The efficiency of post-trade processing is often a hotly discussed topic amongst the European broker community, and the next wave of EU regulation, in the form of CSDR, adds yet another challenge to the mix. CSDR, and specifically, for the purposes of this blog, SDR, the Settlement Discipline Regime, is officially due to come into force in September 2020, although it is widely expected to be delayed until at least November. It is predicted to directly affect brokers’ performance and ability to make markets in certain sectors, according to concerns raised at a recent roundtable discussion, hosted by Torstone, to debate the challenges faced by the UK broker community.
SDR is a game changing component of CSDR. It endeavours to improve settlement efficiency and harmonise processes across Europe by applying rules to resolve settlement failures through late delivery penalties, mandatory buy-ins and ultimately, cash settled close-outs in place of non-delivery. However, whilst the end-game ambition of harmonisation across Europe is admirable, the reality today is that not all markets across Europe are created equal, and common regulation potentially runs the risk of disproportionately impacting certain sectors of the market.
Let’s consider the process to manage settlement failures; Under Article 7 of CSDR, the rules set out a model for a mandatory buy-in of securities when trades have not settled past a certain point – four days for liquid equities and seven days for all other assets, with cash penalties applying for trades that fail to settle. Brokers are concerned that this will significantly limit their ability to support market making in less liquid assets, because under the new rules, the cost of providing liquidity will have to factor in the additional potential penalties and mandatory buy-ins that they could be exposed to; making them uncompetitive. Furthermore, those penalties will be based, in part, on the classification of the instrument as either liquid or illiquid. This classification is reviewed and updated periodically, which my not be often enough. Markets are dynamic and fast moving; a stock can move from being available (liquid), to ‘hard to borrow’ in a matter of minutes, and vice verse.
When brokers do not have inventory available to fulfil delivery obligations, they may look to borrow in stock from another market participant. Recently there have been problems in certain parts of the securities finance market which suggest it is more difficult , to obtain securities over the short term, using repurchase agreements (repo) and securities lending, than has been possible historically. For less liquid stocks, this has always been the case; they’re called “hard to borrow” for a reason.
To optimise processes against any increased risk, brokers will need to monitor settlement status and record settled fail reasons to predict when they are going to fail to deliver, or when their counterparty may be going to fail to deliver. Back-office systems will need to manage the alerting of trade failure events as well as accounting for that failure, by capturing and accruing penalties to be paid.
Managing operational change is complicated and there are often knock-on effects and unintended consequences that need to be considered. This is true for CSDR, as it was for MiFID II, and these concerns around the risks to certain business models have been highlighted by a number of market participants. Brokers need to be certain that they can get the necessary data, optimise the flow of information between front and back office, ensure it is timely and clean, and use it to make decisions on the type of business that they want to transact.
Building certainty around such processes is straightforward when middle and back-office systems are well integrated, however for many firms, development of post-trade processing systems has occurred piecemeal and over time, resulting in fragmented technology siloes. Newer platforms, leveraging open application programming interfaces (APIs) and modular composition create a more accessible flow of data, supporting connectivity to front office systems. Older, monolithic, all-in-one systems support the flow of data but only as far as their functionality allows; and any connectivity that is not built-in tends to create points of operational risk.
On a related note, having a resilient and reliable data ecosystem from front- to back-office is increasingly becoming a cost of doing business for the sell side, so managing that cost is key. Cloud-based middle-and back-office architecture delivers a highly scalable and modular method of supporting straight-through-processing for brokers of all sizes. It limits the total cost of ownership and offers smaller firms the capabilities that were historically only available to larger firms, via large, on premise platforms.
CSDR is the latest example of the increased operational efficiencies that regulators expect to see in capital markets today. For brokers who feel the squeeze on their business, it can be an opportunity to review internal operations, and look maybe from the perspective of “Back to Front” rather than the more traditional view.
About Torstone Technology
Torstone is a leading global provider of cross-asset securities and derivatives post-trade processing technology. Torstone’s modern, award-winning Inferno platform is fast, flexible and future-proof. It enables global financial firms to reduce their costs, achieve greater control, minimise risk, and drive operational efficiency. Combining many decades of investment banking expertise with in-depth global financial market and technology industry knowledge, Torstone offers agile, secure, scalable, and cost-effective solutions.