Settlement fines come into focus as T+1 deadline looms

The lack of automation in capital markets has received increasing attention over recent years. North America’s move to T+1, higher interest rates and scrutiny from regulators all mean that failed trades carry greater penalties.

But the way trade failures are reported and penalties recorded are different across jurisdictions. This makes it hard to calculate the true cost of settlement failures. 

Yet, a new report from Firebrand Research claims to have collated first-of-its-kind benchmark data, which puts global spend for regulatory penalties and resolution measures over the last decade at $914.7bn.

Much was spent during the last four years due to volatile market conditions, with 2021 marking the peak of volatility. Firebrand estimates the industry spent $161.63bn on resolving settlement failures within major equities and fixed income markets in that year alone.

It believes that $96.6bn was spent on resolving failures across the global equities market in 2023, but the move to T+1 could lead to that number being surpassed. This could occur due to an expected spike in settlement failures in the months immediately after the change to T+1.

For Firebrand chief executive Virginie O’Shea, the risk of settlement failures spiking creates several priorities for the sector. One is that the level of spending required to clean up settlement failures is unsustainable. Another is that more consistent global data needs to be produced, and global market practices harmonised.

One example the report mentions is that not all central securities depositories currently publish data settlement failures on a consistent basis. And the majority do not make the information freely available to anyone except regulators.

Firebrand’s estimates are based on a combination of CSD data alongside information from individual institutions. They represent each individual fine plus the costs accrued by every firm in the market in dealing with resolving failures. This aims to give as complete a picture of the damage done by settlement failures as possible. 

“Part of the reason why there are so few public stats is that I don't think anyone really wants to demonstrate how under-invested over the years this area has been,” says O’Shea. “The overall state of the industry [post-execution infrastructure] is lacking. 

“Hence, we have a higher failure rate than the regulators would like and actions like the Central Securities Depositories Regulation in Europe and T+1 in the US to try and force the industry to change their ways, have come in.”

She adds that many regulators are reluctant to introduce financial penalties over settlement failures due to market pressures, and in many instances they are a last resort. The EU introduced the CSDR in 2014, and the European Securities and Markets Authority’s consultation on how to toughen a penalty mechanism against unsettled trades closed last week. 

Esma’s preferred option is to introduce daily penalty rates for unresolved trades that increase by the day. 

“That would be pretty terrifying, as the fines are already pretty high,” says O’Shea. 

In North America there are no penalties for equities failures, yet there are for fixed income failures that emerged from the financial crisis in 2008. These were introduced by the industry after Lehman Brothers, in response to an unsustainable level of failures. 

“Firms just weren’t addressing the problem. So the industry took that step, which is unusual. It’s not often something like that happens but ... it’s not mandatory, it is just market practice,” says O’Shea. 

It is possible the industry could create more consistent standards of data reporting and trade settlement monitoring itself. But could a high proportion of failures force the regulators’ hands?

Sticks and carrots

David Smith, capital markets practice lead at Broadridge Consulting Services, says: “As of now, there are no proposed regulatory penalties for market participants who fail to settle US securities on a T+1 basis. Enforcement for meeting the new settlement timeline has been left to the broker-dealers to decide. 

“Broker-dealers can opt for individualised written agreements with each client outlining their operational relationship, or establish firm-wide policies and procedures outlying the broker dealer’s timing requirements, controls, and supervisory metrics.”

He adds: “I expect to see a rise in securities [failures] post-T+1 as market participants adapt to the new settlement timeline. If the industry fail rate remains high for several months, expect new regulations to be introduced similar to the Treasury Market Practices Group fail charges in the US Treasury market or CSDR in the European market.”

On CSDR, the Association for Financial Markets in Europe has warned Esma it should not make any drastic interventions in the settlement chain. 

Its response to Esma’s consultation points out that proposals to significantly alter the calculation mechanism for cash penalties would increase the complexity of the regime, while also introducing potential distortions.

Additionally, changes to the methodology would represent another significant, multi-year implementation project for market infrastructures and their direct and indirect users. This would divert industry resources away from addressing the underlying causes of settlement failures.

According to Afme, all available public data points to a material improvement in settlement efficiency since the penalty regime was introduced. It argues this is supported by feedback received from a survey of Afme members, some of whom indicated that their fail rates have halved since the start of 2022.

The survey asked how much settlement failures reduced between February 2022 and December 2023. Responses ranged from 1–6.5 percentage points, with an average of 3.18 percentage points.

Pete Tomlinson, director of post trade at Afme, says: “On this basis, we don’t believe that there is any need for a radical overhaul of the existing regime. 

“We think that there is still room for further improvement, but this can best be achieved by tackling some of the structural inefficiencies that we’ve identified rather than ratcheting up penalties.”

Innovation by automation

Regardless of T+1, higher costs of funding trades and regulatory scrutiny, all practitioners should automate their processes. 

Daniel Carpenter, CEO of Meritsoft, a post-trade technology company, says: “[Practitioners] should be thinking holistically because with a shorter settlement period you will get higher volumes by nature. There is just less time to sort out the errors. What is your strategy around all of this? You should automate trade processes with higher volumes.”

James Pike, head of business development at post-trade resolution network Taskize, agrees, saying that the manual process of trading remains far too prevalent and will not be scalable to handle a jump in trade failures. 

“The market should be preparing far more actively and looking to implement solutions to enable accelerated matching, improve exception handling to drive the management and prevention of [failures], and preserve existing performance levels at a minimum,” he adds.