EXCLUSIVE: ‘Regime Change’ – Pete Tomlinson, AFME and Frédéric Viard, Bottomline ‘The Fintech Magazine’

De-risking the European financial markets has finally reached securities trading… but it’s not been an easy ride. Pete Tomlinson, from the Association for Financial Markets in Europe (AFME), and Frédéric Viard, Product Director Securities, at Bottomline, share their views Many of the economic and social impacts of the COVID-19 pandemic are still to unravel, and the only thing that seems certain, right now, is that they will be severe. Nevertheless, for financial services specifically, the 2008 crash is still the biggest black swan event of the 21st Century. In fact, almost everyone is still experiencing the fall-out from it, in some form or other. One of the reasons for this is the way it fundamentally undermined trust and confidence in the marketplace,  by highlighting the role of non-transparent and sometimes unethical practices, which helped to bring the world economy to its knees. The result was a counter-wave of risk aversion and regulation that’s still unfolding today, aimed at preventing any such event from happening again. Securities trading is one of the last remaining financial outposts for reform – and it’s proving somewhat controversial. A new settlement discipline regime (SDR) was supposed to have been fully introduced by now under the Central Securities Depositories Regulation (CSDR), which is designed to harmonise settlement standards and promote competition. But the SDR’s final phase of implementation is facing delay due to lobbying by a range of industry bodies that claim the various counterparties in the transaction chain – as well as the broader ecosystem – need more time to prepare. The European Securities and Markets Authority (ESMA) recently agreed to postpone implementation for 12 months, until February 2022, after the Association for Financial Markets in Europe (AFME), the Investment Association (IA), the International Capital Market Association (ICMA), the Alternative Investment Management Association (AIMA) and the International Securities Lending Association (ISLA), stood shoulder-to-shoulder on the issue. They wrote an open letter calling for a phased approach to implementation and a rethink of the SDR’s controversial mandatory buy-in clause, which requires initiators to stand behind a transaction, regardless of whether a resulting failed trade is actually their fault. It impacts any buy or sell-side participant that invests in any European market, regardless of where they are based, with significant potential penalties for non-compliance. Market participants will be liable to pay penalties, calculated on a daily basis, on any transactions that fail to settle under the mandated T+2 timeframe. Perhaps the most controversial aspect of the changes is the administrative challenge posed by the buy-in process itself, given that the mandatory requirement that initiators fulfil settlement for any financial instrument not delivered within a specified period, varies according to the type of security. Liquid assets, for example, will need to be brought in within seven days of the intended settlement date, while products like equities and bonds will be required within four days. Small-to-medium-sized stocks will be subject to a buy-in 15 days after the intended settlement date. By decreasing the number of outstanding settlement obligations between counterparties, the intention is to reduce risk in the market as a whole and, ultimately, make Europe a region where there is no failed trade. But that must be achieved by harmonising the bloc’s 40 Central Securities Depositories (CSD) markets, all of which use different definitions and methodologies. The industry argued that institutions needed more time to introduce IT, messaging and legal infrastructure changes to cope with the SRD, although some commentators speculated that particularly the buy-in side of the trade would use the time to lobby for permanent alterations. While they broadly support the new rules’ objective of improving settlement efficiency, the letter’s authors were concerned about significant negative impacts on both trading and liquidity, given the far-reaching nature of the regime, which affects market participants inside and outside Europe. Many firms in major trading regions, such as Asia and the US, are still not even aware of what is required of them.

When introduced, participants will, of course, want to understand the underlying causes of their failed trades – which could range from issues with funding and inventories, to inefficient manual operations. And before then, they’ll want to review their systems to ensure they can comply with the new regulatory requirements for processes and communication. Financial messaging formats are a potential key area of challenge, especially as the wider industry goes through the ‘handover’ to ISO 20022.

All that having been said, it’s estimated that 30 per cent of the top 200 global investment managers already use reconciliation solutions to prevent, or efficiently manage, failed trades. So why isn’t everyone better prepared?

