By Matt Johnson, Associate Director, ITP Product Management, DTCC

With just over one year to go before the implementation of the Settlement Discipline Regime (SDR), the buy-side needs to be focused on maximising their settlement efficiency in order to avoid the cost of penalties for trades which fail to settle on time. 

As far as penalties for SDR are concerned, market participants will be liable to pay penalties or charges against each transaction which fails to settle under the mandated T+2 timeframe – an earlier component of CSDR which entered into force in October 2014. A penalty will be charged daily based on the asset class/security type and notional value of the transaction up until the buy-in process is initiated. Further, SDR has no thresholds so every failed trade, even a trade with a value of €1 that fails to settle will incur a penalty.

SDR’s unofficial aim is to raise settlement rates from about 97.5% to more than 99%. This target has never been officially stated in the legislation or any of its accompanying documentation though, most likely because an accurate settlement rate is hard to calculate as the requisite level of detail isn’t provided by all of Europe’s CSDs However, the latest statistics released by the European Central Bank (ECB) on their Target2-Securities (T2S) platform suggest that industry participants may have a long way to go in terms of reaching such rates of settlement efficiency - the Market Settlement Efficiency Indicator (MSEI) for 2019 was 93.27%, versus 93.53% in 2018.  Further, given the Covid-19 induced market volatility which occurred in March and April of this year, the settlement failure rates are likely to be considerably higher in 2020.

Based on the penalty rates calculated in the SDR and the latest statistics from the ECB, this could mean huge costs to the industry. 

The T2S MSEI for 2019 indicated a fail rate of 6.73%. When SDR failed-trade penalties are factored into the average daily T2S trade volume (number of transactions) of 607,000 and average cash value of €1.12 trillion (£980 million), the numbers become alarming. If we assumed that every trade that failed in T2S was a vanilla equity, they would incur a 1 basis point penalty for each day the trades failed. This would mean the post trade market would be dealing with penalties worth €7.5 million per day. Multiply this daily figure by a 22-day working month, and the number leaps to €166 million per month. Another very important point to note is T2S only covers half of the European market. The failure rate across the other CSDs is unknown, but would need to be factored in.

So, how can buy-side organisations best improve their settlement efficiency rates? First, they need to conduct an assessment of their post trade processes, followed by an analysis of reasons for failed trades. Research that DTCC has conducted amongst our client base identified that the most common reasons behind these fails were missing or incomplete standing settlement instructions (SSIs), manual processing in trade matching and post trade processes being managed across different platforms. The good news is that the buy-side can address these issues by switching from manual to automated processes for trade matching and confirmation. Automation adds efficiency and transparency, and available solutions can improve data management, reinforcing internal audit protocols and bolstering risk management.   

DTCC’s CTM™ service has been helping clients achieve full confirmation and affirmation automation for many years. By using CTM’s robust straight through processing capabilities to get trades agreed and pre-matched for settlement as close to execution as possible, firms have been able to mitigate the risk of settlement failure. In addition, enhanced exception management solutions—where a problem trade is highlighted as early as possible and rectified quickly to achieve timely settlement—will be essential to mitigate settlement risk. As testament to this, we have seen an increased uptake in our DTCC Exception Manager service, which enables clients to publish, manage and communicate on exceptions throughout the trade lifecycle with 15 custodians, three brokers, and four prime brokers all actively submitting data into the platform and 42 buy-side clients consuming this data.

Further, automation can also strengthen processing chains by locking-in settlement instructions and fortifying the underlying data, while SSIs ensure that trade settlements, collateral and payments are sent to the correct accounts. This latter point is crucial as SSIs change frequently and therefore automation ensures that account instructions are up-to-date and accurate, enabling timely settlement to take place. In order to address this issue, when DTCC CTM is used in conjunction with ALERT Key Auto Select (AKAS), trades can be automatically enriched with both sets of instructions ensuring all account information is accurate. 

There is no doubt that to be ready for the February 2022 SDR implementation deadline, the buy-side needs to have already conducted an analysis of their post trade processes in order to expose any weaknesses, allowing sufficient time for them to be addressed. However, a recent survey DTCC conducted on the buy-side’s readiness for SDR indicated that some firms still have significant work to do in order to achieve compliance ahead of the regulation’s implementation.  When asked in the survey, 43% of buy-side firms had no indication of how the financial penalties incurred for late settlement would be communicated.

For those members of the buy-side that intend on working with an external provider to increase post trade efficiency, the selection process for this needs to be completed by the end of March 2021 to provide ample time for onboarding and for testing to start in June, just over six months prior to SDR implementation. For market participants to have true confidence in their readiness for SDR implementation, they should choose to work with established providers that have a proven track record of creating post trade efficiencies and a large community of users across both the buy-side and sell-side. Only then can they approach the forthcoming SDR deadline with true confidence.