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The U.S. Transition to T+1 – The Clock is Ticking
TITLE: The U.S. Transition to T+1 – The Clock is Ticking
Jack: Hello. I'm Jack Parker and the lead the industry development and advocacy group for J.P. Morgan Custody in the United States. Today we are discussing T plus one settlement in the US. Before we sort of jump into it, I just wanna give some background of sort of where we are. Over the years in the US, and as markets and regulators views on risk have evolved, and the technology capabilities have improved, so has the industry's desire to shorten the settlement cycle. For example, in 1995, the US settlement cycle shortened from T plus five to T plus three. And then shortened again in 2017 from T plus three to T plus two.
Underpinning the compression of settlement in the US is the general market view that reducing the period between trade execution and settlement reduces credit, operational, market and counterparty risk. While at the same time, it also reduces margin requirements, increases market liquidity, and allows more efficient use of capital.
With the backdrop of the market volatility associated with COVID-19 and the meme stock trading events over 2021, the industry, through multiple trade associations, came together to discuss moving the US market to a T plus one settlement cycle.
These industry discussions resulted in the publication of two white papers in 2021, which set out the technical requirements and potential regulatory amendments required for the implementation of T1. These white papers were followed by a proposed rule from the Securities and Exchange Commission, the SEC, around the shortening of the settlement cycle, and the proposals were issued in February 2022. Since February this year, the industry has been discussing and preparing the implementation of T plus one, which requires ongoing important collaboration by all market actors and participants. In today's session, we will be discussing progress towards T plus one settlement, some of the issues we are thinking through here at J.P. Morgan, and some of the issues which our clients may need to consider going forward. To do this I will be joined by Paul Bishop, Executive Director of our US Custody product team and Enza Megna, Executive Director of our Equities Middle Office team.
Paul and Enza, I wanted to start by discussing the implementation date. The SEC's proposed rule stipulates March 2024 as the implementation date for T1. In response to the SEC's proposed rule, the industry actually argued to push that implementation date to September '24. This position was reiterated by multiple trade associations in a joint letter to the SEC in October this year. The reason the industry sent that letter is because the SEC hasn't said anything really since the February publication around maybe delaying that date.
So as things stand, the industry just has the SEC's March 2024 proposed date. Paul, maybe if I could just start with you. When, when do you think that the industry will get further clarity on the date? And, and how much of an issue do you see it being if the SEC stick to March 2024?
Paul: Yeah, thanks, Jack. And look forward to getting into it today on the audio recording. Before I answer the question specifically I think it's just worth taking a quick step back on something that you said. And that's basically that there's a number of things that we don't know, as much as what we do know, today. And today being December 8th, we're moving into 2023 still looking for some clarity on some things. And I think that's a good segue into your question, one of those being actual implementation date that's been proposed.
So I think to try to kind of answer the question, the SEC has taken on a bit of an aggressive schedule. And so there's been some, at least as we see it, there looks like there's some delays with when those rules will be finalized. We had originally anticipated December of this year. As it is now the end of the first week of December, it does not look like that will happen. It will most likely come in the first quarter. And the reason that's important is until they finalize those rules, the actual implementation date would not be identified.
In the rules proposal, they came back, as you said, they proposed March. The reason September for us made more sense as an industry was simply because it aligns to a three-day weekend. It also aligns to Canada, that is also moving to T plus one. They have a holiday on the same day in September. So, it was just a nice alignment that everybody could get behind. There isn't a profound difference. Nothing really happens between March and September except you get an additional six months. And we think that's gonna be important as we start to look for the test schedules, et cetera, and any of the changes that will need to happen.
So, at this point, J.P. Morgan is taking a, hey, let's- you know, we'll plan for the worst, we'll hope for the best. We will be looking at that March as the time frame. But if we get the additional time to September, obviously we would welcome that.
Enza, I don't know if you have anything else you wanna add to that that I’ve described.
Enza: Yeah. Thanks, Jack and Paul. And I would certainly agree, I think exactly as you mention, Paul, there's a lot we don't know. But what we are doing, you know, particularly on the executing broker side, is preparing as best we can. So, we are thinking about the different aspects of the rule as it is written today. We are working with our technology resources to make sure that we have people aligned to do the work, whatever that may be, and we're preparing for the work, anticipating what that might look like.
So, Paul, I think you said it perfectly, hope for the best, prepare for the worst. So, we expect to be ready by March, but we're hoping that we'll get that September timeframe. And really, one of the things that we're talking about today is for this to really be effective and really work smoothly, the whole industry has to be thinking about this and be ready, and that's a little bit of what we want to talk about today as well.
Jack: That makes sense. So, what we're saying is the current expectation is in Q1 2023, the SEC, we're hoping will get the final rules out there. In terms of planning and perspective, we are planning for our projects and programs of work for implementation date of March 2024, but we're supporting the industry's push to try and get that to September 2024.
Paul: Yeah, that's right, Jack.
Jack: Okay. That makes sense.
Paul: So from the broker-dealer side, hearing Enza talk and then I guess from custody, I would also say, we are obviously looking very carefully as if it is a compressed timeline, are we gonna be ready to go so that all of our work and all of our planning for that is also along those lines? I think the one thing that I just would highlight for clients is if it does end up compressed to March, we really have to look very carefully at the testing timeline, 'cause right now, you're now looking at potentially a year, as opposed to 18 months. And that does matter. If there are changes that a client needs to make to address some of the things we discussed today or if there's new things we're gonna put in place, whether it's on the broker side or the custodian side, that testing timeline really does matter.
I don't remember who gets the credit for the quip of, "Testing is never completed, only abandoned." So in this case, that compression in terms of when we have to implement does make a difference. I'd just kind of leave you on that thought.
