Waters Technology – Marina Daras
The move to a shortened settlement period from three days to two, commonly referred to as T+2, is set to shake up the European buy-side community when it comes into force on October 6. Marina Daras looks at the impact T+2 could have on transaction processing for buy-side firms.
The transformation of the post-trade landscape in Europe is unprecedented. The advent of Target2–Securities—the pan-European project led by the European Central Bank (ECB) that will provide a single system for settling central bank securities transactions—and the first wave of new requirements stemming from the Central Securities Depository Regulation (CSDR), due to come into force at the start of 2015, will bring about many changes.
For buy-side firms, the initial challenge begins on the first deadline of October 6, the date from which 26 European markets currently trading on a T+3 settlement cycle will move to a T+2 cycle, reducing the whole post-trade process by one working day.
As the European Commission works to erase discrepancies between markets and reduce systemic risk, the first phase of harmonization, before it even addresses the issues around the current settlement system, is to homogenize the settlement period. With Bulgaria, Slovenia and Germany already successfully trading on a T+2 basis, it is the remaining European markets, with the exception of Spain, that have opted for later adoption of the move to T+2 in the third or fourth quarter of 2015, a change that will usher in a variety of new challenges for firms.
“There has been an ever-growing push to shorten settlement cycles and reduce the number of days between the moment you trade and the moment you settle the trade,” says Chris Smith, head of post-trade services at Trax, a trade matching and regulatory reporting vendor that is part of the MarketAxess Group. “It has been instrumental in reducing the risk, whether it is operational risk or counterparty risk, which are the principal risks associated with having a transaction outstanding for a number of days.”
Over the years, buy-side firms have adjusted their technology stacks to become more efficient in the face of compliance with a raft of regulations. But according to Smith, the small changes that need to be made in order to comply with the move to T+2 are not enough to cope with the speed implied by the new rules.
“The current automated post-trade systems mimic the T+3 cycle with slight updates to account for increased volume,” he says. “With T+2, we have to think about the process differently, as there is no time allowance to just speed things up a little bit. We actually have to think about the process in a slightly different way.”
Although the buy side is by now mainly automated, there are still a number of firms that don’t see a business case for automating their middle and back offices because they don’t believe they are being penalized for continuing to use manual processes, according to Tony Freeman, executive director of industry relations at Omgeo, a post-trade services provider owned by the Depository Trust and Clearing Corp.
“Sending faxes is not something you would regard as being a high level of automation for straight-through processing and yet it is still quite common because firms just don’t see a reason to change,” Freeman says. “For those firms, it isn’t simply a matter of technology—it is how you use it because behavior is probably the single biggest driving factor here. There are not real technological, operational, or legal barriers to fully automate the middle and back office—it’s a matter of willingness to do so.”
But even if trades can be settled on a near-real-time, or T+0, basis, when the terms of the trade can be agreed and when automated processes are involved, there is still a certain amount of uncertainty around the ability to process them all across different time zones and different currencies.
Although all of Europe will be trading on an equal settlement regime, the US will still be using a T+3 model, at least for some time to come, and Asian markets, although most settle on a T+2 basis, will operate in different time zones, which might complicate the exchange of trade information on a T+0 basis.
“I think firms are not worried about the vast percentage of trades that are actually already ready for settlement on T+2,” says David Pearson, strategic business architect at Fidessa and co-chair of the FIX Trading Community Post-trade Working Group. “It’s more about the remaining percentage of the trades where you have to chase people, where the processes are manual and therefore slower, and for which you are already struggling to gather all the information you have to pass on to your custodian on a T+3 basis.”
If moving to a shorter settlement cycle is not necessarily considered an insurmountable technology hurdle, the latency in reporting trade information to settlement houses can create an increase in the number of failed trades, adding costs and problems.
“It’s an operational problem, and therefore an operational risk, if you are going to have to manually handle or push through the trades for which you receive the information late in the day,” Pearson says. “It might be that firms will have to increase their staffing, at least at the beginning, to be sure they can manage any failing trades in the shortened timeframe.”
