FINANCIAL MARKET INFRASTRUCTURES
     
European Commission, Financial Services Hungary, ECB T2S deputy and ECMI
OMGEO and ICMA, and endorsed by ECMI, organised an event with the aim to represent a forum for policy makers, industry and stakeholders. This industry forum took place 14 December 2010 and was focussed on operational and legal risks, settlement cycles and financial stability.

Discussions, forwarded ideas and useful contributions made it clear risk management have become embedded in the DNA of the industry. It's clear that firms who have taken a serious and holistic consideration of risk across their organization are the ones best prepared to navigate the industry. In many cases, being able to prove risk management policies and procedures to clients and prospects, even regulators, has become a necessary part of doing business.
The global financial crisis has brought to light important weaknesses in the functioning of market infrastructures, of which some issues already were brought under attention by ECMI / CEPS on 22 Januari 2010 through the meeting "
How should market infrastructure be governed?"


Historically the middle and back-office segments were addressed purely from an efficiency perspective - but they actually play a major role in mitigating risk and promoting financial stability. A wide-range of legislative proposals will impact the post-trade segment, while Target2 Securities could in the short term prompt a Europe-wide move to a shorter settlement cycle of T+2 and drive higher levels of harmonised market discipline. Regulators want more automation, better reporting and higher levels of pre and post-trade transparency.

3rd Quarter 2011 growth in exchange-traded funds (ETFs) has raised concerns. The risk involved in the use of structured financial instruments by some of these funds in the form of total return swaps. The European Securities and Markets Authority (ESMA) recently held a consultation on ETFs and structured UCITS to gather evidence which should help it establish whether UCITS rules need fine-tuning to adapt to these vehicles.

Askings:
Is the buy-side ready for new regulations and new infrastructures? Is there a trade-off between efficiency and safety? Can new technological developments mitigate operational risks and increase the efficiency of the infrastructures? What is (also) the matter (eg. harmonization) of the European Commission (where is present a strong awareness, commitment and will)?

Relationship between SDA Rates and Settlement Efficiency (top 20 markets)
Speakers from Omgeo, ICMA, ECMI, Bank of New York Mellon, Euroclear, Xtrakter, CESR, European Commission, Permanent representation of Hungary to the EU and ECB.

Omgeo composed the paper 'Mitigation Operational Risk and Increasing Settlement Efficiency through Same Day Affirmation (SDA). Below you find the executive summary: The financial crisis has clearly shown that risk management - the way we knew it - didn't adequately manage risk. The turmoil in the financial markets has been the catalyst for firms worldwide to look more closely at their risk management methodology while thinking about risk more holistically, including gaining a better perspective of their operational risk. At the same time, regulators on both sides of the ATlantic are focusing on overhauling post-trade infrastructures. Regulatory action has often, if not always, been an effective driver of change. But proactive firms don't always rely on regulatory drivers and, instead, consistently review their international operations for continued oportunities to mitigate risk.

In the area of operational risk, there is one industry best-practice that firms should pay particular attention to: Same Day Affirmation (SDA). We define SDA as "the agreement of all trade details on trade date (T+0) between a broker/dealer and an investment manager (or their agent)". The case for SDA is based on the simple premise that by agreeing on the details of a trade more quickly, operational risk, costs and ineffiencies are significantly reduced. If you can lock-in trade details sooner and affirm on trade date, you will have that much more time to identify and resolve any potential errors, and so the chances of a trade failure are reduced.

SDA is a vital prerequisite for mitigating operational risk and increasing settlement efficiency. It is also an important prerequisite for achieving shorter settlement cycles, a topic heavily debated in preparation for the launch in 2014 of TARGET2-Securities (T2S) in Europe. In 2008, Oxera, an independent research firm, conducted an analysis on the benefits of SDA. One of the key findings was that firms adopting automated processes to achieve SDA can expect reductions in the risk and costs associated with trade verification and other post-trade processes, including reduced trade failure rates.