Jack: Okay, great. Thanks, Paul and Enza. So, moving on to a different topic. There's been a lot of discussion around the T1 and discussion around same day allocations confirmations and affirmations. But before we jump into that, it'd be good to just give our listeners a bit of an overview of how the allocation confirmation affirmation process works today in the T2 environment. Enza, would you mind if perhaps you kick that off, if that's okay?
Enza: Sure. And we'll keep this pretty high level, just to talk through how it generally works today. So executions are done throughout the day. Then clients will send their broker their allocation. And really that varies a bit client by client on how they do that and when they do that, but we will say generally the allocations are sent to the broker by end of day on T. However, and I think potentially most pertinent to the group listening and for what we're focused on in T+1 will be that a lot of clients that are non US actually send that information on allocation on T+1 because of the various time zone differences.
What then happens is, once that allocation is received, the executing broker has to send a confirm, and this is largely because of the 10b-10 confirmations requirement. The broker will send that confirm out, and that confirm includes all of the main aspects of the transaction, all of the pertinent details. The client or an agent for their client will then affirm those details back on the confirm. This whole process is really aimed at trying to verify all of the details upfront to try to mitigate any risk of settlement or any delay in settlement. So, it pushes the verification of all the details as early as possible so that you can have a smooth settlement. And as we just walked through, right now, this is done, in some cases, on T, but often on T+1.
There is also, for the US markets, something called CNS, Continuous Net Settlement, which allows settlement to happen more efficiently. The current deadlines for CNS settlement are transaction date plus one. So it gives you a little bit of time to really get all of that information vetted and agreed and affirmed, and that's what we're working with in today's world.
Jack: Okay, that makes sense, Enza. And Paul, perhaps could you just give a little bit of detail around the current affirmation processes today and maybe the models that J.P. Morgan Custody offers today in the affirmation space?
Paul: Yeah, yeah, sure. I can, I can try to go through that. It- it's a bit of a mouthful, but I will certainly try to get through that as efficiently as I can (laughs). So yeah, I mean, I think what's interesting from Enza's perspective, right, talking about Continuous Net Settlement, and I don't know if a lot of people even pay much attention to the amount of netting that goes on in- in the US market today that never actually gets to a bilateral settlement. But despite that, even with all the netting, we still do somewhere to, the industry does, you know, somewhere to five million settlements on any given day. And so in that settlement, where the shares are actually not netted down, but they're going to move between two parties, the custodian ends up playing a fairly significant role in that.
And in fact actually Enza called it out. She said, "Whether the client's doing the affirmation or an agent for the client," and oftentimes, the custodian ends up playing that role of agent for the affirmation process. So, you asked a little bit about those models, and generally speaking, right, as far as the industry goes, Jack, I think there's three models. I'll use the terminology that we use at J.P. Morgan. The terminology may differ slightly if you're talking to another custodian, but I think the process is generally the same.
So in the first, what we call the auto affirmation, and that is generally where as an agent, the custodian, the client will send me a settlement instruction after they've done the trade. I will take in the confirmation from Enza as the broker. I will actually compare the settlement instruction to the confirmation. If it's within tolerance, I will go ahead and I will affirm it back on behalf of the client.
The second method that you'll often see is what we call a direct affirmation. That's actually where the client affirms the confirmation themselves, so they're in that process. And I'm actually being told by the client, "Hey, we've affirmed this. Go ahead and settle it." And so I'll actually create the settlement record on behalf of the client to do that.
And the third model that you have today from custodians is the hybrid, which is basically clients doing both. The client will affirm, but they will also settle, send me a settlement instruction. And unfortunately, time is not gonna permit today for us to kind of really dig into why would you have those different models or what's the value of all those different models, et cetera. So, I guess just to keep it at that high level, what we are finding is that when trades are affirmed before we try to present for settlement, they have a much higher accuracy rate as far as being settled. There's less failure when we affirm.
So, there's been a lot of interest and, in not just from ... not speaking for you, Enza, but just, you're very interested in that Continuous Net Settlement, but obviously from a custodian as the agent, I want to make sure that if it has to be settled in the market, it has the best chance of accuracy. Enza, I don't know if you want to jump back in on anything I just said, but yeah, I just kind of want to make that point.
Enza: Yeah, Paul, and I would, I would 100% agree, and I think everyone would agree with that statement. Once we- we have a trade, we have an execution, we want to verify all of the details and give it the best chance of settlement on time. It's in everyone's best interest to do that. And we do that today, but we'll- we'll also get into why that becomes even more relevant as we look at an accelerated settlement cycle.
Jack: So is it fair to say that the confirmation affirmation process is very much around trying to increase the likelihood of settlement? But I think it's also to highlight that an affirmed confirmation, if you like, doesn't equal settlement.
Paul: Yeah. It's a great point, Jack, 100%. The settlement process is still that we receive instruction from a client to settle, right. We will present that into the market, but we still do all of the position check, the cash check. That whole process still has to happen regardless if the, if the trade is affirmed or not. So that is a, that is a great point. And again, in the models that we've described, we can actually do some of that on your behalf.
Paul: ... we can help you with settlement instruction. We can actually run the, the position and credit check as that needs to go, yeah.
Jack: Okay, perfect. Maybe we can jump into that a little bit later in the discussion.
That’s helpful to sort of understand the process and how various parts of that process fit together. But if we'd sort of shift now into a T+1 environment, in terms of the industry discussions around this, the, the industry is aligned behind kind of new best practices and cutoffs for T1.
So, allocations are going to be at 7:00 PM on trade date. And then affirmations by 9:00 PM on trade date. They're the kind of best practices out there in the industry.
