Significant value of trades face failure risk

A new study has found that settlement failure rates are as high as 10% for equities and 7% for fixed income, incurring substantial costs for the industry.

By None

A new study has found that settlement failure rates are as high as 10% for equities and 7% for fixed income. The proportion of trades that fail to settle on time, while small in proportion to the overall amount, translates into staggering amounts in monetary terms, according study from post-trade services provider Omgeo.

The research, based on respondents to the two annual surveys of agent banks by Global Custodian magazine, finds the value of equity transactions at risk of trade failure could be upwards of US$970 billion, and the value of fixed income transactions at risk is estimated at approximately US$300 billion. The cost of stock borrowing to avert the risk of trade failure on this scale could be as much as US$3.8 billion.

However, while sub-custodian banks and their clients in 26 major markets and 60 emerging markets report the extent of the failures rates, over half of sub-custodians and half of global custodians do not calculate the cost of failure, indicating a lack of awareness of the trade failure problem as well as the associated costs.

“The fact that you can trade in nanoseconds and you still have three day settlement cycles in most markets but fail rates of 2.8% and 1.4% for equity and fixed income trades respectively is surprising,” says Matthew Nelson, executive director of strategy at Omgeo. “Looking at the 13 central securities depositories (CSDs) and two ICSDs in Europe, there was €895 billion settled between them in 2010. If you apply failure rates of 2-3%, that is a cost of almost €20 billion just in one arena. It’s a big number despite the fact that we have tools to fix that.”

Custodian banks agree that trade failure rates would reduce if settlement failure incurred a financial penalty, particularly with the shortening of settlement cycles to T+2. The European Commission has advocated the use of financial penalties for settlement failure, as well as a requirement for trades to settle within T+2, in its proposal for CSDs, published in March 2012.

Custodian banks, however, are concerned that the risk of settlement failure will increase exponentially if shorter settlement cycles are not preceded by an increase in the efficiency of the middle office, particularly in the trade matching process.

“Even though this is two and a half years away, it’s not that far off considering the significant systems changes and market practices required in order to prepare for the new cycle,” says Nelson.

For the worst offending countries, namely Portugal (10% fail rates for equity and 5% for fixed income) and Israel (7.5% for equity and 7% for fixed income) the fail rates becomes a bigger issue when the settlement cycle is shortened, says Nelson. “It is surprising given that you have T+2 coming in Europe and T+1 being talked about in the US,” he says. “As you compress these trade lifecycles and still have these 2.8-3% fail rates for equity there’s going to be even more at risk. The key to achieving these settlement cycles is going to be same day affirmation or matching on or as close to trade date as possible. There are solutions like ours that can help meeting that goal and it will be critical in meeting that deadline.”

Emerging markets like Taiwan – the best performing in terms of settlement timeframes - have forced buy-ins and strong penalties for repeat offenders. 

“Penalties are the only way to get them to focus on reducing their fail rates and get to the right market practices. It has certainly been effective in Taiwan, which has zero fail rates,” says Nelson. “Even though some emerging markets have failure rates of more than 2.8% and 1.4%, the inclusion of Taiwan, which has invested in infrastructure, has built strong operational infrastructure for the entire trade lifecycle helps to offset that. They have a newer system and they’re not burdened with the legacy systems of some of the major markets. These major markets have a big challenge to upgrade their legacy systems, but it has to happen over the next 18 months. 

“The technology exists to clear and settle securities transactions faster, so the obstacles to achieving this are purely procedural and behavioral,” added Nelson. “The world-wide shift towards shorter settlement cycles will increase the number of failed trades, unless post-trade operational practices are adapted to reduce the period between trade execution and settlement. The most important change required is that market participants should affirm trades on the day the trade is executed, enabling both timely and accurate settlement.”

Custodian banks and their clients cite inaccurate settlement and account instruction data as the most significant reason for failure, followed by the deliberate failure to settle by counterparties and mismatches between cash and securities cycles.

Nelson concludes: “We’re hoping that the CSD regulation and white papers like this will highlight the need for investment in automation and that these countries will start to focus on not only ensuring that their infrastructure is sound but that the people are investing in the relevant technology to reduce fail rates and to meet the new settlement timeframes.”

Reporting by Janet du Chenne, Global Custodian, an Asset International publication