Six key challenges of implementing the Settlement Discipline Regime

David Veal, Senior Executive: Client Solutions, corfinancial, explains the major operational hurdles facing buy- and sell-side firms before achieving compliance with the Settlement Discipline Regime.

The EU’s new Settlement Discipline Regime (SDR) will harmonise the way Central Securities Depositories (CSDs) operate. Two key aspects of this regulation are the enforcement of mandatory buy-ins and penalties for failed trades, steps that will add to the pressures and critical deadlines faced by buy- and sell-side Operations teams. The settlement discipline rules are timetabled to come into force on 1 February 2021, giving firms less than a year in which to revise their post-trade operations.

From our own conversations with buy-side participants we have learned that asset managers and asset servicing firms are steadily becoming more accustomed to the middle office operational processes that they need to establish in order to be compliant with SDR. Project teams are being formed from Compliance, IT and Operations personnel to tackle the implementation issues and, in the main, these teams are reasonably content that they understand much of what needs to be done, although there are still many unanswered points. As always, the devil is in the detail of any regulation; here are six specific pain-points being raised:

  1. CSDs may only issue one net figure for penalties
    The CSDs may issue one net figure (via custodians) to asset managers for a penalty. In other words, the CSD issuing the penalty amount will only be providing a number for the high-level trade position, not necessarily the fund or portfolio allocation. The asset manager will have to then calculate how that penalty will apply to the underlying positions. Market participants are concerned with the potential complexity involved in an asset manager allocating minor penalty amounts to all the relevant portfolios they are managing
  2. Standardising communications with custodian banks
    Following on from the previous point, there is also uncertainty surrounding the method with which custodians and broker dealers will communicate the breakdown of trade information to asset managers (since asset managers don’t have a direct relationship with CSDs). Buy-side firms are hoping that all parties will agree on a standard for communicating the penalty information, and this is key as an asset manager may deal with between five and several hundred custodians.

    If all custodians send the penalty information to the asset manager as a specific SWIFT message, at least there will be some structure in the way the data is presented. This policy has been discussed by the EU but has not been confirmed to date and lingering doubts concerning communication standards remain.

  3. Root cause of failure
    Some asset managers are analysing their trading over the last three or six months and then applying the EU’s formulas in order to calculate what the penalty would have been for any failed trade. A number of such firms who have very effective trade processing solutions and processes in place while undergoing these tests suggest that around 90% of their failed trades are due to stock shortages. If the asset management industry as a whole determines that trade fails are mainly due to sell-side stock shortages, then it will be the brokers that have to bear the brunt of the penalties, but will this become a financial benefit to the asset manager?
  4. The economics of processing small penalty amounts
    In testing out the formulas put forward by the EU to calculate penalties, some buy-side firms are finding that the potential fines are miniscule – often less than €1. In many instances the calculation reveals that the actual penalty will be less than the administration cost of processing the fee. As a result, buy-side firms are hoping that the industry will settle on a minimum gross penalty cost, below which the penalty will be written off and not passed on. The consensus appears to be that this minimum figure should be in the region of €500.

    A number of buy-side firms have even told us that, in order to avoid the painful buy-in process, it would better if the regulator made the penalties higher to incentivise firms to avoid failed trades in the first place, and leave the buy-in process as it is today.

  5. The problem of reconciling penalties
    It is likely that multiple penalties will be communicated via a monthly statement, where each amount will need to be attributed to an individual trade in order to check that they are correct. If it transpires that asset managers must reconcile penalty information across all of their trading activities, the fear is that this may result in firms having to significantly increase their staff numbers due to the sheer volume of data involved.

    Some firms we have spoken to are questioning whether the buy-side should bear the responsibility of checking that all of the penalty calculations are correct when the penalties may not reference which underlying trade they relate to. Clearly, this immense task of reconciliation will need to be undertaken in an automated fashion, but the current view is that there are no automated solutions on the market that adequately perform this task, at this level.

  6. The issue of price changes
    According to the EU’s guidelines, penalty amounts should be calculated according to the settlement day’s market price for the stock. The issue is that the price of the stock may have changed by the time the trade has failed. 

    Some buy-side firms don’t have the ability to import the current trading price, which is what the calculation process requires. These firms need a feed for the closing price for only the stocks that they have traded – not all stocks. This creates a further operational burden for firms.

It is clear from the above that there remains a number of unanswered (or unexpected) questions associated with the implementation of the Settlement Discipline Regime. At this stage, most firms will have an SDR compliance programme well under way and the emphasis for project teams must now shift from conceptual problems to practical solutions. corfinancial has been evaluating all of these challenges as its SDR solution, SureVu, has evolved throughout this year, in order to offer firms an exception management solution that will ease the challenges ahead.

Click here to learn more about corfinancial’s SDR solution, SureVu.

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