The SEC in the proposed rule doesn't go into those sort of time periods per se, but what the SEC is doing is they're proposing same-day allocation confirms and affirms through its proposed exchange at rule 15C6-2, which applies to the broker dealers.
And then it's also got its proposed rule 204-2, which applies to the investment advisors. As we've talked earlier that the SEC has yet to publish the final rules. But we, we do expect them to still push for this, this same day confirm allocation and affirmation process in one way or another.
So Enza, perhaps you could just sort of give us a bit of info around what you think this same day allocation confirm affirmation process will mean for the broker dealer sides of the industry and our clients.
Enza: Sure, Jack. And, and as you said, I think this is one of the areas where we're saying, okay, we don't know what the final rule will look like. But we're really starting to focus on and think about with what we know, what's out there right now, how are we thinking about if things are proposed to be done on T?
So what does that mean? What are we looking at as a broker and what, what do we think clients should really start thinking about? It's, well, think about what it means to do all of that, right? Receive your confirmation, provide your allocation, and provide an affirmation all on T in the US time zone.
And that's really the biggest thing. So that means that a client will need to send their broker their allocation, the broker will need to send the confirmation, and the client will need to affirm on that confirmation all on T.
For any client that is in a different region, that is two, three, six, 10, 12 hours ahead of the US market where they're already into the next day, this is really something that needs to be considered and thought about. How to functionally adhere or send information on T.
Now in terms of affirmation, we also just wanted to make, make a distinction because there are some clients that are on electronic platforms when they allocate their transactions. So there are some platforms, consider CTM where you send something electronically and the client and the broker match trade details electronically on T.
That is actually just an allocation process. When we talk about affirmation in this context, it is the affirmation and the acknowledgement officially of the trade details off of the broker's confirm. So it's after the confirmation is sent where you officially affirm back.
We also just wanted to touch on the fact that there are a couple of ways that you can affirm. Either electronically, through Trade Suite, or if you don't have electronic confirmation, you can provide a paper confirm. But the impact of not using an electronic confirmation goes back to some of the things that we were discussing earlier. You can miss the CNS deadline. It takes a lot longer. You can miss these deadlines that are being discussed and proposed.
So really, it delays the potential of identifying a problem and could potentially be more costly to do it in that paper confirm fashion. So we really are looking at, what does it look like to do things on T. And we're, we're posing that clients think about, what does that mean for you in where you're based and what your time zone is? And what are some options for you to potentially use or become more electronified or potentially have coverage in different areas so you can meet or adhere to those new deadlines.
Jack: So it sounds, it sounds like there needs to be a, an increased focus, if you like, on the kind of automation across, across the industry end to end. Paul perhaps you could sort of give a bit of a view as well from your side.
Paul: Well, you know what, I think Enza said it really, really well. I mean, there's not a whole lot I would add except, as you switch over from where we leave off at the broker and you pick up from the custodian and that whole affirm model and what we're doing on your behalf.
So selfishly, a custodian's ask is, hey, get me your settlement as early as you can. Right? The more we can get in on, on trade date in the T+1 environment, the better off we're going to be. It may be more cost effective, both just for the industry but also directly to the client, depending on how transaction charges are managed.
But it also then does give us an opportunity to fix anything before we're running up against the T+1 deadline. If everything's coming in on T+1 and it's not in good order, we have much less time now to actually get it repaired before we're actually crossing threshold and now we're failing settlement.
So I think, you know, that's really the big, the big issue. And then I guess the only one I would kind of come back on quickly, Enza was mentioning Trade Suite. I know we've heard an uptick in this new program that the DTCC has available, which is Match to Instruct. So again, this is something that J.P. Morgan will be looking at to identify if this is going to increase or improve. It has a lot to do with, with the way the rule change is actually gonna be finalized. Can the DTCC actually fulfill some of the obligations that either the broker may have or the client may have.
And until those rules clarify, I'm not sure we're gonna get complete.. We want to have that ascertained. But I think, um, there's been a lot of interest lately that we've seen with, where this goes. And again, Jack, I think time is gonna be limiting here on, on how much we can really go into on, on how the program works.
But at, but at 100,000 feet basically it's the confirmation and the affirmation process are happening at the Trade Suite level within the DTC, and then they are notifying the custodian about the settlement or the result of the affirmed confirmation.
So it's happening earlier in the stage and as a result, we think that means that the settlement instruction has a much higher chance of getting to us from an earlier perspective. I'll leave it there unless Enza, unless you think I've missed something that was key on that.
Enza: Yeah. So the one thing I would just add, Paul, definitely to really highlight. Jack, you summarized this as well. The real focus here and what we, we are considering and what we propose clients are considering is leveraging tools that are electronic will really help in the overall process. And really thinking about what is out there, what are you leveraging today, what are the other tools.
So from a broker side, we're already using things like FIX. We are looking at M2I as one of the other solutions. So it's, what's out there that will make the process most efficient and help us to do things as quickly and accurately as possible on T.
Jack: That makes sense. And I think, I suppose there's, there's something here for our clients to just think through the different models, think through the different methods of automation, and we're open to having conversations with clients about what model works best for them but it's a sort of two-way conversation if you like around what works for the nuances of different clients if that, that makes sense. That's how I, how I see it.
Paul: Yeah. And I think that's right, Jack. I think there's so many different iterations you can run through with the way our clients interact today. There may just be the need and I think that's something we need to key up on as we go-
Paul: ... through this, uh, over the next few months.
Jack: Great. Okay, thank you. So I just wanted to go into something I think Enza you mentioned, the time zone side of things. And I think one of the largest concerns for our clients who have domiciled outside the US is their ability to meet US eastern time cutoffs and things here.
