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Settlement fails: Getting to the root of the problem

Settlement fails: Getting to the root of the problem

Securities,
27 April 2022 | 6 min read

Securities settlement fails create both added costs and operational risks for trading counterparties. These challenges are only going to intensify under CSDR’s Settlement Discipline Regime and the decision by certain markets to adopt T+1. Better transparency on securities transactions will be essential if we are to reduce settlement fails moving forward.

To the uninitiated, it would appear that trade settlement fails are fairly rare occurrences. According to a European Securities and Markets Authority (ESMA) study of 31 European jurisdictions, an average of 2%-4% of all bond trades were unable to settle between 2018-2020, rising to 5%-10% for equities. While 2021 data showed similar trends, ESMA noted equity settlement fails reached 12% three times between November 2020 and June 2021, but this is still below the pre-pandemic highs when fail rates hit 14%.

Although such low fail rates imply the settlement process is very efficient, the costs related to trade fails are high. “In a market where billions of dollars of transactions are being settled each day, a percentage point here and there translates into a large proportion of overall trades,” says Vikesh Patel, Head of Capital Markets Strategy at SWIFT. “And these fails are costing the industry billions every year.”

Settlement fails happen for a variety of reasons. “The main causes are often due to inventory management problems, when the securities are not where they’re needed on the settlement date. Fails can also be caused by inaccurate or incomplete data sets – which can lead to matching issues,” says Charifa El Otmani, Director, Capital Markets Strategy at SWIFT.

These sentiments are echoed in a European Repo & Collateral Council (ERCC) report, which said 70% of all settlement fails occurred because sellers were unable to deliver securities on time, while errors relating to matching of instructions accounted for 27% of all fails.

Charifa El Otmani
The less time there is in the settlement cycle, the less time market participants have to resolve potential problems in areas such as inventory management.
Charifa El Otmani Director Capital Markets Strategy, SWIFT

Settlement fails felt across capital markets

Settlement fails can have an adverse impact on a wide range of market participants. In addition to exposing trading counterparties to increased credit and liquidity risk, the knock-on effects of fails can also cascade into the securities lending world, especially if settlement and collateral movements are affected by a large trade failure. All of this ultimately eats into firms’ margins and operating costs.

“Trading counterparties are also likely to face heightened costs because of settlement fails now that the Central Securities Depositories Regulation’s Settlement Discipline Regime (SDR) has taken effect,” comments Patel. Although the SDR’s proponents have shied away from imposing mandatory buy-ins for failed trades, the cash penalty regime has gone ahead. 

Under the framework, CSDs can impose penalties for settlement fails on trading counterparties ranging from half a basis point (bp) to 1 bp depending on the assets involved. For instance, settlement fails involving instruments traded in the most liquid markets will incur the highest cash penalties under the new rules. Many within securities services will want to avoid these costs, especially as revenues have been relatively subdued despite the healthy growth in assets under custody. “With many post-trade providers already being squeezed on margins, such costs will be felt acutely,” explains El Otmani.

The impetus to root out settlement inefficiencies has been given a further boost following the decision by several major markets to shorten their settlement cycles. India has confirmed it will phase in T+1 for equities over the course of 2022, while the US and Canada have both indicated they will introduce T+1 from 2024.

Shorter settlement cycles bring benefits including reduced operational and counterparty risk, but they also create a number of challenges – most notably market fragmentation and constraints around liquidity management, especially for financial firms operating in different time-zones. Removing a day from the rolling settlement cycle will also heap more pressure on counterparties to ensure their post-trade processes are in good shape.

“The less time there is in the settlement cycle, the less time market participants have to resolve potential problems in areas such as inventory management,” says El Otmani. A wholesale shift to T+1 is likely to increase the risk of trade settlement fails, which in turn will lead to more cash penalties. These are impediments which financial institutions urgently need to resolve.

Vikesh Patel
Being able to track transactions throughout the entire securities lifecycle will be vital to facilitating settlement efficiencies. And the Unique Transaction Identifier (UTI) will serve as the basis for achieving this.
Vikesh Patel Head of Capital Markets Strategy, SWIFT

Transparency as an enabler

If firms are to avoid costly settlement fails, they must improve the visibility and transparency they have into the securities transaction lifecycle. “Having access to a central source of data and being able to track transactions throughout the entire securities lifecycle will be vital to facilitating settlement efficiencies. And the Unique Transaction Identifier (UTI) will serve as the basis for achieving this,” notes Patel.

The UTI is an existing, industry-recognised standard – the ISO 23897:2020. Industry-wide adoption of it would help to reduce risk and improve the client experience across the full trade lifecycle, regardless of the technology platform a firm is using. Although implementing the UTI will require an upfront investment on the part of market participants, it is a key enabler to reduce cost and risk in the short and long-term.

The business case is there, but it takes more than just creating a standard to make it successful. Success is predicated on industry adoption, agreement on the principles of the standard, and the process through which it is generated and implemented.

We are working closely with the financial community to make sure the industry’s adoption journey is as smooth as possible. In addition, we’re now running a pilot to leverage adoption of the UTI and provide increased efficiency in the post-trade securities settlement lifecycle. As part of the solution we’re developing with our community, parties involved in securities settlement will get visibility on the end-to-end two-sided transaction flow, enabling them to prevent and resolve fails much faster.

Want to find out more?

To learn more about the ongoing work to implement the Unique Transaction Identifier and the benefits it can bring to your organisation, check out our paper Solving the post-trade transparency challenge: The case for a unique transaction identifier in securities or contact your SWIFT account manager today.

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Solving the post-trade transparency challenge – The case for a unique transaction identifier in securities
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