Pete Tomlinson, responsible for CSDR within the Association for Financial Markets in Europe (AFME), which represents European and global banks, brokers, custodians and other market participants, and Frédéric Viard from Bottomline – the software-as -a-service provider creating solutions to help those same organisations adapt – share their views.

Pete Tomlinson: The European Commission has been getting market feedback on settlement discipline and other topics, as part of the ongoing CSDR review and, even though the rules haven’t gone live yet, three-quarters of the people who responded think they need to be changed already, including AFME.

In particular, the mandatory buy-in is not seen as the most effective way of delivering the objectives of CSDR, which are otherwise good and widely supported by the industry and AFME members – harmonisation in Europe and better and more efficient capital markets are steps in the right direction. But there are definitely barriers to overcome. One flaw in the regime, I think, is the way it places the regulatory obligation on the injured party – which has done nothing wrong – because someone’s failed to deliver to them.

The regime will have a global impact and that was the deliberate intention of the regulators – any non-EU counterparty wanting to trade and settle in European securities will be affected. The regulation achieves this extra-territorial reach by requiring that the rules are contractually incorporated.

In Asia, for instance, there is no central operator for buy-in for non-cleared transactions, and the responsibility for executing the buy-in falls with the trading counterparties. So, asset management firms there need to understand that, if they are executing a trade in Europe, they now have a regulatory responsibility, as the receiving party, and if another player fails to deliver securities to them, they have the responsibility to execute that buy-in.

That means appointing an independent buy-in agent who will potentially require them to post collateral in order to execute the buy-in on their behalf. This is not replicated in any other jurisdiction. It’s a huge operational headache to get their heads around.

The contractual requirements mean that everyone has a compliance risk. But do all buy-side clients have the capability and the capacity to manage that buy-in process from start to finish? In a lot of cases, maybe not. So they might look to their brokers or service providers to take control of appointing a buy-in agent, settling the buy-in, and any price differentials arising from that. In that way, the end buyer takes more of a passive role, but I would emphasise that they still have the regulatory responsibility.

Frédéric Viard: Bottomline does have customers in Asia where, traditionally, there has been a strict culture of settlement, so the ratio of failed trades is very low. However, they now have to be prepared to adapt their environments to support the new reporting requirements and the messages that transport that. They will have to really assess their exposure to the European market, in terms of how these new disciplines will impact them.

The key point for our customers today, wherever they are, is how to implement the requirements to be sure to not be the bad guy in the chain. Even a simple securities settlement transaction can get pretty complicated, pretty fast, when you try to map that out. You’ve got the vertical chain, from the Central Securities Deposit to settlement agents, to global custodians, all the way through to end clients, and you’ve got a horizontal chain between, maybe, a trading venue and the broker dealers, through to their end clients. There is a contractual relationship between those parties and CSDR mandates that any contract is updated to incorporate the new rules.

The broker will probably be more exposed because these are the guys who might be in a position to be short sellers, and then they will have to control this position.

The penalty regime is quite well defined but we have to keep in mind that the charges will increase over time, for as long as you are not able to deliver the shares. So, the aging of the delay will have an impact on the cost, and after that, the buy-in regime will apply. In this space, it’s important that the information that is transported over a network, such as SWIFT, can be used to monitor and to anticipate potential penalties and failed trades – because you have the trade and settlement dates, you can monitor the aging.

With regard to messaging, the 15022 standard is more suitable for the securities market and there is no regulatory driver to force the banks to use ISO 20022 for settlements, even if there is an equivalent in ISO 20022 for almost all the business aspects of the exchanges. This is a challenge,  though, because you might receive the same information from different rails and you have to combine them. That’s brought a lot of confusion and it’s the reason Bottomline is offering translation tools and coexistence possibilities across the various networks.

The aim is to have something which is completely machine-readable because that is the only way to achieve 100 per cent straight-through processing.

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This article was published in The Fintech Magazine #21, Page 99-100