pay dividends anyway.
Faster settlement
With lots of hard work and effort going on in this space to ensure a smooth go-live date for CSDR’s SDR, some industry participants believe CSDR is going to work towards moving towards faster settlement times as well as greater risk elimination. DTCC has made it clear that it supports a move to T+1 for securities transactions due to the benefits it will deliver, such as significant risk reduction and a lowering of margin requirements, as well as capital and operational efficiencies.
Whether other markets follow suit remains to be seen but, as the saying goes, “nothing good happens between trade date and settlement”.
Johnson highlights that if settlement time can be reduced to T+1, there will be a number of benefits including a subsequent reduction in both operational risk and cost while freeing up capital.
Pountain concludes: “Bringing greater efficiency, improving STP rates for the settlement lifecycle should certainly enable the adoption of T+1 as standard settlement practice. Moving further to T+0 or beyond to real-time settlement brings very different challenges, not least in market liquidity, that will need to go beyond optimising current processes in order to resolve. I believe those changes are coming but on a much longer time horizon than moves to T+1.”
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