Global Cosultig Practice White Paper Migratig to a T+2 Settlemet Cycle Implemetatio Imperatives
About the Author Sajeet Mishra Sajeet Mishra is a busiess cosultat with Tata Cosultacy Services (TCS). He has 13 years experiece i post-trade capital markets. This icludes experiece with broker-dealers, ivestmet baks, ad global custodias i areas spaig tradig, clearig ad settlemet, custody, ad corporate actios. His curret area of focus is clearig ad settlemets for cetral securities depositories (CSDs), custodias, cetral couterparties (CCPs), ivestmet baks, ad brokerage houses. Sajeet has a Master s degree i Busiess Admiistratio.
Abstract The big bag Europea migratio to a T+2 settlemet cycle was seamless, disprovig predictios of catastrophic market disruptios arisig from a large umber of settlemet failures. Both regulators ad the idustry worked i syc, demostratig strog collaboratio, timely preparatio, ad icreased awareess to make the trasitio a success. This paper takes a closer look at the operatios, processes, ad techological eviromet for the post-trade value chai i jurisdictios with loger settlemet cycles (loger tha T+2). The key issues aalyzed i this paper are whether: The chages required are icremetal or substatial The adjustmets are similar for both the buy ad sell side i a trade There are other challeges, such as behavioral chages amog the operatios staff, to successful migratio to a T+2 settlemet cycle Usig the Europea experiece as a example, this paper also highlights the critical success factors for a T+2 trasformatio iitiative ad the key isights for markets that are plaig to implemet such a move i the ear future. There is o oe size fits all solutio. The applicability of various best practices will deped o specific post-trade market practices ad regulatios prevailig i the relevat markets.
Cotets The Need for a Shorter Settlemet Cycle 6 Impact o Post Trade Processes 6 Trade Verificatio 7 Clearig 8 Settlemet 9 T+2 Migratio - the Europea Experiece 10 Markets Migratig to T+2 - Specific Challeges 11 Key challeges for the Australia ad New Zealad market 11 Key challeges for the US market 11 Coclusio 12
List of Abbreviatios AFME AG BCG BD CCP CSD CSDR ESMA EU FAQs FIX HSG ICMA IM NoE SDA SSI STP SWIFT T Associatio of Fiacial Markets i Europe Advisory Group Bosto Cosultig Group Broker-Dealer Cetral Couterparty Cetral Securities Depository Cetral Securities Depository Regulatio Europea Securities Market Authority Europea Uio Frequetly Asked Questios Fiacial Iformatio exchage Harmoizatio Steerig Group Iteratioal Capital Market Associatio Ivestmet Maager Notice of Executio Same Day Affirmatio Stadig Settlemet Istructio Straight Through Processig Society for Worldwide Iterbak Fiacial Telecommuicatio Trade Day or Trasactio Date T+2 Two Days after the Trasactio Date T2S Target2 Securities
The Need for a Shorter Settlemet Cycle The crisis of 2008 was a defiig momet for fiacial markets aroud the world. No market remaied immue from its impact. A crisis of such magitude ad scale forced atioal govermets ad regulators to brig i a host of legislatio ad regulatio to prevet its recurrece. Although most of this focused o addressig the deficiecies i over-the-couter derivatives markets, regulators also cosidered the legth of settlemet cycles prevailig i major capital markets. Addressig couterparty risk through operatioal meas became a focal poit for regulators. Sice this risk is directly proportioal to the legth of a settlemet cycle, movig towards a shorteed cycle became a crucial legislative ad regulatory priority. I October 2014, 29 Europea markets migrated to a shorteed settlemet cycle, a T+2 settlemet regime from T+3.¹ This was a remarkable achievemet cosiderig the umber of markets ivolved, diverse market practices, ad the presece of multiple market players i the trade-processig value chai. Europea legislators, regulators, ad the fiacial markets commuity proceeded with this migratio despite beig i the midst of aother largescale ifrastructure iitiative the implemetatio of the TARGET2 Securities (T2S) settlemet platform. This idicates the importace placed o esurig a shorter ad harmoized settlemet cycle across Europe. I the Asia Pacific regio, Australia has already aouced a move to T+2 settlemet i March 2016 ad is i a advaced stage of preparatio with respect to the migratio.² Most of the other large markets i Asia, barrig Japa ad Sigapore, have bee operatig o a T+2 cycle for a umber of years. Japaese regulators are also actively cosiderig a similar move. South Africa is curretly i the midst of reducig its settlemet cycle from T+5 to T+3.