In a DerivSource Q&A, Matt Johnson, Associate Director, ITP Product Management, at the Depository Trust & Clearing Corporation (DTCC) shares his view on how buy-side firms can address the complexities of CSDR including managing mandatory buy-ins and reduce trade failures by leveraging automation to enable a no-touch processing workflow rather than increasing headcount. Join upcoming webinar on Buy-Side Regulation to hear more.
Q: The Central Securities Depositories Regulation (CSDR) was formally delayed earlier this year. Was this extension expected and is it a good thing for market participants?
A: A delay until February 1, 2021 was anticipated and is welcome as it gives people more time to prepare. However, when you factor in the holiday period in December and the end-of-year code freeze, firms in practice will only have an extra three months rather than four.
Q: At a high level, what are the main compliance requirements under CSDR?
CSDR calls for a harmonised settlement cycle across Europe, and Europe already moved to a T+2 settlement cycle in 2014. All eyes now are on the Settlement Discipline Regime (SDR). This mandates that failed trade penalty charges must be passed on by the Central Securities Depositories (CSDs) to their participants – the custodians or the broker/dealers. Mandatory buy-ins mean that firms are now legally obligated to buy-in a failing party should a transaction fail over a specific period. Each firm will be leaning on their internal counsel to understand what their interpretation of the text is and creating processes around that to make sure they have robust solutions and are not falling foul of the regulation.
Q: Can you explain the mandatory buy-in requirement and how you see firms dealing with this from a process and operational perspective?
In essence, a buy-in is a way to fulfil settlement obligation and get people back to the economic position they would have been in if a failed trade had settled correctly. Brokers are probably more at fault for trades failing than the buy-side as a result of their market making activities, such as short selling, which means they are not always able to deliver on time. Thus, we can generally assume the buy-side will be issuing more buy-ins than the sell-side.
European buy-side firms currently initiate no more than a handful of buy-ins each year. People try to avoid buy-ins at all costs because they are cumbersome, administrative-heavy, and take a long time to process and complete; and they are expensive as the buy-in price can move significantly against the original execution price. Under the new regime, however, buy-side firms could have to initiate 20-30 buy-ins each per day which is a significant increase.
Buy-side front-office traders don’t want to book buy-ins because their job is to fulfil orders from the portfolio manager and get the best execution. Middle-office functions are not currently set up for this volume of buy-ins either, so firms might need to create a new desk to manage this process.
From a regulatory standpoint, all firms will have to go through a buy-in execution agent. At the moment, only one company – Deutsche Borse– has said it will offer a buy-in service to the market. With upwards of 4,000 buy-side firms in Europe and just a single buy-in agent, that represents a potential concentration risk. However, there may be at least one more market entrant in the next few months. There is no reason a broker/dealer cannot go through the authorisation process to become a buy-in agent. They would need to look at the procedure around that and the constraints, such as whether they need to separate the buy-in execution business from their normal day to day market making activities.
Q: What about liquidity risks?
A: The way the text is currently written, firms are legally mandated to issue buy-ins. But there can sometimes be a whole chain of institutions involved in one trade; as soon as one institution fails to another, they each have to initiate a buy-in. There could suddenly be six firms trying to access the same asset in order to settle a single trade, putting liquidity pressure onto the market. There has been talk of whether a pass-on mechanism is needed to reduce the volume of buy-ins because this is one of the unintended consequences of the way the text is written.
Q: How will the new requirements change current settlement processes and the resources required?
Some people think the penalties will succeed at increasing settlement efficiency. However, there are unintended consequences in the way the penalty mechanism will be calculated and distributed. CSDs are on the hook for calculating, distributing and collecting the penalties, and they will pass those on to their participants.
Buy-side firms are rarely direct members of a CSD. In most scenarios, they will get a view of the penalty from their custodian. Although the CSD should be providing a daily view of penalties, we have heard that they will not credit or debit the account until around the 15th business day of each month, and they will probably do it as a net amount.
When a custodian gets a net credit or debit on their account, they need to decide whether they were at fault for the trade failing. If so, they need to pay the penalty, or if their client was at fault, they need to pass it on. But untangling the net credit movements for all their clients will not be straightforward. Both buy-side and sell-side firms will need very robust reconciliation mechanisms. And the buy-side will likely need a daily update from their custodians to enable them to keep track of credit movements.