Paul, if I could turn to you. What does a client, in your view, that's maybe in plus six or eight or 12 hours ahead of the US, need to do for the moment, or need to think about, um, to sort of manage some of these changes?
Paul: Yeah. (laughs) I wish I could give you a complete list of what you need to do.
Paul: And I think that's what clients are all after. Unfortunately, we don't quite have that yet. But we'll continue to work on trying to make some clarify for that.
But yeah. There's no doubt. I mean, if you're sitting in plus time zone from, from east coast, I could spend a lot of time on this Jack. But I think as I look at it, there's a couple of things clients should probably be thinking about now.
First, what are you trading today? How does your business model work today? Are you just doing some bilateral equity moves? Or maybe you're doing some repos, or maybe you've got stock loan and borrow issues that you have to consider. Or is there collateral concerns you may have? I mean, the list goes on and on.
All of those things are gonna have some implication in a T+1 environment based on how that needs to process through and then how that relates to these cutoff times being compressed.
The other key thing I think that's out there for our clients to think a bit about is, how do you do this today? Do you already have a trading desk that is US-based or at least is easier on the time zones? If not, and again, by the way, that is by no way- means me suggesting that clients should be looking to put boots on the ground here. That is, that is not the indication.
It just makes a difference about the way you trade today and how those trades end up into a settlement file. That's the part that needs to be thought through. So we have clients that have a whole different types of setups in terms of how they actually trade. I think that's a key thing that clients should probably be keyed up and thinking a bit about.
I guess from the custodian's perspective, Jack, just so that, that I'm clear. We don't see anything fundamentally changing like from settlements that are versus payment. Yes, it's being compressed by a day. But today, as you asked earlier about, affirm trade not being a settle trade. Our settlement process remains the same. We will still do position and cash checks just like we do on settlement date. That's the way the US model works today, we'll continue to do that.
So yes, you're funding a day earlier. But it's not that you have to be funded earlier from a standpoint of what goes in on settlement date is still what goes in on settlement date. That is still where our checks and balances would be kicking in.
So then the thought is, okay, well what's wrong then? Why is this such an implication? Well, clients need to be very careful about everything else that goes on in their accounts. That's where you run into some concerns. So for example, and just one example, what if you're using a cash sweep, right, and you're waiting to use your cash sweep proceeds to fund? Is that going to be done on time so that your cash is available so that you can actually transact your business? Right?
And there's a host of those, Jack, we could go through. Whether it's when do you run your FX's or are you using proceeds from a sale of a different market to be able to move on in the US market and now we've got a difference between T2 and T1. All these thoughts that start to kind of kick around I think is stuff that, that we really have to give some consideration to.
So from a pure, hey, you're doing T+1 settlement in the US, no, I don't think that that's the fundamental change. I think it's everything else that goes into the business book that really starts to make that concern and something that clients should think about.
And I'll pause there just, Enza, I don't know if you had anything that you wanted to add or, or Jack, if there's a follow on. But I think that kind of high level.
Enza: Yeah. Sorry, Paul. You know, I think you really covered all aspects. I really want to reiterate is at this point, there's a lot of unknowns. And there are so many nuances about where clients are and, and the way you are doing your business.
So the ask at this point is to really consider, as Paul was saying, all the aspects of your business. We're throwing out some ideas, some of the things that we are thinking about. How do we automate, what's the best way to automate depending on the activity you're doing, where are people located, can we leverage people in different locations, is there something that can be done with extended coverage?
These are the things that we are thinking about and giving, and offering people some thoughts on. However, certainly the ask at this point is for you to consider your business, those aspects, and see what might work best for you. And this will be an ongoing conversation for months to come as we prepare for this.
Jack: Yeah , I agree. I think another area of discussion out there is around the securities lending, and recall and cutoffs. I think from a J.P. Morgan perspective our securities lending team is engaged in the initiative and in the industry, involved in trade association discussions around for instance the, uh, I think the industry's aligning behind a best practice of, uh, 1159 is the cutoff on T for, for loan recalls.
I think that for this stage we're assessing the impacts of that and enhancing our processes in vendor integration essentially to support the changes. But I think like many of these topics, it's probably a topic in itself.
And, I, I was talking to the team and they plan to do a securities lending session similar to this perhaps, uh, in, in Q1 next year. So maybe a way for our colleagues in that group to go into more detail on the SEC lending aspect.
Okay so great. I mean, we've covered a fair amount here in this sort of last half hour or so. And there's definitely more conversations to be had in 2023 as we get into a bit more detail on some of these issues.
But before I finish off, Enza and Paul, I think it would be good maybe if you were able to maybe highlight some key actions or key points from today's discussion that, that you think our clients should maybe focus on right now or think about. Enza, maybe you go first?
Enza: Sure. As we said, we spoke about a lot. The main message if you come away with anything for today is, T+1 is coming in the US. There are a lot of open questions. However, there's a lot to really think about. So consider the things that we've put out there, think about what is your current framework, what you're doing today, and how you can leverage, or what changes would need to be done to comply with the rules as they're currently being proposed. And then certainly, keep an eye out as these things are ratified on what changes may be out there to the current proposals.
Jack: Thanks, and Paul?
Paul: Yeah, I mean, that pretty much nails it I guess. (laughing) The only thing I would, I would highlight is once these rules get clarified and we know what, what we're doing, and whenever that implementation timeline's gonna be I think the client, as we will be doing the same, the client needs to be thinking about test, test, test to make sure you're okay with anything that you think needs to change as a result. And obviously, J.P. Morgan stands by that to assist us any way that we can. So please, reach out to your client service reps or whatever that you're k- you're key contacts, if there's additional questions.