We have now taken SDA analyses one step further by closely comparing Omgeo service performance data with Global Custodian settlement efficiency intelligence. Key findings:

We have now taken SDA analyses one step further by closely comparing Omgeo service performance data with Global Custodian settlement efficiency intelligence. Key findings:
  • The analyses confirms that securities trades affirmed on the same day have a much higher chance of settling on time and are less likely to fail. Quantifying settlement performance improvements across multiple markets can be challenging given the range of factors that affect the ability of counterparties to settle trades successfully. However, we found evidence from Global Custodian survey intelligence that operations managers at major global custodian and investment banks have noticed improved settlement performance in markets where levels of SDA are high.

  • The combination of Omgeo data on SDA rates and Global Custodian settlement efficiency data suggest that there is a direct correlation between high SDA rates and high settlement rates. Settlement efficiency in countries with SDA rates of over 90 percent - India, Taiwan, Hong Kong, Japan, Singapore and Korea - is 26% higher than in countries with SDA rates of less than 70 percent - Brazil, Italy, South Africa and the United States.

  • As Europe debates shortening settlement cycles, the analyses showed that there are benefits of a regulatory and industry push to shorten the settlement cycle. Four of the five countries which display the highest SDA rates and highest settlement efficiency scores require T+2 settlement for mosty securities, including India, Taiwan, Hong Kong and Korea. Similary, South Africa, which has one of the lowest SDA rates and settlement efficiency scores, operates on a T+5 cycle. These data points suggest that countries that have imposed shortened settlement cycles are achieving higher efficiency and lower operational risk than other countrieswith more relaxed standards.

  • Our analyses shows that approximately $4.1 Trillion DTCC eligible trades are at risk on an annual basis because of poor market practice that allows trades to settle even if they have not been affirmed or matched.

  • Generally speaking, regulatory, cultural and regional workflow practices are the main determinants of SDA rates, with regional regulation being the most important driver. Unless firms are under strict obligations to comply with specific market rules and regulations, it's often very difficult to change and improve historical processing behaviours.

  • From a regional persspective, Asia displayed the highest SDA rates and the Americas the lowest, making Asia the region with the lowest operational risk. Asian rates are a reflection of regulatory and cultural practices. A number of regulations are in place in different markets that require, for example, prompt trade matching or affirmation on T+0. In addition, a regional culture of efficiency which has shaped day-to-day life as well as financial processes is an important contributor to high SDA rates. The same cannot always be said for the Americas (with the exception of Canada), where the US most negatively impacts the regional average.

  • SDA rates across Europe are consistently in the mid 80% range, with Switzerland leading the region and Italy at the bottom of the SDA curve. Again, differences in rates can be attributed to local regulation, cultural and market practices. Switzerland has the highest SDA rate in the region (87,6%), where a Code of Conduct requires trades to be confirmed on the day of execution (T+0) and where there is also a regional culture of efficiency that has shaped day-to-dau life as well as financial processes.

  • Centrally matched trades are much more likely to be affirmed on the day the trade was executed. On average, centrally matched trades achieve an average SDA rate of 86,5% wheras locally matched trades obtain 66,6%.

  • There are significant differences in SDA rates between equity and fixed income trades, with fixed income rates being considerably lower. This gap is primarily due to the relatively recent fixed income automation effort (as compared to equities), the over-the-counter nature of fixed income, the sheer number of fixed income products, and workflow practices within the fixed income market.

As global economies slowly emerge from the financial crisis, few would doubt that the lessons learned in risk management have become embedded in the DNA of our industry. It's clear that firms who've taken a serious and holistic consideration of risk across their organization are the ones best prepared to navigate the industry. In many cases, being able to prove risk management policies and procedures to clients and prospects, even regulators, has become a necessary part of doing business.

It's clear from the findings of this analysis that SDA correlates highly with settlement efficiency and that institutions in countries which have pushed forward automation, either through industry best-practice or regulation, are achieving a higher degree of efficiency and reducing risk and cost for their firms and their clients.

Other remarks from the forum:To be sure to get all the information is of importance, operational aspects should be regulated by laws (which could become difficult, due to differences in laws), parties should meet coordination of supervision (by the EC).