Banks and asset managers will soon be grappling with a revolution in European securities markets that could push up the cost of trading by billions a year. New European rules are due to come into effect in September that will impose tougher standards on trades that fail to settle on time — either because the buyer does not deliver the funds to pay for the deal, or because the seller does not supply the securities.
The rules are expected to shake up an industry which is used to resolving such problems on an informal basis, and where late penalties are rare. Big investment banks each have to deal with about 10,000 failed trades every day in their core markets in the region, according to Cognizant, a New Jersey-based provider of IT services. ICMA, a bond industry trade association, has warned that the new regime is likely to hit pricing and liquidity in securities lending and some corners of the fixed-income market. Equities trading could also be shaken.
“It’s the final mile of the trade where the money changes hands,” said Virginie O’Shea, research director at Aite Group in London. “The industry has benefited from nobody paying any attention and now the regulator wants to address this elephant in the room.” Like its regulatory cousin Mifid II, the new failed-trades regime was formed in reaction to the global market crash of 2008.
Policymakers hope to reduce uncertainty among investors that a default would mean they may not receive the goods they had paid for — and to reduce the risk of those unsettled trades ricocheting through the market. But failures are as likely to be caused by tech glitches or paperwork problems as a default, say market participants, and a few informal phone calls normally smooth over most wrinkles. Now that informal system is being taken away.
Trades that fail to settle, usually within a window of two or three days, will undergo a mandatory “buy-in” to close the deal. The counterparty, clearing house or central securities depository will be required to buy the asset at the prevailing market price and then deliver it to the non-defaulting party within seven working days. The party that created the failed trade will have to pay the initial penalty — a fraction of the value of the trade — as well as any difference between the buy-in price and the price of the original deal.
Costs could be considerable. At present, failed trades account for about 3 per cent of the value of trades in corporate bonds and sovereign debt markets, and about 6 per cent in equities markets, according to the European Securities and Markets Authority. Whether those numbers will increase under the new regime is unclear. Ms O’Shea points out there is no standard way across the EU to classify a failed trade.
Daniel Carpenter, head of regulation at Meritsoft, a Dublin-based group owned by Cognizant, said that many bank and fund managers’ systems were not yet capable of tracking or valuing failures. However, determining who is to blame for a breakdown will be crucial. Matt Johnson, associate director at DTCC, a post-trade services provider, said the extra costs were likely to sit with the trading desks of the party responsible, “eating into their profit margins”.
He estimates that an equity trade has an average commission of about 2.5 basis points, but would face a charge for failure of 1 basis point per day. That means a two-day delay would nearly wipe out the desk’s income. Some brokers and asset managers may have left it late to adapt. A survey by ICMA of its members in November found that just 10 per cent had “broad awareness” that a change was coming, while the remainder said they had “limited” or “very little” awareness.
The impact of the new regime will stretch beyond Europe, as the rules apply to any security bought within the EU and settled within an EU central securities depository, such as Euroclear and Clearstream, which collectively hold more than €40tn of assets for investors. Awareness outside Europe is very low, Mr Johnson noted. Executives fear that market dynamics could change drastically as traders try to protect their profits.
Banks may widen their spreads — the difference in prices for buying or selling the asset — by up to 250 per cent for assets such as high-yield bonds, emerging-market bonds and illiquid investment-grade credit, according to Andy Hill, a former Goldman Sachs trader and now director of ICMA. For every €1tn in annual volume on bond markets, investors could pay up to €1.4bn in wider spreads, on ICMA estimates.
Mr Carpenter said the new rules would add fresh uncertainty to the business of trading, where banks already face shrinking margins because of rising automation and patchy volumes. “You can’t afford to have a failed trade,” he said. “If they’re not going to offer a price, [senior] people will look at their trading arms to see if they’re viable.”