By Matt Johnson, associate director, ITP Product Management, DTCC.
Of particular relevance to SDR is the sell-side’s securities lending/stock borrow loan businesses (SBL), which are heavily used in conjunction with activities such as short selling strategies and risk pricing.
SBL is where the sell-side lends out securities for a fee to make a profit. The problem many sell-side firms have is the SBL inventory isn’t always segregated from the normal trading and market making inventory.
This means a trader on the cash equity desk may have a long position, only to find that stock is no longer available when it comes to settlement as it has been loaned out by the SBL desk. This scenario would result in a failed settlement, which triggers a fine under SDR rules or a potentially expensive buy-in.
Avoiding these penalties may require sell-side firms to implement a fully-resourced team to carry out a stringent reconciliation process. Some of the large broker dealers to which we have spoken estimate that based on existing settlement failure rates across different asset classes, a dedicated team to handle settlement penalties would need to be 25 individuals strong, with the potential addition of another 25 people required to handle buy-ins.
Due to the potential level of resourcing required, some market participants are predicting a reduction in SBL, which would lead to a decrease in liquidity and possibly short selling strategies. At the same time, there’s an argument that SDR may in fact result in an increase in SBL business as market participants borrow stock in order to avoid the financial penalties of failed settlement.
This approach requires the sell-side to implement a more efficient, automated inventory management process that provides a real time understanding of how much inventory is owned and where it is located so that it can be moved to the correct location for timely settlement.
A further complication is that SBL activity will be in the scope of the Securities Financing Transactions Regulation (SFTR) and so, as of SFTR’s July 2020 implementation date, all SBL transactions would need to be reported.
It appears likely that in addition to SBL, SDR is likely to affect the sell-side’s equity commissions. In 2019, based on data from DTCC’s CTM matching engine, DTCC estimated the average commission rate of a European equity trade to be approximately 2.5bp per trade. Under SDR, if a trade fails to settle on time, it incurs a charge of 1bp per day, which would quickly eliminate that profit.
The impact of this rule is even more challenging to predict for fixed income trades, because the commission rate is opaque and not as transparent as it is in equities trading. In order to implement appropriate resourcing ahead of SDR’s deadline, sell-side firms should conduct a thorough analysis of their fixed income businesses to determine the impact of settlement fails on profits.
SDR’s resourcing challenges also encompass the buy-in process and partial settlement. Firms report that buy-ins will more than likely be a front-office function, but a significant increase in the volumes of buy-ins required may necessitate a new front office role, created solely to fulfil the buy-in regime requirements of SDR.
Likewise, partial settlement requires additional front to back processes to ensure the buy-in is booked to only cover the outstanding amount of the trade that has failed to settle. To ensure the buy-in is executed correctly, the front office will need to know the outstanding amount of the trade to be settled.
However, there are boundaries established between the front and the back office designed to eliminate rogue trading and to segregate specific operational processes from front office activities. SDR’s partial settlement rules will ultimately require enhanced communication between these deliberately segregated functions, which in turn requires further resources.
Another requirement of SDR that may necessitate additional resources and equally affects both the sell and buy-side are the historical trade settlement failures. They must be addressed before the SDR implementation date, as immediately afterwards such trades will become in scope for failed trade penalties based on the outstanding amount and the type of security.
SDR also requires the sell and buy-side to appoint a buy-in execution agent who cannot have been party to the original transaction. Given that only one provider has announced they will offer these services, this requirement could present serious challenges around bandwidth, availability and potential liquidity.
SDR will also have an impact on market-making and liquidity. For inefficient buy-side clients, brokers may be required to increase their rates of commission to compensate for the cost and inconvenience of high fail rates or the level of buy-ins. In even more extreme scenarios, they may cease trading with such unprofitable clients.
Further, specialist sell-side firms that make markets in illiquid markets such as corporate bonds or growth equities, such as the UK’s Alternative Investment Market (AIM), often require considerable time to source the assets which in many cases can lead to late settlement (up to T+10 for more illiquid products).
According to the rules of SDR, the cost of late settlement or buy-ins required for such products could be so high that the business model of these specialist market makers will simply not be viable, resulting in a lack of market-making and hence liquidity in these specialist markets.
SDR’s strict rules around trades that fail to settle and the potential for a significant jump in buy-in volumes means that the level of resourcing required to implement the regulation could prove extremely challenging for the sell-side.
In addition, SDR may have implications for liquidity and market-making which will not only impact the sell-side but will have repercussions for a wider audience such as asset management and corporate clients.
However, sell-side firms are not powerless. Effective planning and adequate preparation that includes adoption of a best practice approach of automation to front, middle and back office processing will equip them to mitigate the potential negative impact of SDR and benefit from significantly increased operational efficiencies as a result.
