Significant value of trades face failure risk
A new study has found that settlement failure rates
are as high as 10% for equities and 7% for fixed income. The proportion of
trades that fail to settle on time, while small in proportion to the overall
amount, translates into staggering amounts in monetary terms, according study
from post-trade services provider Omgeo.
The research, based on respondents to the two annual
surveys of agent banks by Global Custodian magazine, finds the value of equity
transactions at risk of trade failure could be upwards of US$970 billion, and
the value of fixed income transactions at risk is estimated at approximately US$300
billion. The cost of stock borrowing to avert the risk of trade failure on this
scale could be as much as US$3.8 billion.
However, while sub-custodian banks and their clients
in 26 major markets and 60 emerging markets report the extent of the failures
rates, over half of sub-custodians and half of global custodians do not
calculate the cost of failure, indicating a lack of awareness of the trade
failure problem as well as the associated costs.
“The fact that you can trade in nanoseconds and you
still have three day settlement cycles in most markets but fail rates of 2.8%
and 1.4% for equity and fixed income trades respectively is surprising,” says
Matthew Nelson, executive director of strategy at Omgeo. “Looking at the 13 central securities depositories (CSDs) and two ICSDs in Europe, there was €895 billion settled between them in
2010. If you apply failure rates of 2-3%, that is a cost of almost €20 billion
just in one arena. It’s a big number despite the fact that we have tools to fix
Custodian banks agree that trade failure rates would
reduce if settlement failure incurred a financial penalty, particularly with
the shortening of settlement cycles to T+2. The European Commission has advocated
the use of financial penalties for settlement failure, as well as a requirement
for trades to settle within T+2, in its proposal for CSDs, published in March 2012.
Custodian banks, however, are concerned that the risk
of settlement failure will increase exponentially if shorter settlement cycles
are not preceded by an increase in the efficiency of the middle office,
particularly in the trade matching process.
“Even though this is two and a half years away, it’s
not that far off considering the significant systems changes and market
practices required in order to prepare for the new cycle,” says Nelson.
For the worst offending countries, namely Portugal
(10% fail rates for equity and 5% for fixed income) and Israel (7.5% for equity
and 7% for fixed income) the fail rates becomes a bigger issue when the
settlement cycle is shortened, says Nelson. “It is surprising given that you
have T+2 coming in Europe and T+1 being talked about in the US,” he says. “As
you compress these trade lifecycles and still have these 2.8-3% fail rates for
equity there’s going to be even more at risk. The key to achieving these
settlement cycles is going to be same day affirmation or matching on or as
close to trade date as possible. There are solutions like ours that can help
meeting that goal and it will be critical in meeting that deadline.”
Emerging markets like Taiwan – the best performing in
terms of settlement timeframes - have forced buy-ins and strong penalties for
“Penalties are the only way to get them to focus on
reducing their fail rates and get to the right market practices. It has
certainly been effective in Taiwan, which has zero fail rates,” says Nelson.
“Even though some emerging markets have failure rates of more than 2.8% and
1.4%, the inclusion of Taiwan, which has invested in infrastructure, has built
strong operational infrastructure for the entire trade lifecycle helps to
offset that. They have a newer system and they’re not burdened with the legacy
systems of some of the major markets. These major markets have a big challenge
to upgrade their legacy systems, but it has to happen over the next 18 months.
“The technology exists to clear and settle securities
transactions faster, so the obstacles to achieving this are purely procedural
and behavioral,” added Nelson. “The world-wide 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. The most important change required is that market participants
should affirm trades on the day the trade is executed, enabling both timely and
Custodian banks and their clients cite inaccurate
settlement and account instruction data as the most significant reason for
failure, followed by the deliberate failure to settle by counterparties and
mismatches between cash and securities cycles.
Nelson concludes: “We’re hoping that the CSD
regulation and white papers like this will highlight the need for investment in
automation and that these countries will start to focus on not only ensuring
that their infrastructure is sound but that the people are investing in the
relevant technology to reduce fail rates and to meet the new settlement
Reporting by Janet du Chenne, Global Custodian, an Asset International publication