As you pointed out already, Jack, I think this is one of maybe several in a series of discussions or recordings we will be looking to do. Whether it's on combined effort broker, or in custody, or each of us independently. But I think we'll, we'll have more information coming out for sure over the coming months.
Jack: Great. Paul and Enza, thank you very much. I think it was a good discussion, and hopefully our clients listening will find it informative. Thanks everybody who's listening, and I think it's fair to say that T+1 in the U.S. is going to, uh, take up a fair amount of our time in 2023 (laughs).
Jack: And as Paul said, like, we're here to engage.
Paul: Yeah, for sure.
Jack: So yeah. Thanks, everyone.
Paul: Thanks, Jack..
[END OF PODCAST]
CSDR Refit and Mandatory Buy-in Regime
Hello! And welcome to our second audio discussion on the CSD Regulation or CSDR.
My name is Alex Dockx and I lead the J.P. Morgan Global Custody Industry Development. I'm joined today by my colleague, Emma Johnson, who has been playing a leading role in CSDR discussions with European trade bodies and regulators. In this episode, we will be discussing the CSDR Refit, the mandatory buy-in and the implication for the industry.
Emma, to help set the scene, please can you provide a brief overview of the European Commission's review of CSDR?
Yes, of course. In October, 2020, the European Commission instigated a review of CSDR, to appraise the effectiveness of the regime, which included a public consultation open to industry and market participants which sought feedback on all aspects of the regulation, including the Settlement Discipline Regime or SDR, as we sometimes refer to it as, despite the fact that it had not yet entered into force.
The inclusion of the SDR provided an opportunity for J.P. Morgan to advocate on behalf of our clients and the firm, on targeted amendments to the regime, and to provide suggestions to resolve the many open questions raised by the industry. Needless to say, the mandatory buy-in dominated the responses for public consultation and subsequent discussions.
So, we welcomed the European Commission's interim report, published in July 2021, which seemed to acknowledge the mounting concerns the industry had on this topic. In addition, there were also proposals in the Refit covering the provision of banking services and a simplification of the requirements for cross-border services by CSDs, which we won't cover in this audio discussion.
In March 2022, the European Commission published its legislative proposal, for what would be a Refit, which is the term used for the European Commission's ‘better regulation’ fitness and performance agenda, which aims to make EU law simpler, more targeted, and easier to comply with.
The Refit proposal outlined targeted changes to the regime, including the proposed introduction of what is referred to as the two-step approach to tackle settlement fails, which could see the mandatory buy-in introduced if cash penalties did not improve settlement fails in the European Economic Area.
This is the start of the formal negotiation process between the European parliament, council, and commission. And once agreed by all three institutions, will lead to the final revised CSDR legislation. This is a standard process for any regulation in Europe, and it also means there'll be additional revisions to the EC proposal.
So, the mandatory buy-in regime appears to be retained in the European Commission proposal. Can you explain what this means exactly and when or indeed if, mandatory buy-ins could be introduced?
Yes. I believe the rationale for the European Commission retaining the buy-in, is as the ultimate vehicle to address settlement fails. Seems to stem from their concern that the volume of fails in the region is high, compared to third country markets. In particular, the US market seems to be the main point of comparison, despite the marked differences in the US market, compared to the EEA. In terms of when and how buy-ins may be introduced, based on a Refit proposal as currently drafted, the EC may decide to adopt mandatory buy-ins to certain financial instruments, or categories of transactions, based on the following.
· If the application of a cash penalty has not resulted in a long term, continuous reduction of settlement fails in the union;
· If settlement efficiency have not reached appropriate levels, considering the situation in third country capital markets that are comparable;
· And the level of settlement fails in the union has always likely to have a negative effect on financial stability.
In terms of the draft itself, there appears to be some flexibility of when the MBI can be introduced, although we do welcome more detail. This is not to suggest that J.P. Morgan is supportive of retaining MBIs in CSDR. We believe that, historically, the challenge and the implementation of the regulation has been the incorporation of a trading related measure in the post-trade regulation, pitched at the level of the CSD participant, rather than the actual party to the trade. We're concerned that the MBI could impact the jurisdiction's securities markets, as buy-ins impact trading liquidity and come at a heavy cost to all parties. Even if the MBI is to be introduced for limited asset classes, it could still threaten the competitiveness and attractiveness of the EU's capital markets. In addition, it's important to note that settlement fails can be the result of a number of factors, such as market structure, and the mandatory buy-ins will not address these root causes.
So to add to that, Emma, in August this year, European Central Bank published similar concerns. They recommend that Mandatory Buy-in regime should be removed, stating it would cause a ‘significant interference in the execution of securities transactions and the functioning of securities markets.’ The ECB also recommend that should the MBI be retained, that securities financing transactions or SFTs be excluded from the scope of the MBI. They also highlighted the operational cost and complexity and negative impact MBIs could have on market liquidity. While the ECB doesn't have the final say, it indicates that ours and the wider industry concerns seem to be shared by the ECB.
This feels like an important development, as the ECB's opinion will be influential. And even though we know the ECB are not part of the triologue process, they are a powerful ally, and their public statement will be of interest to the Member States and MePs. Notwithstanding the merits of retaining the mandatory buy-in or not, on a positive note, the Refit proposal does attempt to improve the drafting and operation of the mandatory buy-ins and cash penalties, which we very much welcome, although we would caution that there are still areas of concern with the proposal as currently drafted.
Okay. So, putting the merits or not of the MBI aside, could you please briefly summarize the other proposed changes to the settlement discipline regime?