The size of the penalties could be significant. One basis point for an equity, going down to around 0.1 basis points for a government or municipal bond doesn’t sound like very much. But the sheer volume of trades failing in the market means penalties could grow quickly. The European Central Bank’s (ECB) 2018 annual report quoted a 2.6% failure rate across the system. With around 570,000 transactions a day going across Target 2-Securities (T2S), worth around €900 billion euros a day, a 2.6% failure on that comes in at €23.4 billion in fails. If all those trades were equities, that would be €23.4 million in penalties per day, which over the course of a month becomes a very high figure – and that is only half the market and only counts the first day that a trade fail. Trades can fail for many days at present.
Firms need to significantly increase either their technology spend or their headcount in order to monitor and deal with these penalties and to confirm their accuracy.
Finally, there is a huge front-office exposure when it comes to CSDR – especially in the equities world. Cash equities will be charged one basis point as a fail penalty per day. The average commission rate on an equity transaction is about 2.5 basis points. A trade only has to fail for two days and the sales trader loses most of their commission. That gets the attention of the front office. A year ago, they saw CSDR as a post-trade problem, but they are starting to understand how it can impact their P&L and now front office people from both buy- and sell-side firms are attempting to understand how it impacts them.
Q: How can firms utilise technology and/or solutions to support compliance requirements and also deliver the operational efficiency and infrastructure required to manage these new post-trade changes on a long-term basis?
A: The ideal post-trade ecosystem is one that enables no-touch processing through automation. DTCC’s Institutional Trade Processing (ITP) offers clients a no-touch workflow to ensure that post execution trades can be captured, matched, confirmed, allocated, instructed and settled without anybody touching that transaction.Clients can also monitor trade exceptions and notify clients near real-time about a problem so that it can be fixed before it causes a fail penalty. The solutions and technology are already out there. Confirmations and settlements can be digitised very easily but some firms are still using email or even fax.
“The solutions and technology are already out there. Confirmations and settlements can be digitised very easily but some firms are still using email or even fax.”
The most important thing is making sure both counterparties have accurate data for each other. DTCC’s ALERT® platform enables investment managers, brokers/dealers and custodian banks to share accurate account and standing settlement instructions (SSIs) automatically worldwide. There are nearly 9 million SSIs in ALERT and with its optimal Custodian managed model, Global Custodian Direct, DTCC enables its global custodian community to manage the data directly on behalf of the buy-side to guarantee that the data in ALERT is coming from the golden source.
DTCC’s Central Trade Manager (CTM) platform works on a central matching basis. Both sides of a transaction need to agree electronically on the components in a data set for a transaction before they can start to try and settle it. When both parties agree on the data around the economic match, place of settlement and SSIs, that trade shouldn’t fail because they have locked in their economic risk and done their pre-settlement match at the same time.
Many banks have teams pre-matching transactions and confirming SSIs the day before they settle with custodians. Using ALERT,they can do that electronically within seconds after a trade has been executed.
The banks can then use the information that they have agreed up front as part of the confirmation process to enrich SWIFT messages out to a settlement agent or to the CSD on the same day as execution. They have the two-day settlement period to ensure inventory is where it needs to be – maybe a loan needs to be recalled or stock needs to be a borrowed to make sure inventory is there. Banks can lock in all of that pre-settlement risk and settlement risk on execution day.
DTCC Exception Manager then enables them to capture exceptions when they occur so they can be fixed prior to settlement. If trades do fail, the exceptions can be highlighted, and the dataset can be shared among the relevant parties to that transaction. Fixing exceptions prior to trade failure, or quickly after, allows firms to mitigate their exposure to penalties and buy ins.
A complete no-touch post trade processing workflow, using resources and tools that are already available through DTCC, provides a higher chance of trades settling on time, every time, because the fewer times a transaction is touched, the higher the chance of it settling correctly. It also arguably reduces or eliminates the need for a dedicated pre-matching team, so employees can focus on reconciliation and other compliance obligations.
However firms decide to address CSDR, they need to make sure they are preparing now. The deadline extension is short and will be shorter than people think because of the holiday period. Firms are legally required to comply with this regulation, and they will find it seriously impacts their P&L if they are not ready on time.
To hear more from Matt Johnson on CSDR, please join the upcoming webinar March 31ston “Navigating the Perfect Storm of New Regulation: Exploring Post-Trade Strategies for the Buy Side”.