It is a rare day in the securities finance industry when you can’t read or be directed to the latest article on the preparedness, (or not) of market participants with regard to SFTR, solutions offered by a number of providers and most importantly, the countdown to the go live date of April 13th 2020. Looks like next year’s Easter plans are cancelled for many. An extraordinary amount of time, expense and effort has gone into this regulatory initiative and no doubt will continue to do so as testing, which has already begun for some, produces its first outputs for analysis.
No sooner will the dust have settled and the lazy days of Summer have passed when the market will be subject to the next EU regulatory implementation in the form of the Central Securities Depositories Regulation (CSDR Regulation No 909/2014)). The regulation is, at its heart a necessity given EU ambitions to improve post trade settlement efficiency across Central Securities Depositories (CSDs) within the EU and to some extent across the EEA. To achieve that, operational legalities require some harmonisation particularly with its aims to reduce settlement cycles across the CSDs of member states. Actually, September 2020 will be the culmination of the regulation that has already been implemented which dates back a number of years to 2014. The final piece, and one that is important to securities finance participants, custodians and CSDs is the Settlement Discipline Regime (SDR). This will include mandatory buy-in regulation for failed transactions. Anyone who has lent, borrowed, bought or sold securities knows this could have a material impact.
CSDs carry a lot of the heavy lifting under the regulation. They are subject to re-authorisation by their National Competent Authority (NCA) by applications they would have made back in 2017. Once authorised they will be subject to the extended requirements which includes not only the settlement discipline mentioned but reporting and record keeping requirements. Interestingly, the record keeping requirements (Article 29) are not that dissimilar to a number of fields contained within SFTR. Other obligations include the maintenance of account segregation and operational risk which will include the monitoring of areas of inter-dependencies between participants and the CSD itself. Identifying material risks that could arise from participating client activity will be an interesting challenge.
Under the settlement discipline regime, CSDs will have a number of pre- and post-trade obligations for which some are admittedly already levied at investment firms under MiFID II to ensure fails are limited and avoided by sound operational processes. It is the introduction of mandatory buy-in’s on failed transactions that has the potential to spill over into the liquidity of securities finance.
As we all know, in the current prevailing securities finance markets, failed transactions can and do occur for a number of reasons. Poor matching processes on fields such as trade date or economic mis-matching criteria that are not identified prior to settlement can make trades fail. Typically, these are largely mitigated by the use of a number of vendor systems that are dedicated to pre-trade matching and reconciliation. The utility provided by such firms will no doubt become prevalent if not outright universal.
Failed lending transactions at initiation, i.e. the start of a loan is irritating but tend to be rectified immediately given at some point in the chain, the actually position is held by a custodian. The natural return of a loan i.e. when the borrower no longer needs it could be described as an internal event as there is no impact on a lending client but only an economic one on the borrower if the trade was executed against cash. With interest rates where they are, this is fairly minimal.
When a client sells a security the agent lender will either recall the security from the borrower of substitute it with a holding of another participants security to ensure settlement. On occasion the recalled securities will fail to settle and the prevailing market action is a combination of efforts by all parties to take remedies to secure settlement as quickly as possible. Agent lenders and borrowers have contractual recourse under existing provisions for resolution contained within governing contracts such as the GMSLA or GMRA that allows for a buy-in or a close out of the failing transaction. In the securities finance markets, this action is rarely required or invoked.
Fortunately, under Article 7 (4)(b) on the Regulation, securities financing transactions (SFT’s) will be exempt for all trades for a duration of less than 30 days.
The other good news is that on the whole, settlement rates across the industry are extremely high, certainly in excess of 85% but it depends on which criteria one measures. The important statistic would be to know the number of client sales that fails as a result of a securities finance transaction. Global custodians and their clients’ that participate in a securities lending programme will certainly be accurately aware of these figures. Deeper analysis as to the reason for failure and the assets involved ought to be a project now if it isn’t already.
Why? Because the regulation requires that for a liquid security that fails for longer than four days, the buyer must instigate the buy-in process on the seller regardless if they want to or not. It is a legal requirement. Securities deemed illiquid will have seven days, referred to as the extension period prior to the mandatory buy-in. On the face of it for most securities finance transactions that maybe causing a client sale to fail, the timeframe seems reasonably sufficient to avoid having to take this action.
However, the market is more interested in the “what if’s” and certain sectors could see a reduction in available supply based on a risk/reward analysis. This is why statistical information gathered now of current client failing transactions could be highly informative in shaping a policy going forward. Currently failed sale transactions cause intense irritation and potential reputational risk. After September 2020 that irritation will not be contained between client and agent lender but will now force the buyer to buy-in the seller at the expiry of the extension period. That is a very different scenario and one that needs mitigating. It is likely that agent lenders with assets deemed illiquid such as small cap corporate debt will think twice before lending such issues and they will certainly want to know far more about the available supply in the “auto borrow” programmes of ICSD’s. Moreover, their underlying clients may want to restrict securities deemed to be “illiquid” from lending regardless as the risk of buy-in could easily consume the lending fees earned on an offending transaction not to mention the added burden to all parties involved.
The only true avoidance of this scenario is to not lend certain securities. That would have a detrimental effect on overall market liquidity not to mention the potential rise in reluctance to make markets in certain assets classes. Decreased liquidity will reflect in wider bid/offer spreads which is certainly not the outcome envisaged. And it may not be the case that it is only illiquid securities that become the focus. Government bonds and index equities can and do become “ special” at times when the fee to borrow rises dramatically which is a direct reflection upon available supply. Large scale sales in the middle of this activity could be of concern as to the potential of a fail rather than the reality. It would be a curious and unwanted scenario in which clients are generating high lending fees on special securities only to be spooked by concerns of market wide liquidity should they want to sell.
So, what is to be done? The elimination of unnecessary poor matching prior to settlement. As mentioned, there are vendors offering detailed pre-matching and reconciliation services that are widely used by the industry already. Perhaps the market insists that stragglers get on board and market participants develop policies that they only trade with those who use such a service?
The auto-borrowing capabilities of the ICSD’s may become more important but the dynamics of how they truly operate and to what extent is somewhat opaque. An opportunity for them to engage with clients perhaps? Sub-custodians may also want to develop or enhance failed coverage programmes and charge high fees but by doing so contribute to the overall market liquidity.
Understanding the extent of failing trades now and their duration will give investors the necessary tools to determine what the impact would be on them currently were CSDR live today. From that output they can make any necessary changes to their lending supply at an asset class or individual security level if needs be. In collaboration with their custodians this is a worthwhile undertaking to really know the buy in risk involved.
Improving market settlement cycles and overall efficiency is an important and welcome development. Whether a mandatory buy-in regime contributes to that efficiency or detracts from it remains to be seen. What can be counted on is that in preparation for its arrival, market participants are forced to review their current business models, systems and practices. That in itself isn’t a bad thing.
John Arnesen, Consulting Lead