³ These developmets idicate a global tred towards a shorter settlemet cycle by all major markets to reduce risks such as couterparty, liquidity, credit, ad settlemet risks; improve settlemet efficiecy; ad further harmoize the fuctioig of global capital markets. Impact o Post Trade Processes Post-trade processes commece immediately after the coclusio of a trade, either i a exchage or over the couter, ad differ for each of the participats i the post-trade value chai. Participats i a typical istitutioal trade process iclude buy-side ivestmet maagers (Ims); sell-side etities such as broker-dealers (BDs), custodias, ad settlemet agets; ad market ifrastructure providers such as exchages, CCPs, ad CSDs. Figure 1 illustrates the pre-settlemet ad settlemet phases of the post-trade process. [1] ECSDA, A very smooth trasitio to T+2, October 2014, accessed o 2 March 2015, http://ecsda.eu/archives/3793 [2] ASX, Trasitio to T+2 Settlemet for Cash Equities, accessed o 2 March 2015, http://www.asx.com.au/services/t2.htm [3] Johaesburg Stock Exchage, JSE successfully implemets Phase 2 of T+3 project, 6 November 2015, accessed o May 5, 2015, https://www.jse.co.za/articles/jse-successfully-implemets-phase-2-of-t3-project 6
Trade Verificatio 1] NoE 2] Allocatio 3] Cofirmatio 4] Affirmatio Clearig 1] Determiatio of obligatio 2] Margiig Settlemet 1] Pre settlemet matchig 2] Settlemet 3] Falls maagemet Figure 1. Post Trade Processig Life Cycle Trade Verificatio The trade verificatio process requires iteractio betwee the IM ad the BD. Timely trade verificatio is key to successful settlemet. This is a multi-stage process comprisig otice of executio (NoE), trade allocatio, allocatio cofirmatio, ad affirmatio. Durig this process, the IMs ad BDs verify ad fialize the terms of a trade either maually through phoe, fax or email, or through automated tools such as third-party allocatio ad matchig utilities. Impact of Migratio to T+2 Migratio to a shorter settlemet cycle will have a sigificat impact o the middle ad back office fuctios at the IM ad BD, sice the time available for cofirmig trades will be reduced. Successful settlemet will therefore deped o achievig same day affirmatio (SDA) trade cofirmatio o the trade date where the IM ad BD operate i the same time zoe. For trades occurrig at the ed of the day or across time zoes, trade cofirmatio should be obtaied early i the day after the trade. The operatios staff may eed to work loger hours to esure timely verificatio. Key Requiremets for Faster Trade Verificatio Automated trade matchig This may be bilateral or through cetral trade-matchig utilities. It requires ivestmet i electroic trade cofirmatio (ETC) applicatios, subscriptio to cetral matchig services offered by idepedet matchig utilities, ad stadard commuicatio protocols like SWIFT or FIX. Achievig true straight through processig (STP) will require automated geeratio of post-trade verificatio ad settlemet istructios. These are set to custodias ad settlemet agets from the back office of the IM ad BD respectively, usig the available stadig settlemet istructios (SSI). 7
Stadardizatio of data for matchig trades: This requires prior agreemet betwee the IMs ad BDs o the trade data elemets (such as quatity, price, ad securities idetifiers) that eed to be exchaged durig the trade verificatio process. Natioal regulators may also madate a specific set of data elemets for exchage durig the trade verificatio process. This will esure harmoizatio of the data used for trade cofirmatio. The Europea Securities Market Authority (ESMA) has proposed a specific set of data elemets as part of its techical stadards for CSDs. Oce edorsed, these will be the applicable stadards for the trade cofirmatio process betwee the IMs ad BDs withi the Europea Uio (EU), irrespective of whether trade matchig is bilateral or through cetral matchig utilities. Accuracy of referece data for stadig istructios: BDs should exercise cautio while settig up static data related to ivestmet maagers, sub-accouts, SSIs, commissios, ad other details i their back office systems. Best practices such as privileges framework ad the four-eye priciple should be adopted to set up referece data i the back office systems. The privileges framework esures that maual data set up is doe oly by authorized persoel, while the four-eye priciple etails a secod