Europe In Drive To Shorten Settlement Regime

Terry Flanagan

Tougher rules designed to prevent the breakdown of the last stage in the lifespan of a securities trade appear to making headway through the corridors of power in Brussels—as one recent survey suggested that trade failure rates are as high as 10% in some asset classes.

In March, the European Commission announced plans to overhaul the settlement of share and bond trades across the region. Currently there are overs 30 central securities depositories (CSDs) across the EU—including the biggest two, Belgium-based Euroclear and Deutsche Börse’s Clearstream— that processed approximately €920 trillion worth of transactions in 2010, but the Commission wants to turn this fragmented landscape into a more efficient and better regulated system.

It wants to introduce legislation that cuts settlement to a two-day (T+2) timeframe, fine market participants who fail to settle securities deals, cut cross-border trading costs for investors, which can be as much as four times the amount of a domestic trade, and abolish paper share certificates by 2020.

“For me, one of the key components of the CSD regulation is a harmonized regime for settlement periods,” Kay Swinburne, Conservative MEP and member of the European parliament’s economic and monetary affairs committee, told a conference in London hosted by European banking lobby AFME this week.

Settlement of trades in most European equities markets currently takes T+3, but the European Commission believes that a T+2 model would be better suited to ensure a quicker settlement and in an attempt to align settlement procedures around the globe to T+2. The US is still stuck at T+3 but it is believed that if Europe moves to T+2 it will likely follow suit.

“The Commission has made it clear that it believes T+2 is the most workable period, personally I believe that we should be aiming to shorten this period over time,” said Swinburne, a senior EU lawmaker. “However, I have been convinced by the Commission’s justifications that this is the best we can currently achieve. However, this should be seen very much as a starting point and we should aspire to shortening this in the future.”

A recent survey by Omgeo, a provider of post-trade services, claims that global trade failure rates are as high as 10% in equity markets and 7% in fixed income markets. While the value of equity transactions at risk of trade failure could be upwards of $9,701 billion, according to Omgeo, and the value of fixed income transactions at risk is estimated at approximately $300 billion.

“While the percentage of trades that fail to settle may be somewhat low in some markets, even low rates of failure can represent a high value at risk,” said Matthew Nelson, executive director of strategy at Omgeo. “At a time when both the buy and sell side are looking to mitigate counterparty and operational risk, as well as reduce costs, the industry cannot afford to ignore the risks of trade failure.”

And moving to a settlement time of T+2 could actually exacerbate these risks.

“The worldwide 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,” said Nelson. “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.”

Nelson added: “The technology exists to clear and settle securities transactions faster, so the obstacles to achieving this are purely procedural and behavioral. In Taiwan, for example, where settlement failure leads to an obligation to buy in the stock or cash to settle the trade, there is no settlement failure.”

Seen as the plumbing of the financial system, settlement is the last of the three main market infrastructure sectors to be exposed to competition by the European Union. Trading and clearing have already been opened up to new entrants.

It was also reported last week that nine of the region’s larger CSDs, including Clearstream, have now signed up to the European Central Bank’s long-running Target2Securities (T2S) scheme, which is intended to streamline settlement across the region—but 22 have still to commit as the final deadline of June 30 approaches.

In an important milestone for the controversial project, around two-thirds of the settlement volumes in the euro area have now signed up. The ECB says the IT project will provide a single harmonized platform on which almost all heavily traded securities circulating in Europe can be settled and will cut cross-border settlement by 90% and make it more competitive with the US, which only has one settlement provider.

T2S, which was originally launched in 2006, has encountered long delays and disputes among likely users as well as large costs with some predicting that the final investment for the scheme could top €1 billion. CSDs from the UK, Sweden and Switzerland have already opted out of the plans, while Euroclear has still to say yes but is contemplating signing up.

“Naturally I see the connection between T+2 and the other efficiencies that will be gained within those areas of the EU that are signed up to ensuring that Target2Securities finally becomes operational,” said Swinburne. “I am committed to linking my work on the CSD regulation to that of T2S and will ensure that my regulation is not the reason for any further delays to the project.”

The Commission’s proposals on the settlement of trades first needs the support of the European parliament and the countries of the 27-nation bloc before it can become law. Any new law is expected to hit the statute books some time in 2014.

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