With market regulators pushing for a shortening of settlement cycles, new research from trade matching utility Omgeo indicates that trade failure rates may be as high as 10% in the equity market and seven per cent in fixed income markets.
Omgeo estimates that the value of equity transactions at risk of trade failure could be upwards of $970 billion, and the value of fixed income transactions at risk is estimated at approximately $300 billion. The cost of stock borrowing to avert the risk of trade failure on this scale could be as much as $3.8 billion.
Matthew Nelson, executive director of strategy at Omgeo says: "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."
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 continues: "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.