The G20 is currently working towards a regulatory framework for a new financial architecture aimed at delivering financial stability.
Some of the initiatives – such as efforts to overhaul the over-the-counter derivatives markets – are intended to address the risks identified by the financial crisis of 2008, others are much more pre-emptive in nature. The European Commission’s proposal for central securities depositories (CSDs), and for improving settlement efficiency (known as the CSDR) falls into this pre-emptive category.
The CSDR is just one area of a plethora of regulatory reform that market participants are trying to navigate. That said, the rules contained within the proposal will have a significant impact on trade settlement. Namely, the CSDR would require trades to be settled within two days of the trade date (T+2) and introduce financial penalties for trades which fail to settle on time.
At present, there are no standard guidelines in Europe relating to how CSDs (the entities that operate settlement systems) communicate with each other, or how quickly a transaction should be settled after the trade has occurred. The same is true of the settlement cycles in the United States. Conversely, a number of key Asia markets such as Hong Kong, Taiwan and India already settle on a T+2 cycle and, as a result, settlement regimes in these countries tend to be highly efficient.
Market participants in Europe are largely in favour of the move to T+2 and, perhaps somewhat surprisingly, they have also shown support for the use of financial penalties as a way to incentivise counterparties to settle on time. This has arisen from three characteristics of today’s financial markets. First, trading in the front-office has reached millisecond speeds, yet it can take more than three days to confirm and settle the transaction – market participants want to see this gap closed.
Second, because of the divergence in national settlement regimes, the processing of cross-border trades is more costly and results in a higher level of trade fails than domestic trades – harmonising settlement practices should solve this issue.
Finally, in Europe specifically, harmonised settlement cycles are a prerequisite to the creation of a single market (if this is still the political intention) and of a pan-European platform for settlement (known as T2S or Target2Securities).
There are practical steps which market participants, on both sides of a transaction, need to take in order to prepare for a move to shorter settlement cycles. Namely, market participants will have to become more efficient at confirming the economic details of trades. It is highly likely that trade verification will need to take place on the day the trade is executed, this is what we call same-day affirmation (SDA). We believe that T+2 will encourage investment in higher levels of post-trade automation, which will help firms to manage and mitigate their risk exposures and achieve higher SDA rates.
The proposal on securities settlement and CSDs shows a determination to improve market structures through pre-emptive regulation and highlights Europe’s leadership towards shorter settlement cycles compared with the US, which currently operates on T+3. The deadline for the harmonisation of settlement cycles in Europe is being mooted as 1 January, 2015, which provides a three-year timeline for the US to catch up with Europe. If this were to happen, the settlement cycles of Europe, the US and a number of key Asian markets would be harmonised to T+2. This would be a significant step forwards in mitigating operational, credit and counterparty risk.
Tony Freeman is executive director and head of industry relations at Omgeo
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