level of verificatio prior to the static data beig used i productio eviromet. Iaccuracies i static data may result i delays or mismatch i trade verificatio leadig to settlemet failures. Ivestig i a idepedet referece data solutio is a optio that large BDs ca cosider. Timely idetificatio of recociliatio breaks: Recociliatio breaks may result from the use of differet systems or maual exchage of iformatio o trade positios betwee the frot ad middle offices. Frequet recociliatio may be required, depedig o the trasactio volume, to assist i early idetificatio of errors. Prioritizatio of exceptio maagemet: I a fully automated trade verificatio eviromet, operatioal staff will have icreased opportuities to focus o exceptios or errors. Exceptios i trades should be ivestigated ad resolved o the trade date. Firms should also cosider implemetig measures such as service-level agreemets (SLA) betwee teams hadlig various processes across the post-trade value chai. These will assist i idetifyig ad rectifyig ay bottleecks. Icreased coordiatio for cross-border trades: Coordiatio betwee back offices located i multiple geographies is imperative for achievig SDA i case of cross-border trades. For large BDs ad IMs that maitai a follow the su operatig model, maagig a shorteed settlemet cycle may be easier sice operatioal staffs are located i multiple time zoes ad there is a smoother hadover of trasactios. Clearig CCPs maage the couterparty risk i a trasactio by esurig that parties to a trasactio do ot default o their commitmet to settle. Clearig fuctios iclude determiig et settlemet positios for clearig members (CMs) ad calculatio of margis based o these positios. CCPs provide this iformatio to the CMs for them to arrage for cash or securities to be delivered o the settlemet day. Impact of Migratio to T+2 Shorteig the settlemet cycle to T+2 will have a limited impact o CCPs operatios ad core systems. The exposure widow for ope trades will reduce by oe day, leadig to a correspodig reductio i the duratio for computatio of iitial margi (IM) ad mark-to-market (MTM) margis. A overall reductio i market risk will also affect regulatory capital required from CCPs ad CMs, resultig i reduced fudig costs ad clearig fees. 8
Key Requiremets for Clearig To facilitate timely clearig withi a shorteed settlemet cycle, CCPs should receive trade iformatio from the exchages withi a specified period after tradig, icludig the trade cacellatio widow that exchages offer to participats. This will eable accurate ad timely (o the trade date or early the ext day) calculatio of et positios ad margi cotributios for idividual CMs, especially by CCPs that provide clearig services across exchages. These CCPs rely o sophisticated risk maagemet models that cosider positios across exchages ad portfolio margiig techiques for calculatig margis. Settlemet Securities settlemet is the fial step i the trade processig life cycle. Through pre-matchig, CSDs match settlemet istructios prior to the settlemet day. Pre-matchig helps i timely detectio of errors i settlemet istructios. This prevets settlemet failures ad is a prerequisite to successful settlemet. Impact of Migratio to T+2 A shorteed settlemet cycle will affect CSDs, custodias, settlemet agets, issuers, ad issuer agets i multiple ways. Settlemet operatios: CSDs, custodias, ad settlemet agets will have less time to perform all the activities required to complete settlemet. Custodias ad settlemet agets will require iformatio o the trade cofirmatio process by the ed of the trade day (T). CSDs will be required to move the pre-matchig process from T+2 day to T+1 day. There will be a associated impact o the timig for issuig settlemet istructios. Arragig the required foreig currecy to settle cross-border trades will also be more challegig sice it will deped o timely trade cofirmatio from cliets. Securities ledig ad borrowig process: The time frame for loa recall will be reduced ad securities that are let may eed to be recalled early, if eeded, to effect settlemet. Corporate actios: Corporate actio aoucemet messages eed to reflect the chage i sequece of record ad paymet dates ad cosider the reduced time frame betwee the ex-date ad record date. The record date will be the ext busiess day immediately after the ex-date. Key Requiremets for Timely Settlemet Chages to the settlemet process should be iitiated by CSDs ad custodias to mitigate the impact arisig from the migratio to a shorter settlemet cycle. Custodias eed to esure that trade cofirmatios are received from cliets o the trade day, i compliace with striget timelies, i order to issue settlemet istructios to CSDs ad also to book foreig exchage i case of cross-border trades. Prime brokers ad custodias may eed to update the securities ledig ad borrowig master agreemets for chages i the recall time frame ad procedures. CSDs should determie appropriate cut-off timigs for receivig settlemet istructios ad schedule additioal settlemet batches depedig o whether the istructios are for domestic or cross-border trades. 9
