The wider effects of Europe’s transition to T+2 securities settlement suggest under-investment in technology is leaving investment managers heavily reliant on the sell-side.
The extra-territorial impact of regulatory reforms has been a growing issue for market participants and infrastructure operators since the global financial crisis. In particular, politically mandated changes to the securities and derivatives markets – in the form of the US Dodd-Frank Act, the European Market Infrastructure Regulation and the second Markets in Financial Instruments Directive – have caused ripples far beyond the borders of their intended jurisdictions, as legislators seek to protect their taxpayers against future systemic risks.
Preparations for next year’s introduction of TARGET2-Securities (T2S), the European Central Bank’s single securities settlement platform, provided a central theme at the Market Infrastructures forum at Sibos 2014. Perhaps less recognised, however, is the knock-on effect of the initiative further afield. On 6 October, many European securities markets migrated to T+2 settlement, the date chosen by the industry for the transition required by the Central Securities Depositories Regulation (CSD-R), in preparation for the launch of T2S in June 2015. Until then, for most major markets with the exception of Germany, settling securities trades three days after execution has been the market norm.
For Harry Newman, head of market initiatives EMEA, at SWIFT, the pre-T2S migration to T+2 has the potential to change the priorities and business models of securities market participants and infrastructure operators in many ways. For example, the easier flow of information on the settlement of securities will make reporting capabilities an area of increased competition. “Among the different CSDs, it will be a case of how much information they can deliver, with clients choosing their CSD based on that level of service given the increased need for information,” he says.
But the CSD-R also applies to market participants located outside Europe, meaning securities trades placed on European venues by market participants in Asia-Pacific will also be required to adhere to the T+2 settlement cycle. The CSD-R calls for the imposition of penalties for transactions that fail to settle by the deadline. These penalties are seen as a necessary measure to ensure adherence to the T+2 settlement regime. The penalties will include monetary fines for failed trades, and even suspension of trading for participants whose trades fail consistently.
Broker buffer
Research commissioned by post-trade services provider Omgeo and conducted by Celent suggests that brokers on Asia-Pacific’s sell-side are well-prepared for the new settlement regime in Europe. In stark contrast, one in five investment managers in the Asia-Pacific region claimed to be unaware of T+2. Overall, while more than 80% of respondents said they would move to T+2 settlement, 58% said they had yet to make the changes required.
Based on the responses of more than 30 broker-dealers, custodians, investment managers and trust banks across Asia, Celent said some buy-side firms, especially tier 1 firms in Hong Kong and Japan, will try to continue to operate on a T+3 basis internally, relying on their brokers to provide a buffer.
Though settlement is a ‘back-office function’, T+2 reforms reach many areas investment and trading operations. Nearly three-quarters (73%) of respondents said they will need to make post-trade process changes, while a slightly smaller proportion (64%) will require post-trade technology changes. More than half predicted changes to front-office processes and three-quarters planned changes to front-office technology. Few expect an impact on their investment strategies as a result of the European T+2 settlement regime.
Two-thirds of the respondents expect to complete the necessary improvements for T+2 settlement with an investment of less than US$500,000, and one-third for less than US$100,000. For firms that have already enabled straight-through processing (STP) in the middle office, this will likely focus on internal IT development. Firms without STP-enabled processes may find they need to spend on vendor systems as well, Celent suggested.
Moreover, nearly 40% of respondents feel they are at risk for incurring failed trades in a T+2 settlement cycle. Many firms also expect operational costs to increase with T+2 settlement.
Overdue investment
With most changes to market structure and practice, it’s a matter of short-term pain for long-term gain. “The key people who are going to struggle are the custody community, as a whole day is taken out of the settlement cycle. It could be painful in the short term,” says Omgeo’s executive director for industry relations Tony Freeman.
“T+2 is mandated in CSD-R but it has areas of uncertainty. While T+2 is technologically and operationally feasible, it’s likely there will be bifurcated settlement. Some market participants will try and stay on a T+3 cycle as they could struggle with the standard T+2 cycle and they want to avoid a buy-in.”
Denis Orrock, chief executive of GBST Capital Markets, a provider of technology solutions to broker-dealers and custodians, says there are risks if buy-side firms ask their brokers to allow them to continue to trade on T+3 terms. “That would involve the broker bearing an extra day’s risk, which I don’t think was the objective of the whole T+2 initiative.”
While investment banks, broker-dealers and custodians can provide support their clients, Orrock says under-investment in post-trade technology and processes on the buy-side is an ongoing battle. “Technology should be the enabler of all market participants to reengineer their processes and operational flows, notwithstanding the compliance and regulatory perspective,” he says.
Orrock suggests that many buy-side firms take a short-term tactical approach to technology investment rather than improving processes and operational flows, and investing in underlying platforms. A flexible IT structure should help firms to comply with multiple ongoing regulatory-mandated process changes but, he says, the crux of T+2 compliance is processing trade affirmations effectively on the day of the trade.
“The research suggests those who are less automated on the processes side i.e. the buy-side, will struggle to manage that cycle. For any such shifts, experience suggests fail rates will significantly increase in the early days. Fail rates will increase before they go down,” he says.
European fail rates are relatively high compared to other markets globally despite the fact that may others have already migrated to T+2, suggesting there is much confirmation and matching process inefficiency in Europe at present. Will the proposed fines introduced by CSD-R reduce settlement fails? Orrock suggests so.
“As the cost of fails increases, the focus will narrow to how firms reduce their fails. The market infrastructure providers, the exchanges and the clearing houses will utilise fail penalties to increase the outcomes of what has been a strategic shift in the industry. Although this change has been a long time coming, we have endured unprecedented volatility and regulatory change in recent years. As such, regulators will be sympathetic initially, but if they don’t see improvements I have no doubt that fail penalties will increase,” he warned.