Matt Stauffer, DTCC Managing Director and Head of Institutional Trade Processing
Trade fails happen. Regardless of the level of sophistication of a market participant’s operations and processes, a portion of transactions will likely fail to settle.
This unfortunate reality is underscored by recent data from the European Central Bank in the 2019 Target2-Securities annual report, which showed that the trade fail rate increased by 0.5% over that of 2018 – where the average fail rate was 2.61% and 3.11% in 2019. While this figure may appear low, under the forthcoming Settlement Discipline Regime (SDR), firms will soon pay a high price in the form of daily fines and buy-ins for trades that fail.
To mitigate the financial impact of SDR, market participants should first examine their post-trade processes and procedures to identify weak points, and then formulate an action plan to optimize settlement arrangements. SDR is a component of the Central Securities Depositories Regulation (CSDR) settlement discipline regime, which covers trading in securities that settle at any European central securities depository. Although SDR implementation has been delayed - scheduled to go live in February 2022 - market participants should take advantage of this time and work to improve their settlement processes now to avoid penalties and higher costs.
Once post-trade processes have been assessed, an analysis of failed settlements should expose areas of vulnerability that break down under pressure but perhaps only become apparent when examined over an extended timeframe. At the beginning of the post-trade chain is data, which logs the identity of the parties involved in a trade, settlement date and account settlement instructions. An assessment of the likelihood the trade will settle is built into the middle of the chain in the form of systems that generate exception reports that serve as early warnings to problem trades. Finally, both counterparties must confirm whether a trade has actually settled and then quickly communicate it to their counterparties to resolve the fail and avoid potential fines. Incomplete or out-of-date fundamental data, clunky and opaque reporting systems, or manual exception processing are all vulnerabilities that sit along the post-trade chain and can increase the chance of failed trades. Resolving these issues and processing exceptions will become more costly once SDR is enforced - another reason it is wise strengthen the chain now.
Settlements typically fail due to one of three primary reasons:
- inaccurate or incomplete standing settlement instructions (SSIs)
- securities have been sold but the party does not deliver them,
- the trade is not known or matched by the counterparty.
Post-trade systems should be set up to analyze each of these potential issues, and then the post-trade processing chain further strengthened via automation.
For most firms, simply switching from manual to automated processes for matching and confirmation can be a game-changer in reducing trade failures. Automation adds efficiency and transparency, and current solutions are capable of improving data management, reinforcing internal audit protocols and bolstering risk management.
The benefits of automation are not limited to matching and confirmation. When strengthening their processing chains, automated solutions lock in settlement instructions and fortify the underlying data. SSIs guarantee that trade settlements, margin and payments are sent to the correct accounts, but because SSIs change frequently, automation ensures that account instructions are up-to-date and accurate, which in turn facilitate timely confirmations. For the underlying data, legal entity identifier utilities standardize the data on trading parties, while processing systems with built-in reporting can identify failed settlements in close to real time.
High trade volumes and volatility during the rise of Covid-19 in March and April resulted in an increase in trade fails, exposing weaknesses in post-trade systems. Addressing these weaknesses is key to avoiding financial penalties and costs related to trade failures under the upcoming SDR. Although analyzing and upgrading the post-trade lifecycle to reduce failures may seem like a daunting project, it is a critical exercise to avoid increased costs from SDR. The good news is that adaptable, automation solutions are readily available to simplify the process.