In July this year we learned that the European Securities and Markets Authority (ESMA) had asked the European Commission for a further delay to the Settlement Discipline Regime (SDR) to February 1, 2022.
The buy side’s readiness requirements are daunting. Those requirements will bring considerable planning followed by significant organizational change, with heavy repercussions should they fail to comply with SDR, namely financial penalties and potentially expensive buy-ins. Regulatory preparation advice often focuses solely on technologies, systems or cultural change. In the case of SDR, preparations will most likely require the implementation of new middle and front office processes. However, firms should take advantage of the extra time for SDR’s deadline to work on adjusting and streamlining processes to avoid difficult conversations with their brokers and custodians once the regulation goes live.
SDR will require assessment of the settlement performance of brokers, and for those who are continually underperforming, firms may have to initiate difficult conversations. In parallel, SDR requires mandatory buy-ins should trades fail to settle beyond a certain period. In combination with MiFID II’s best execution rules, SDR creates a potential scenario where middle office managers may begin advising their front office to avoid certain brokers who are causing settlement failures resulting in higher costs and increased administration effort on an ongoing basis. Conversely, brokers may raise their commission rates for asset managers that have lower settlement efficiency or are deemed to have problematic post-trade processes.
SDR requires the appointment of a buy-in execution agent, so the buy-side will need to expand their relationships. This requirement will affect both the buy- and sell-side, but it is a bigger issue for the buy-side, which will need to conduct more buy-ins than the sell-side. The rules state that the buy-in agent cannot have been part of the original transaction, so asset management firms must appoint a separate broker (buy-in agent) - and possibly, more than one - to conduct buy-ins.
Compliance with this requirement is further complicated by the fact that to date, there is only one provider that has announced they will offer services as a buy-in agent, presenting serious challenges around bandwidth, availability and potential liquidity.
Once the buy-side has identified a suitable buy-in agent, the relationship work continues through an additional onboarding process wherein all the necessary documentation must be completed in advance of the SDR implementation date to allow a buy-side firm to become a known party to the buy-in agent.
Additionally, there is a very realistic scenario where a buy-in request may be unsuccessful. Under the SDR rules, if a buy-in is unsuccessful after two attempts, the transaction is resolved via cash compensation rather than physical delivery. A recent DTCC survey highlighted that over 80% of buy-side firms did not know how they will obtain an accurate price for the cash compensation model.
SDR will also impact the buy-side’s relationships with their custodians and brokers. Buy-side firms must understand the levels of service that custodians will deliver to their clients for SDR requirements. In a recent DTCC client survey, for example, 40% of buy-side firms still don’t know how their custodian will provide a view on what their daily failed trade penalty rates are. Some custodians will provide daily reports on issues such as the status of financial penalties, while others will report monthly. This inconsistency is further complicated because often, it is the underlying fund that determines which custodian services a particular fund. As a result, the middle office will require an accurate understanding of the varying levels of service which each custodian provides and then must make adequate provisions.
SDR’s implementation requires a best practice approach to post-trade processing to expedite timely settlement. This increased automation ultimately will help to minimize the impact on relationships between the buy-side and their brokers, as well as with their custodians. While the timeline for SDR implementation has been extended, given the scale of changes the regulation requires, buy-side firms should be addressing the issues raised above sooner rather than later to ensure they are ready for February 2022.
This article first appeared in Funds Europe on October 7, 2020.