Of course, and at a high level, there are some attempts to resolve some of the industry's main challenges, such as
· amendment to transactions scope, exempting settlement fails ‘not attributable to the participants and not including two trading parties’;
· There's a pass-on mechanism;
· symmetrical payments for the buy-in differential; and
· a temporary suspension of the regime, for example, in the event of market turmoil, which is also proposed, which in principle, we support.
However, who should be subjected to the MBI obligations remains a key issue, as a Refit does not address the language and terminology, which places the obligations on CSD participants, rather than the actual parties to the trade.
In practice, this will mean that the contractual enforcement of the MBI will still fall to the CSDs, who are required to impose a regulation on their participants, through the CSD's rule books, which then requires legal repapering through the trade custody chain, which will be a costly global effort.
This is perhaps, better known as RTS Article 25. It is therefore vital that the Refit makes the distinction between trade and settlement, and revises the language and definitions used in the level one and delegated regulation.
In addition, we would like further clarity on the sequencing, and mechanics by which MBIs may enter into force. A substantial lead time will be required, to prepare for implementation, including the repapering of the relevant contracts I mentioned, plus operational and technology readiness, which typically require a lengthy lead time and budgetary planning across the industry. In this time, fails may have improved, which would result in unnecessary costs which is obviously an issue. And lastly, not to forget cash penalties. An exemption for settlement fails caused by factors not attributable to participants to the transaction, is positive. However, excluding operations that do not involve two trading parties, could prove too broad. As the most appropriate measure to address settlement fails, cash penalties should really apply to as many transaction types and settlement instructions originating from the CSD participants or their clients as possible.
Scaling back too far can only limit the regime's effect and could result in economic loss for the participants who have a chain of instructions involving different transaction types.
So, based on your response to an earlier question on when MBI can be introduced, it does seem that this dependency on metrics and data. Ultimately, this will require clarification then ? as there is no ‘baseline’ measurement of settlement fails. An assessment of the extent of, and reasons for settlement fails parameters, was not conducted prior to the introduction of cash penalties in February.
Exactly. In addition, mandatory buy-ins only address settlement fails still outstanding after four or seven business days. So it's crucial that any policy decision is based on data relating to settlement fails still outstanding after four to seven business days and not settlement fails measured on intended settlement dates. The lack of a comprehensive fails analysis aligning to the CSDs reporting parameters under the SDR, also means then, that it's tricky to be able to truly decipher the success cash penalties are having, since as you say, Alex, there is no comparable baseline.
Now, Alex, if I could turn to you, is there anything in your opinion, the Refit proposal has overlooked?
Well, in my personal opinion, there's still is quite a lot of excessive detail in the level one, I give a few examples:
· Extension period should be in the level two text, and should be applied to the instrument level;
· Cash compensation remains unchanged and should be symmetrical, rather than asymmetric as currently drafted;
· Public disclosure of CSD participants should either be removed or applied to accounts designated as client accounts, so as not to be penalize intermediaries who cannot influence a trading pattern's operational practices of their clients;
· And you already mentioned that legal repapering which will have a global impact.
On a similar note, with regards to extraterritoriality, only shares have a third country exemption when “the principal venue of the trading of shares is located in a third country”. There is no similar exemption for any fixed income instruments, which creates an uneven application of the scope and may create additional complexity on cross border fail chains in third country instruments, which could unduly penalize investors with transacting across jurisdictions. This could become particularly pertinent when more markets start to move to a T+1 settlement cycle.
I would also stress that we believe that only professional regulated entities should be required to initiate and manage the buy-in, and take an upstream approach towards a trading party or CCP member who caused the settlement fail, and not downstream towards the investor. We believe that this requires much more thought, and will be an important consideration for our global custody clients. Despite typically being a buyer, and therefore the impacted party, they're the ones who have to bear with the operation and cost burden of the regime. So we continue to stand by, ready to assist, and defend our clients' interests here.
Now, Alex, you've had a long involvement in CSDR, on both J.P. Morgan's and the wider industry's behalf. Do you see the Refit proposal as a positive development?
Well, going back to 2012 to start the original CSDR proposal by the European Commission, and its adoption by the co-legislators in 2014, with the number of requirements such as mandatory buy-ins, but also with some good developments, such as the roll out of T+2 and consistent CSD regime, it's probably fair to say that CSDR took a long time to implement and has not been a complete success on all fronts. It took a long time and lots of detailed conversations with regulators to establish where the problems stemmed from, and how to address them. To their credit, the authorities were receptive to the industry's concerns, but the major issue was that a lot of the principals were anchored in the level one regulation itself. To address them required re-opening CSDR, which is what the Refit proposal is exactly trying to address and as you alluded to earlier, Emma.
So, in that respect, it is definitely a positive development, as it allow those issues to be addressed at the root. Where a bit more work is required is on some of the detailed proposals like you explained before. Overall, my personal experience has been positive, in terms of working with European Commission, ESMA, and the national authorities. In terms of their openness to listen to the industry and making necessary adjustments, after listening to our views, also challenge us where required.
Alex, just to close up the dialogue on the CSDR Refit, what are the next steps and key dates?
It’s possibly a bit early to tell, however, we believe that the European Council meetings have already begun and expect that the Council reach its conclusions by the end of 2022. The European Parliament are also forming their opinion. We estimate that the entire process of discussions between the Council, Parliament, and Commission will reach conclusion in early to mid 2023 but, of course, we await further information from the European legislators.
So Emma, it looks like the ball is now a bit in the industry's court. So what do we need to do?
