The European Commission has published proposals for improving securities settlement and access to Central Securities Depositories (CSDs – the entities that operate settlement systems) in order to reduce the current high rates of trade failure, costs and operational risks, particularly on cross-border transactions. The proposed rules, termed CSDR (Central Securities Depositories Regulation), are currently with the European Parliament and Council for discussion with the next steps likely to involve the establishment of a taskforce to develop the specific rules.
The major item of note within the proposals is the shortening of the securities settlement period across Europe to 2 days (T+2). The introduction of financial penalties for trades which fail to settle on time has been supported by a majority of market participants and is seen to encourage faster and more efficient settlement practices which will lower counterparty risk.
Germany, Bulgaria and Slovenia already have a T+2 settlement policy so there is a precedent within Europe that proves this can work, adding weight to the proposal for the remaining 26 member states to follow suit. A deadline of 1 January 2015 has been set for this, though participants may need to have capabilities in place as early as mid-2014 as this is also a prerequisite for T2S (Target2 Securities) which is also due to go live early in 2015.
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Will asset managers be ready for a transition to T+2 by this time? Staffing levels, or other commitments to mandatory or discretionary projects will all affect asset managers’ ability to make system changes and amend processes to accommodate a move to T+2. Specifically the changes will need to address:
* same day affirmation, requiring verification of the trade to be completed on the same day the trade is executed;
* a potentially substantial increase in the number of trade failures – front offices are currently struggling to confirm and settle those trades at T+3;
* pressure on STP workflow – resulting in a higher number of settlement failures due to inefficiencies in systems or data issues;
* administration of additional fines levied for not reaching T+2.
The above may be very costly. A ThomsonReuters Risk Management report published in October 2011 claimed that on average across US capital markets: 60% of instructions needed repairing; 10% of confirmations were mismatched; and 15% of trades failed to reach settlement. For an institution making 10,000 trades per day this equates to an annual cost of approximately $4.8m, not to mention an immense risk burden.
T+2 will also have an impact outside of Europe. Cross border transactions will also need to be brought into line with the T+2 deadline. Additionally there are discussions reopening in the US around shortening their limit from T+3 to T+2.
So is the European asset management community ready for T+2? Current settlement periods in Europe are shown in the table below:
Source: CSD Statistics Exercise, ECSDA, February 2010
ESES = Euroclear’s single settlement platform
SCLV/CADE = two platforms operated by Iberclear
Following consultation, the British Bankers’ Association agrees with the move to T+2, however it does not support a standard settlement cycle of T+2 for over-the-counter (OTC) trades. They believe“there is little-to-no evident risk associated with non-standard settlement cycles in the OTC market. More seriously, not only is there no compelling economic case for OTC settlement cycles to be standardised on a T+2 basis, legitimate and economically desirable trading activities may also be hindered or rendered practically impossible by such a stipulation.
These trading activities include:
Repo trading: In many cases, neither leg of a bilateral repo trade will settle on a T+2 basis. Given the CSDR’s prime objective of enhancing the safety and stability of financial markets, it would be a perverse outcome if repo trading – a crucial tool in risk mitigation and exposure management – was inadvertently prohibited due to its unsuitability to settle according to the T+2 standard. This exemption also needs to apply to exchange traded repos, which again, cannot settle on a T+2 basis.
Trades which are agreed off regulated markets, MTFs, and OTFs and according to their rules but are executed on regulated markets, MTFs, OTFs: These types of trade are, in practice, OTC trades, with parties to such transactions free to agree their own terms and conditions. This flexibility is a crucial tool for investors and is a vital component within risk mitigation and strategic hedging strategies.
Pre-IPO trading: Where transactions are agreed before the securities are issued, i.e. the issuances date of the securities, therefore there are no actual securities to settle by T+2.
Trade in illiquid securities: This is of particular concern, as the illiquid securities market is a vital tool in the financing of small to medium enterprises”
As is highlighted above, the European Commission has so far not presented clear intentions for treatment of these types of trade and where exemptions will apply. The BBA has therefore recommended that policy makers exempt all OTC trades from the T+2 settlement period requirement.
Until a more complete picture is given as to how the T+2 restriction is intended to function, how much work will be involved within the asset management industry to make this happen for basic bonds, equities and funds cannot be assessed. It can be assumed that although additional work will be required in the initial period to reassess processes and gain efficiencies, the deadline should be achievable. Should the European Commission disagree with BBA then an increased amount of work may well put the deadline at risk.
Kevin Archibald, Senior Consultant, Citisoft