DTCC Connection

Mar 16, 2016 • DTCC Connection

Four Themes of Collateral Settlement Fails

By Joseph King

Four Themes of Collateral Settlement FailsWhat are the implications for the market when collateral settlement fails occur? In a recent white paper, DTCC-Euroclear Global Collateral Ltd examined this issue, when cash or securities collateral is not delivered or received on the agreed date.

DTCC-Euroclear Global Collateral Ltd, a joint venture of Euroclear and The Depository Trust & Clearing Corporation (DTCC), sponsored the PricewaterhouseCooper (PwC) white paper entitled, Implications of Collateral Settlement Fails, that looks at the leading causes of collateral settlement fails: Miscommunication, Constrained Technology, Insufficient Collateral, and Counterparty Insolvency.


Miscommunication of collateral movement instructions is seen as the leading cause of collateral settlement fails. Collateral movement messages with incomplete or incorrect reference data generally result in a collateral settlement fail if the issue is not resolved by the agreed upon settlement time. For example, when a participant does not include complete SSI10 information in the collateral movement instructions, the counterparty may not have enough information to properly execute the collateral movement by the required settlement time.

Further miscommunication can stem from situations in which there is a lack of clarity regarding whether or not timely settlement has occurred. Although collateral movements leverage the same financial plumbing as Delivery Versus Payment (DVP) transactions, custodians still have issues interpreting free delivery collateral movements. This may ultimately lead to a collateral settlement fail if the custodian places collateral into the wrong account. For example, a custodian for a buy-side participant may receive cash collateral and apply the free delivered cash collateral to an omnibus account rather than the correct sub-account. In such a situation, the collateral settlement fail will typically be identified only after the buy-side participant performs reconciliation between expected collateral balances and the custodian records.

Additionally, cross-border trades with different settlement cut-off times may result in collateral settlement fails. These fails are more pronounced when one or both of the trading counterparties have manually intensive processes (i.e. limited instances of STP and automation). Participants transacting in a cross-border environment may have less time to complete the margin call process due to the non-harmonized settlement/business operations window, making participants more likely to experience a collateral settlement fail.

Constrained Technology

Constrained technology hinders the ability of participants to communicate in a standardized way limiting the use of STP and automation. For example, after a counterparty confirms collateral movement instructions, they will send the instructions to their custodian. Automated participants use a standard messaging protocol to communicate with custodians. In some cases, the counterparty may be forced to send a fax to instruct the movement of collateral because either they do not have standard messaging protocol capabilities or the custodian does not. The manual processing of faxed settlement instructions leads to time lags and/or incorrect data entry, which ultimately can result in a collateral settlement fail.

A custodian’s/counterparty’s inability to use industry-standard messaging for broker release letters also proves to be a challenge and a cause of collateral settlement fails. The broker release letter requires approvals (sign-offs) from the participant and the custodian to affect the movement of collateral. The use of fax to send and complete a release letter is a manual process that can be difficult to complete in a timely manner. Many custodians lack the ability to perform intra-day reconciliations to track and account for buy-side pledged or received collateral. Insufficient record keeping capabilities, driven by batch processing of collateral movements, results in the reactive identification of a fail as opposed to proactively identifying issues before they become a fail.

Constrained technology also limits a participant’s ability to effectively manage their collateral inventory. For example, collateral that has been earmarked to satisfy a future margin call may not show up in the collateral system as pledged until an end-of-day reconciliation is performed and the pledges are manually entered into the system. From the time the initial collateral selection is made and the reconciliation is performed, the same collateral that was initially earmarked to satisfy a specific margin call may be selected to satisfy a separate margin call. This situation may result in additional collateral settlement fails as the original collateral is unable to be used to settle multiple margin calls.

Insufficient Collateral

Insufficient collateral relates to a participant’s inability to post the required amount or type of collateral. This lack of sufficient collateral may be a consequence of a daisy-chain failure, poor inventory management, or non-conformance with wrong-way risk and concentration limit requirements.

Daisy-chain failures can be both a result and a cause of collateral settlement fails by affecting the original failing counterparty in addition to downstream participants. A daisy-chain failure can be defined as a series of collateral settlement fails in which an initial failure to deliver collateral or complete a substitution causes a chain of subsequent fails as the party expecting to receive the security in the initial transaction fails to deliver to its counterpart in the second transaction and leads to additional downstream collateral settlement fails.

Participants may also be burdened by poor collateral inventory management. Visibility into the available collateral pool is a prerequisite to efficiently sourcing and delivering collateral. A lack of up-to-date information regarding collateral can prove onerous, particularly in situations where participants are unable to locate collateral that is expected to be returned from a counterparty’s account. In turn, collateral will need to be sourced from the market, which can be a time intensive and costly process. If the counterparty is unable to source the collateral from the market, a collateral settlement fail may result.

Wrong-way risk and concentration limits may be imposed by uncleared/bilateral margin regulations in certain jurisdictions and restrict the type of collateral that a participant is allowed to post. Such requirements are put in place to limit counterparties from becoming over-exposed to particular assets or issuers. These requirements are likely to increase the instances of collateral fails in scenarios where the counterparty to a trade does not possess diverse types of eligible collateral.

Counterparty Insolvency

As experienced during the 2008 financial crisis, counterparty insolvency, although not a business-as-usual occurrence, may result in a collateral settlement fail. During the crisis, as participants defaulted, their counterparties failed to receive collateral, thereby negatively impacting the confidence in the market and leaving participants exposed to failing counterparties. Counterparty insolvency, although a rare occurrence, has effects reaching beyond collateral settlement fails.