It's such a good question. The MBI is still proposed in regulation and we must take it very seriously. There is a clear call for action now. The entire industry needs to collaborate and quickly gain clarity of what causes settlement fails and work through what they can resolve. For example, taking action to resolve SSI issues and ensure that securities are in the correct depot on ISD. And ensure that the CSD's functionality adequately optimizes settlement. It also need to identify what is structural, i.e. what are the issues in the jurisdictions' complex market structure that impede timely settlement? And what may require new or amendment to existing regulation.
The rhetoric now needs to move from defense to being able to articulate and demonstrate the issues, to educate the authorities, and to suggest solutions.
J.P. Morgan are actively engaged in the industries' efforts to improve settlements efficiency through co-chairing AFME and ICMA task-forces.
The retention of the MBI must be taken seriously. However, we have discussed some of the challenges with the Refit and the retained requirements in the regulation. What should be the next steps for J.P. Morgan, our clients, and the wider industry with regard to regulation?
Emma, in my opinion, the delegated regulation would require full revision. And the industry should be prepared to help shape those requirements. It will be essential for the industry to align on what is required to make the mandatory buy-in regime operable without imposing the operational and regulatory burden on the investor.
As an example, it will be essential to the buy and the sell-side to work through the pass-on mechanism and cash compensation which were both being proposed in the Refit and to find a workable solution. This is a strong area of focus for our division to protect our clients. In addition, there's work to do on basic housekeeping, which we also covered in our last audio discussion on CSDR penalties. The industry will need to be more diligent and precise in the formatting of settlement instructions and use the correct transaction codes.
This is not just important for CSDs to be able to identify which should be penalized or not. It's also fundamental for the CSD's reporting of fails to their national competent authorities. More granular, accurate fails reporting is the need of the hour, which serves a means to draw a conclusions for where the issues exactly lie. That could be, for example, at the trading party level, at the market level or certain fail reasons, which would each warrant further assessment.
Remember, European Commission are also considering finance stability. And if market participants instruct all settlement instructions as cash trades then that could suggest there's actually a bigger issue that there in reality is. Meanwhile, I agree on your point about collaboration. On the whole I would say that there needs to be greater transparency in collaboration across the industry and across market infrastructures as well. That includes more partnership with regulators. We all have a shared interest in ensure European Economic Area is an attractive place to invest.
Emma Johnson :
Alex, it's been a pleasure discussing this CSDR Refit and the consequences for the industry. It is such an important topic that we both feel strongly about, and we will provide a future update for the Refit’s lifecycle.
We would like to thank you for listening. Please look out for our next issue in the coming months, where we will focus on the Refit’s progress through the European Council and Parliament. And follow up on cash penalties as the regime matures.
This discussion was recorded on October 5, 2022.
CSDR Cash Penalties
Hello, and welcome to the first in the series of J.P. Morgan securities services global custody, CSDR podcasts. This one is titled, "Reflections on CSDR cash penalties." My name is Emma Johnson and I work in J.P.Morgan’s securities services global custody, industry developments team. And I'm joined by my colleague, Doug Bambrick, who is the global custody regulatory change lead, and has led securities services implementation efforts for CSDR. In this podcast, we'll be discussing the cash penalties regime, which went live earlier this year on the 1st of February.
Doug, to help set the scene. Would you be to give an overview of CSDR's cash penalties regime and how it works in practice?
Thanks, Emma, cash penalties are a tool introduced as part of CSDR to incentivize timely settlement. And charges are applied according to the value of the trade with different rates applied for different asset classes and liquidity classification. For each transaction, the CSD is responsible to identify the fail reason, determine the at fault party, provide reporting to participants on a daily basis and on a monthly basis to collect and distribute the net cash amounts.
A key feature of the CSDR regime is that CSDs are not permitted to retain any part of the cash penalty. And instead, this is credited to the participant that did not cause the fail. Some participants are therefore making money each month from this process. Although it also means those participants need to introduce processes to handle the penalties, regardless of whether they themselves cause any fails.
I think it's safe to say that this is a substantial piece of regulation, which has required significant planning and preparation across the securities industry. How smooth has the implementation been?
It's fair to say that implementation has not been without its challenges, which have been experienced across the whole industry. In some ways, and in retrospect, this is perhaps not so surprising. CSDR penalties are a brand new type of post-trade process, akin to a trade settlement or a corporate action. But unlike those other processes, have not had the benefit of years or decades to evolve a working market practice. Even where penalties have existed before, the scope, scale and manner of processing has been developed for CSDR from scratch with the industry all going live together on the 1st of February.
Individually, CSDs, custodians, and investors completed testing of their own systems in UAT ahead of the production dry run in the latter part of last year. However, UAT is not the same as production and it is during the dry run that most issues started to become apparent as the clinically designed UAT test cases were replaced with large volumes of production messages from multiple sources, differences in formatting, duplicate messages, and often late reports. With these issues on the daily messages, this also gave very limited opportunity to prove out the monthly process and no clean end to end process from daily to monthly was able to be completed across the industry ahead of go live, resulting in issues at all levels being carried into the live environment.
Definitely the process has improved over the last few months, both in terms of the messaging we receive as custodian and our own processing, but there is still work to do at CSDs and at all levels of the custody chain.
Doug, I think you make an important point that this is a regulatory requirement that impacts all factions of the securities industry with considerable interdependency between providers and consumers of services, which ultimately serve the investors. As you mention, a number of issues have been identified post go live. What are the main issues that need to be resolved and how is J.P. Morgan and the wider industry reacting?
In many cases, the actual issues will originate with either the CSD or a sub-custodian.
We're continuing to see examples of late reporting, reporting with key data missing, which adds to the challenges which custodians face. To help address this, JP Morgan are actively engaged and leading in a number of industry task forces focused on creating efficiency through standardization. The first of these task forces is focused on the processing calendar. Under the current process, monthly penalties are reported by CSDs on the 14th business day of the month with actual payment being debited or credited on the 17th business day.