Cliets eed to iform custodias ad prime brokers prior to short sellig securities, so that securities ca be arraged i time for delivery through borrowig or recall. Issuers ad issuer agets should esure that ay etitlemets arisig from corporate actios are available at the begiig of the paymet date i the accouts of the beeficial owers. This esures that settlemet istructios relyig o such proceeds are successfully executed. T+2 Migratio the Europea Experiece I Europe, there were several measures take i preparatio for the migratio. The Cetral Securities Depository Regulatio (CSDR) came ito force i April 2014,⁴ acceleratig the move. The T2S Advisory Group (T2S AG) also cotributed by requirig T+2 settlemet i the T2S markets as oe of the harmoizatio activities. The key elemets for preparatio ad executio of the T+2 migratio were: Formatio of a Harmoizatio Steerig Group task force by the T2S AG with wider idustry participatio to prepare for ad adopt a commo approach for a shorteed settlemet regime. Detailed recommedatios by the task force,⁵ icludig o: Scope of trasactio types ad coverage of fiacial istrumets affected Specific post trade processes, such as, trade cofirmatio ad pre settlemet matchig Avoidace of specific activities durig the migratio period, icludig corporate actio processig, ew issue of securities, rebalacig of idices ad portfolio trasfers Use of trasitioal arragemets durig the migratio Awareess o various aspects of the move geerated by idustry associatios such as AFME ad ICMA through workshops, semiars, ad white papers, as well as by stock exchages ad depositories through FAQs coverig all aspects of the migratio. Key takeaways Timely preparatio ad close collaboratio betwee stakeholders was key to the success of the Europea migratio. This esured that all etities had sufficiet time to make ecessary chages i operatios, techology, ad processes to successfully migrate to a T+2 regime. There was a broad agreemet betwee all those impacted o the chages eeded. Detailed recommedatios from the HSG TF also esured that all market etities had access to the same iformatio durig their preparatory phase. Ulike i coutries where the move to T+2 was a market-drive iitiative, the Europea migratio was madated through legislatio. This provided the required urgecy to expedite the move. [4] Europea Commissio, New Europea rules to regulate settlemet ad Cetral Securities Depositories (CSDR), accessed o 5 May 2015, http://ec.europa.eu/fiace/fiacial-markets/cetral_securities_depositories/idex_e.htm [5] ECB, Best Practices for T2s Markets Migratio to T+2: Updated Versio of Proposals by the T2s Harmoisatio Steerig Group (HSG), Jue 2014, accessed o May 10, 2015 http://www.ecb.europa.eu/paym/t2s/progress/pdf/taskforcet2/2014-06- 10
Markets Migratig to T+2 Specific Challeges Some of the major global fiacial markets are cosiderig migratig to a T+2 settlemet cycle over the ext two years. While Australia will migrate i March 2016, New Zealad ad the US are i the process of determiig their migratio timelies, with a likely date i early 2016 ad 2017 respectively. Each of these markets will have to cofrot varied challeges that emaate from prevailig market practices, ad will require specific resposes to address them. Key Challeges for the Australia ad New Zealad market Higher SDA: The SDA rate i Australia is curretly at 81 percet.