Front-office warned as CSDR penalties threaten to wipe out commissions, says DTCC

Daily penalties mean the upcoming Settlement Discipline Regime (SDR) is an issue for the front-office as well as the back, according to the DTCC.

Penalties for failed settled trades could result in commissions for buy-side traders being wiped out in as little as two days, according to the DTCC.  

The stark warning from the market infrastructure giant comes as buy-side firms, banks and securities services firms prepare for the upcoming Settlement Discipline Regime (SDR) in Europe.

Under the SDR, market participants will be liable to pay daily penalties of one basis point (bps) for liquid shares against each transaction that fails to settle within the T+2 timeframe. The rate has been criticised before by industry participants for not being high enough to solve the issues which regulators have introduced the rules to counter.

However, according to Matt Johnson, client and industry relations at the DTCC, some ‘quick mathematics’ proves that the regulation is not confined to the back-office, and that the front-office also needs to pay attention to the settlement process before the fines begin to eat into the sales trader’s commission.

“For a cash vanilla equity, you are looking at a 1bps per day fail penalty, which doesn’t sound huge. However, we did some analysis in Q1 and Q2 this year using data that goes through our central trade management platform which is the biggest used globally in post-trade, and we looked at what the average commission size was on the European equity markets,” Johnson said.

“This was very basic mathematics…we saw that the average commission rates across Europe went from about 5.8 bps as a high to 0.7 bps as a low, so take a medium and say the average commission is 2.5 bps per transaction. That trade only has to fail for two days and the front-office sales person has had their commission wiped out.”

SDR is part of the broader Central Securities Depositories Regulation (CSDR) and requires investment firms to put in place measures to mitigate settlement fails. The daily penalty aspect of the regulation has been less concerning to the market than the mandatory buy-in regime to this point, which the buy-side believes could impact market liquidity.

According to a study from the International Capital Market Association (ICMA), three-quarters of asset managers and pension fund respondents expect a negative impact on bond market efficiency and liquidity when the buy-in regime comes into force in 2020.

Buy-ins, which are presently used at discretion as they can create unpredictable costs, are used for market participants to manage settlement risk in the case of failed trades, as the buyer goes to market to source the bonds from another party.

Initiating a buy-in against a failing counterparty will become a legal obligation under the CSDR regime, with limited flexibility on timing to complete the process. The payment of the difference between the buy-in price or cash compensation must also be made by the failing trading entity.

Johnson added that the buy-in regime remains the biggest challenge, and highlighted that some banks could transition from doing two-to-three buy-ins per month, to upwards of 100 per day.