Even without the sometimes-differing definitions of business days between CSDs, this three day life cycle for a penalty to be reconciled and reported through the custody chain has proven very aggressive indeed. As a custodian, J.P. Morgan and our industry peers are advocating that the actual payment date at CSD should be extended to allow for these processes to be carried out while maintaining consistent value date throughout the custody chain.
The second task force focused on messaging standards is intended to identify and agree key messaging requirements, which either need capturing as a standard or for which in existing standard, such as SMPG is not consistently being followed. Related to this, we are also working with industry groups, such as the Association of Global Custodians on market processing standards, including handling of reconciliations and corrections for both daily and monthly penalties.
The third and final task force relates to reference data. CSDs are challenged by the lack of a single authoritative source of security reference data to help them determine both the scope and the amount of any penalties. An ideal solution could be a central pan European source of security and pricing data to give the required transparency. But the task force will also seek to identify any other opportunities for greater consistency and transparency.
Looking inwardly, what is J.P. Morgan doing to improve the process?
Despite these industry challenges, we have been issuing reports and processing payments each month since inception. And we've been providing reporting via a range of channels, including SWIFT, web-based reporting, and via third party providers such as AccessFintech. We continue to have an active technology enhancement program in place removing manual touchpoints in our process to industrialize the process and delivering change with direct client impact. For example, reporting enhancements.
CSDR intends to improve the safety and efficiency of security settlement in the European economic area with the settlement discipline regime, introducing measures to prevent and address settlement fails. Whilst it's obviously early days, what impact do you foresee cash penalties having on security settlements rates?
So this is the main goal of penalties, to incentivize good settlement discipline. The cash penalties create a clear economic incentive. Individual penalties may vary in size from a few euro cents to tens of thousands of euros with the total impact across the industry estimated in the hundreds of millions. Even the existence of a penalty of any size, which must be accounted for is causing investors to devote time in understanding why trades fail and to focus on bringing these numbers down. The extent and of the impact and the timing remains to be seen, but it will depend on a number of factors.
Firstly, what the actual changes needed are, undoubtedly, there are some quick wins, but to the extent technical development is required by the trading parties or their service providers, there will undoubtedly be a lead time. Operational resourcing. Certainly there's still a focus of operational resources and management time on simply processing the penalties. This may mean that some of the work by parties to investigate root cause and put in required changes may actually still take a little longer while the process beds in. It's also worth noting, at least from the perspective of the JP Morgan global custody client base, that we are receiving more penalties in favor of our clients than we are paying.
CSDR is currently subject to a review by the European Commission. And the draft proposal has recently been published. What changes might we expect to the cash penalties regime over time?
As it pertains to cash penalties, the changes advocated by the industry are for the most part, reasonably light touch. One benefit we might see could be additional clarity on transaction scope. For example, industry groups are advocating the removal of corporate actions, derivative settlement, and primary issuance activity from the scope. Over time, we may also see some modification to the penalty amounts, but generally speaking, the regime we have now it's likely to be around for the foreseeable future.
Cash penalties is a significant milestone for CSDR. And as you have described, it has been a huge undertaking. Moving forward, what lessons can be learned for the future implementations of this scale and nature.
That's a great question. Putting into context, CSDR settlement discipline has seen possibly the largest change in European securities processing for quite some years and penalties on its own has been a major implementation for all parties in the settlement process. Within this context, I think the industry did simply underestimate the scale of issues that would be experienced first by CSDs in implementing their penalty mechanisms, then by participants within their processing.
But perhaps these issues are not all that surprising. The defined framework for processing the penalties allows three business days from the first notification of the monthly amount, from the CSD to actual movement of cash. To manage this, we've all implemented, automated reconciliation and reporting. And this works if all providers are sending their correctly formatted reports on the 14th business day, they fully reconcile STP to the daily penalties, allowing automated and complete reporting by the global custodian on the 14th, maybe 15th business day.
Experience has shown this is simply not realistic. Hence why industry groups are working with CSDs post implementation to possibly extend that calendar potentially even needing involvement of regulators to agree in alternative timeline. A contributing factor has also likely been the focus on buy-ins, which were only finally descoped from implementation in the final weeks ahead of regulatory go live after substantial industry pressure, for which JP Morgan also played a leading role. Cash penalties remain a challenge, but the issues remain relatively small compared to what would've been the impact of mandatory Buy-ins and whose presence perhaps served as the distraction from the scale of penalties.
Lastly, future implementations of this scale should consider clear success criteria ahead of implementation. Certainly if this was a discretionary initiative by one or more CSDs, instead of a mandatory requirement from a regulation, it is unlikely that the industry would've considered going ahead with implementation in light of the challenges seen in dry run. However, we had to progress due to the regulatory live date. To ensure that the entire settlement chain has sufficient opportunity to test their processes, participants would ideally have had opportunity to conduct their dry run testing in an environment that was relatively clean of CSD issues and been able to conduct at least one or two full clean monthly cycles ahead of the go live. This was not the case and the issues we are facing are very much a symptom of that.
Doug, this has been a fascinating insight. Thank you very much. We would like to thank you for listening to the first in our series of podcasts on CSDR. Please look out for our next podcast in the coming months where we will focus on the mandatory buy-ins and the CSDR refits. Please visit jpmorgan.com for more information and note that JP Morgan disclosures apply and are available on www.jpmorgan.com/disclosures. JPMorgan Chase & Co., all rights reserved. This episode was recorded on Friday, June 17th, 2022. Thank you very much for listening.
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