⁶ This eeds to be improved to brig it closer to the Asia average of 94 percet to esure successful implemetatio of a T+2 settlemet system. While large buy ad sell-side firms may already be techologically eabled, the challege will be to get the small ad mid-sized firms to implemet automated trade cofirmatio. Regulators ad idustry associatios should assist this by raisig awareess about the beefits of a automated trade processig eviromet. Real-time paymet: Aother challege for this market is achievig retail paymet clearace o the settlemet day. This will require a move to more real-time paymet methods i place of checks to reduce credit risk for market participats, due to the requiremet of pre-fudig retail customer accouts. Faster settlemet cycle: Curretly, aroud 14 percet of istitutioal settlemet istructios are matched o the T+1 day ad the remaiig o the T+2 day.7 Migratio to a T+2 settlemet eviromet will require settlemet agets to receive trade cofirmatio, arrage for securities ad cash, ad prepare ad sed settlemet istructios withi a spa of 24 hours, to esure that a substatial majority of settlemet istructios are matched o the T+1 day. Settlemet of dual listed securities: Australia ad New Zealad have dual listed securities. I the evet that New Zealad migrates to T+2 settlemet at a later date, corporate actio processig of such securities may pose issues, sice the sequece of key dates i the settlemet cycle will be differet i both exchages. Key challeges for the US market The US is the largest capital market i the world, ad home to a large umber of ivestmet firms of various sizes. Large firms, both buy ad sell-side, will fid it easier to implemet a automated trade processig eviromet as compared with medium ad smaller sized firms, due to their existig techology, processes, ad best practices. Also, large ivestmet firms have the resources required to ivest ad acquire the ecessary techology ad systems. Therefore, achievig SDA will be a major challege for small ad medium-sized firms sice the relatively low trasactio volumes may ot justify the ivestmet required whe compared with the beefits derived. Further, these firms may have competig regulatory priorities that ihibit ivestmet i the techology required for automated trade processig. Such firms ca cosider outsourcig their middle ad back office fuctios as a alterative. [6] ASX, Shorteig the Settlemet Cycle i Australia: Trasitioig to T+2 for Cash Equities, February 2014, accessed April 23, 2015, http://www.asx.com.au/documets/public-cosultatios/t2_cosultatio_paper.pdf [7] ASX, Shorteig the Settlemet Cycle i Australia: Trasitioig to T+2 for Cash Equities, February 2014, accessed April 23, 2015, http://www.asx.com.au/documets/public-cosultatios/t2_cosultatio_paper.pdf 11
Stadardizatio of the format for trade cofirmatio betwee IMs ad BDs is also importat to achievig high SDA rates. I additio, elimiatig the presece of physical securities ad achievig complete dematerializatio will be ecessary to achieve successful migratio to a shorteed settlemet cycle. Coclusio Migratio to a T+2 settlemet cycle will require several chages to be implemeted i clearig ad settlemet processes withi the various affected etities. While market participats that are advaced i terms of their techology adoptio may oly eed to implemet icremetal chages, others may eed substatial improvemets to their iteral processes. These iclude automatio of trade cofirmatio ad matchig to achieve SDA, implemetatio of STP (especially by sell-side BDs ad custodias), ad advacemet of timelies for processig settlemet istructios. Process audits may be required to elimiate redudat middle ad back office activities ad determie the best way to make chages. The adoptio of ew techology or tools or a shared services model should be determied by a aalysis of curret trasactio volumes, level of techology use, ad future growth i volume, amog other factors. May of these chages may eed the operatios staff to work loger workig hours, which will require behavioral chages. For market ifrastructure etities such as CCPs ad CSDs, o large-scale system chages are required. However, the Europea experiece clearly idicates that existig timelies will eed to be advaced to meet the T+2 settlemet period. This will require amedmets to rules relatig to operatioal procedures, ad eforcemet of settlemet disciplie or pealties to esure compliace with the shorteed cycle. Timely preparatio, close cooperatio, ad effective coordiatio betwee all market participats are prerequisites for successful migratio to a T+2 settlemet cycle. Markets such as the US, Australia, ad New Zealad, which have recetly begu their migratio efforts, should cosider ad implemet best practices based o the experiece i Europe, while cosiderig local market practices. Ultimately, a harmoized settlemet cycle across global fiacial markets will brig i greater efficiecy to the post-trade eviromet ad reduce the overall risk for ivestors i securities markets across the world. 12
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