By Matt Johnson, Associate Director, ITP Product Management, DTCC

The Settlement Discipline Regime (SDR) will have a significant impact on buy-side firms. In addition to the financial penalties levied for any transactions which fail to settle under the mandated T+2 timeframe, as well as the buy-in regime for any financial instrument not delivered to fulfil settlement, SDR will create a need for new and specialised skills in buy-side firms’ middle and back office functions. Against this backdrop, it is no surprise that the recent news of a one-year delay to SDR granted by the European Securities and Markets Authority (ESMA), moving the implementation to February 2022, was welcomed by the buy-side.

In order to get a better understanding of how the buy-side is progressing with SDR preparations, DTCC recently conducted a survey of over 400 market participants including 196 buy-side respondents, as well as broker dealers, custodians and outsourcers. The survey revealed that in areas such as financial penalties and the buy-in process, significant work remains for buy-side firms to achieve compliance ahead of the regulation’s implementation in just over a year’s time.  The survey also revealed that there are three significant ways in which SDR will impact the buy-side’s back and middle office processes:

* Identifying ways to continue to lower trade settlement failures

Historical trade settlement failures which will require additional buy-side middle office resources.  Such failures must be addressed by the middle office before the SDR implementation date, because immediately afterwards, these trades will incur financial penalties based on the outstanding amount and the type of security. It is likely that buy-side firms will need to allocate considerable resources well in advance of implementation date to address these problem trades before they incur penalties from February 2022.

* Addressing how they will receive updates from their counterparties and handle the reconciliation of financial penalties due to be credited/debited from accounts

A key area of concern is the need to have an up-to-date status of financial penalties which will be due to be debited or credited from buy-side firms’ custodian accounts on a monthly basis by central securities depositories (CSDs). For this to be possible, the buy-side requires daily communication from their custodians, prime brokers and settlement agents; however, when asked in the survey, 43% of buy-side firms had no indication of how the level of penalties would be communicated. Where the buy-side is aware of how these penalties will be communicated, existing trade fail reports and SWIFT Messaging MT537 were the preferred forms of communication. From an operational perspective, these findings were highly significant as they indicate that market participants will be receiving datasets from multiple sources in multiple formats, potentially resulting in significant inefficiencies around processing these messages.

Further, when it comes to the monthly net credits, debits and allocation of financial penalties levied by the CSDs, nearly half of the survey respondents still have no information from their custodians, prime brokers or settlement agents as to how this process will be carried out. This raises the issue that market participants, including buy-side firms, will need to conduct daily reconciliation of failed trade penalties and credits to ensure the accuracy of their monthly debits/credits. This may necessitate a new middle office function requiring a dedicated resource to ensure all failed trade penalty credits and debits are accurately reconciled on a daily basis.

* Outlining how they will handle the buy-in process with an agent

For any financial instrument which has not been delivered to fulfil settlement, SDR mandates a buy-in process which must be conducted by a buy-in agent that was not involved in the original transaction. Of concern to buy-side survey respondents was that under half (45%) have not even begun engaging with a potential buy-in agent. The issue is that even after a buy-in agent has been selected, there can potentially be a lengthy process of negotiating terms and conditions, as well as drawing up and signing contracts, which could cause issues with just over a year to go before SDR implementation.

Moreover, if a buy-in is unsuccessful after two attempts, the transaction will be resolved via cash compensation rather than physical delivery. For equities, calculating the cash compensation is a straightforward process as historic pricing data is available; however, for illiquid bonds, that process is far more challenging. Illustrating this point, our survey found that 88% of market participants do not know how the cash compensation price amount for illiquid bonds will be sourced, which is certainly an area that needs to be addressed. 

When it comes to communication around buy-ins, while not mandated by regulation but appears likely to become best practice, over 50% of buy-side firms surveyed stated their intention to send post buy-in notifications to the counterparty failing into them versus 74% of sell-side firms. Worryingly, most respondents expressed an intention to communicate these notifications via email, a manual process that is vulnerable to human error and increased risk.

One of the most interesting points raised by the survey was that – unlike previously thought – the majority of respondents (89% buy-side firms and 85% sell-side firms) expect the buy-in process to be initiated by the middle/back office rather than the front office. For context, the buy-side currently issues, on average, one or two buy-ins per quarter (and in many instances less); following SDR implementation this number could rise to as many as 20 a day, indicating that firms will need to set up a separate middle office process and resource to execute and administer buy-ins.   

Taking into account all of the requirements mandated by SDR, it is essential that firms partner with a solutions provider who is able to facilitate these new processes. This includes the provision of aggregated reports in a single location to keep track of penalties, along with the ability to automatically download requisite data.

Automating as much of the post-trade/pre-settlement process as possible can help buy-side firms achieve timely settlement and maximise the chances of avoiding financial penalties and expensive buy-ins. DTCC’s CTM™ service has been helping clients achieve full confirmation and affirmation automation for many years. By using CTM’s robust straight through processing capabilities to get trades agreed and pre-matched for settlement as close to execution as possible, firms have been able to mitigate settlement risk. Additionally, there is a growing understanding of the importance of highlighting all trade exceptions as quickly as possible to make sure they can be rectified quickly in order to achieve timely settlement. As testament to this, we have seen an increased uptake in our DTCC Exception Manager service, which enables clients to publish, manage and communicate on exceptions throughout the trade lifecycle with 14 custodians, three brokers, and four prime brokers all actively submitting data into the platform and 41 buy-side clients consuming this data.

For buy-side firms, SDR implementation presents significant operational challenges.  In some cases, the regulation will require new middle- and back-office processes, along with additional human resources dedicated to areas such as reconciliation. By using the extra time provided by the regulatory delay to automate as much of the post-trade process as possible, buy-side firms will be able to achieve more timely settlement and therefore minimise the potential for any penalties or buy-ins which may arise once SDR comes into force in February 2022.

By Matt Johnson, Associate Director, ITP Product Management, DTCC