Value of Trades at Risk of Failure Significant, According to New Study

Hong Kong, London, New York and Boston; MA - 16 May 2012

Settlement failure rates as high as 10% for equities and 7% for fixed income

A significant proportion of trades still fail to settle on time, despite improvements to clearing and settlement infrastructures globally, according to a new study from Omgeo, the global standard for post-trade efficiency. The value of equity transactions at risk of trade failure could be upwards of USD$9701 billion, and the value of fixed income transactions at risk is estimated at approximately USD$300 billion. The cost of stock borrowing to avert the risk of trade failure on this scale could be as much as USD$3.8 billion.

Sub-custodian banks and their clients report that trade failure rates are as high as 10% in the equity markets and 7% in the fixed income markets. However, over half of sub-custodians and half of global custodians do not calculate the cost of failure, indicating a lack of awareness of the trade failure problem as well as the associated costs.

Matthew Nelson, Executive Director of Strategy at Omgeo said, “While the percentage of trades that fail to settle may be somewhat low in some markets, even low rates of failure can represent a high value at risk. At a time when both the buy- and sell-side are looking to mitigate counterparty and operational risk, as well as reduce costs, the industry cannot afford to ignore the risks of trade failure.”

Custodian banks agree that trade failure rates would reduce if settlement failure incurred a financial penalty. The European Commission has advocated the use of financial penalties for settlement failure, as well as a requirement for trades to settle within two days of the trade date (T+2), in its proposal for Central Securities Depositories (CSDs) and settlement efficiency, published in March 2012.

Custodian banks, however, are concerned that the risk of settlement failure will increase exponentially if shorter settlement cycles are not preceded by an increase in the efficiency of the middle office, particularly in the trade matching process.

Matthew Nelson continued, “The technology exists to clear and settle securities transactions faster, so the obstacles to achieving this are purely procedural and behavioral. In Taiwan, for example, where settlement failure leads to an obligation to buy in the stock or cash to settle the trade, there is no settlement failure.”

“The world-wide shift towards shorter settlement cycles will increase the number of failed trades, unless post-trade operational practices are adapted to reduce the period between trade execution and settlement. The most important change required is that market participants should affirm trades on the day the trade is executed, enabling both timely and accurate settlement.”

Custodian banks and their clients cite inaccurate settlement and account instruction (SI) data as the most significant reason for failure, followed by the deliberate failure to settle by counterparties and mismatches between cash and securities cycles.

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