By implementing a level playing field for settlement, European authorities are hoping to reduce the number of failed trades and the use of collateral. But without the extra working day to deal with the less-conventional trades, some firms might actually experience the opposite and see their number of failed trades escalate, increasing cost and reputational risks.
“What I think is really going to be a catalyst for change is the penalty regime coming out of the CSDR,” says Freeman. “I think the subsequent settlement discipline regime where there will be penalties for failed trades will provoke the change in automation as the chances for failing a trade are going to increase and be even more prominent in a T+2 settlement cycle than a T+3 cycle.”
A trade that settles one day late doesn’t necessarily represent a huge risk, Freeman says. It is more of a technical failure for a day than it is a large risk exposure. However, the cost associated with this and the impact it will have on a firm’s reputation if it has a record of regularly failing trades will be significant.
According to Euroclear, Europe’s largest settlement house, national and international securities depositories can meet the potential increase in the number of trades that settle on October 8, including both those trades that are struck on October 5 under the old regime and those conducted on October 6 under the new reduced settlement cycle. “However, much will depend on whether we received the necessary instructions from our clients in due time,” says Paul Symons, head of public affairs at Euroclear. “Ultimately, the place of settlement in the trading instruction determines whether the two business day cycle is applicable or not. One would imagine that trading parties would be aware of this important data field. Averting fails is a question of speed and accuracy. Upon trading, it comes down to whether clients can conduct trade affirmation and confirmation on the same day that the trade is struck.”
Some vendors and industry bodies have published best-practice guidelines for sending out trade information. Trax suggests that within 15 minutes of a trade being struck, the counterparties agree electronically the principals of that transaction, the net figures involved, the amount to be exchanged, the currency, and—more importantly—the place where the trade will be settled, as the inability to agree where the counterparties settle is the number one cause of failed trades, explains Smith. By addressing these requirements for the majority of trades, settlement can be issued on T+0, leaving two more days for exception management.
A Case for Outsourcing
The move to T+2 and the subsequent implementation of the CSDR and T2S might prove to be a catalyst for manually intensive buy-side firms to automate their middle and back-office processing. However, if those drivers are not sufficient to spur the laggards into action, what they might do is cause those firms to consider outsourcing their post-trade processes.
“When you are a global custodian and outsourcing provider, what you do is shield your clients from any complexity,” says Julien Kasparian, UK head of sales and relationship management, banks and brokers, at BNP Paribas Securities Services. “Following the crisis, the regulators have increased their scrutiny and firms are struggling to maintain profitability and keep track of all the regulations they have to comply with. The most logical reaction is to outsource the services that are not part of their core capabilities, and I believe the transformation the post-trade space is witnessing at the moment will drive the business case for outsourcing.”
With the number of vendors currently in the market offering automated post-trade processing, trade matching and reconciliation, the only problem buy-side firms are faced with is that of choice, not supply.
“The issue is not so much on the technology side because there are plenty of vendors out there that the buy-side community can partner with,” Kasparian adds. “The issue really comes down to whether the buy side can operationally cope with a shorter settlement cycle.
For Andrew Butler, UK head of product for asset and fund services at BNP, this transition won’t be a problem for the bigger players that are well prepared and have everything in place to easily make the move. But many smaller or even mid-sized asset managers that are not as prepared will rely heavily on their financial intermediaries to facilitate the trades for them.
So, what was originally seen as a challenging issue for the buy side might fall in to the laps of the custodians and financial intermediaries, asked by their buy-side clients to facilitate trades for them. But such arrangements, like everything else in the capital markets, have a cost.
- The move to a T+2 settlement cycle is the foundation stone of the European ideal of establishing a common settlement system. It is planned to fully come into effect in January 2015 as part of the CSDR, and is aimed at harmonizing the post-trade landscape throughout the region.
- European authorities are hoping to implement a level playing field for settlement in order to reduce the number of failed trades and the use of collateral. But without the extra working day, some firms might actually experience the opposite scenario and see their number of failed trades escalating, increasing costs and reputational risks.
- Much will depend on whether settlement houses receive the necessary instructions from their clients in due time. Ultimately, the place of settlement in the trading instruction determines whether the two-day cycle is applicable or not.
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