To: European Commission DG Markt G2 D(201) 8641 Rue de Spa Brussels BE 1049 by email to: markt-consultation-csd@ec.europa.eu March 1 st 2011 From: Omgeo Ltd 33 Aldgate High St London GB - EC3N 1DL For publication Dear Sirs Re: Public consultation: CSD s and Harmonisation of Securities Settlement Omgeo Limited ( Omgeo ) is grateful for the opportunity to respond to the CSD and Harmonisation of Securities Settlement consultation. Omgeo is a global joint venture equally owned by The Depository Trust & Clearing Corporation (DTCC) and Thomson Reuters. Our principal products are: Omgeo Central Trade Manager ( CTM ) and Omgeo ALERT. For more information go to www.omgeo.com Omgeo is one of the largest providers of trade confirmation systems globally. Our systems process on-exchange and OTC equity and fixed income trades in domestic and cross-border markets. Our client community includes buy-side firms, broker/dealers and third-party service providers such as prime-brokers, custodian banks, fund-administrators and outsourcers. As of Jan 1 st 2011 Omgeo CTM, our core European product had 564 live clients. Omgeo s global client community exceeds 6,000 firms in 46 countries, including in excess of 2,000 clients live on its electronic confirmation /matching services of CTM & OASYS Global. Trade volumes from those solutions range between 4.5 and 5.0 million trades per month. Omgeo does not operate any CSD services so we will not be providing any responses to Part 1 of the consultation i.e., appropriate regulatory framework for CSD s. Instead, we will focus our comments on the settlement harmonisation aspect of this consultation request. Specifically, we will express our views on the Commission s proposal to shorten settlement cycles across the European Union to T+2 and the steps which we believe must be taken in advance of such a change to ensure a smooth transition period to T+2. In particular, we will comment on the benefits of faster trade confirmation as a critical condition precedent to T+2 settlement. We believe the consultation should look at the issue of market harmonisation from multiple perspectives: 1
1. The development of a real single-market in Europe o The development of a single-market across the European Union has long been a goal of European legislators and regulators. It is believed that such a market improvement would greatly enhance the EU s trading and processing efficiency and improve the region s global competitiveness. However, the achievement of an effective single market is dependent on many factors, including the elimination of national barriers and the adoption of properly harmonised market practices across the EU, particularly the harmonisation of settlement cycles. It is also our belief that efficient middle-office trade processing is a key pre-condition to the achievement of this objective. We will expand on this point later in our submission. 2. The requirement to automate all trades at all stages of the processing lifecycle o Efficient pre and post-trade processing, increased transparency and improved risk management will all be facilitated by an industry-wide move to true STP. Indeed, it will take strong regulatory direction to bring about the improvements that will be necessary in this area, as they will not happen without some form of regulatory push. A move to faster middle-office trade processing is just one example of such a proposed processing improvement. 3. Reduction of operational risk o It is our contention that accurate and timely risk management is a crucial regulatory objective that is easier to achieve in a more harmonised and automated market. 4. The pending implementation of Target2 Securities o A higher level of harmonisation is clearly a key pre-requisite for successful implementation of T2S. T2S requires all market participants to be ready for market testing in 2013 and implementation in 2014. The required changes therefore need to be planned and implemented during 2012 and 2013. If T+2 is to be implemented on schedule, planning must begin now, including identification of the steps which must be taken in advance of T+2 to prepare the market for a change of this magnitude. Here again, faster trade confirmation is an excellent example of such a condition precedent. Faster Trade Confirmation, i.e., Same Day Affirmation Omgeo is highly focussed on the concept of Same Day Affirmation referred to as SDA. 1 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 inefficiencies are significantly reduced. If you can lock-in trade details sooner and confirm on trade date, you have more time to identify and resolve any potential errors. Therefore, 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. Omgeo has published two reports on this area: the 2008 Omgeo/Oxera study entitled: SDA: Why should Europe care? and the 2010 Omgeo analysis entitled: Mitigating operational risk and increasing settlement efficiency through same day affirmation. 2 In the 2008 Omgeo/Oxera study 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 an improved settlement performance The two research reports mentioned above indicate the following benefits of SDA: 1 Note that SDA is also identified by other terms: Trade Date Matching and Trade Date Confirmation are synonymous with SDA. 2 Both reports are available at www.omgeo.com 2
Securities trades affirmed on the same day have a much higher chance of settling on time and are less likely to fail There is a direct correlation between high SDA rates and high settlement rates. Countries with SDA rates of over 90 percent India, Taiwan, Hong Kong, Japan, Singapore and Korea consistently collect the most impressive settlement efficiency scores. On the other hand, countries with SDA rates of less than 70% Brazil, Italy, South Africa and the United States consistently collect below-average settlement efficiency scores. The analysis 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 most securities including India, Taiwan, Hong Kong and Korea. Similarly, 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 countries with more relaxed standards. 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. SDA rates achieved by Omgeo CTM clients for January 2011 were as follows: 93.68% on T, 98.59% on T+1 and 98.80% on T+2. In our opinion, this shows that, at least in the middleoffice space, there are no technological barriers to be overcome before we can move to T+2 settlement. Those firms that have embraced central matching solutions are already in a position to accommodate a shorter settlement cycle. The middle-office and the buy-side Efficiency of the settlement function is directly impacted by the speed and accuracy of trade processing in the middle-office. It is therefore our opinion that any regulatory action taken to harmonise settlement cycles should include this segment within its scope Omgeo clients utilise our services principally in the middle-office. The principal objective of the middle-office is to capture and disseminate accurate trade details in a short timeframe. The middle-office is a strategically important function that has historically received insufficient attention in the policy debate on clearing and settlement, or in many of the regulatory issues related thereto. It has been our experience that the increased volume and sophistication of trading in recent years has not been matched by similar improvements in the operational capacity of the middle-office. Huge increases in volume and increased ability to execute smaller trades have placed strains on many buy and sell-side firms. It is clear that the accuracy of this function drives downstream efficiency. It is not possible to maximise efficiency and minimise risk without having an accurate near real-time picture of what has been traded. The middle-office, and the trade-confirmation/affirmation process, which is a core middle-office process, therefore deserves close attention in the policy debate in this area. In particular we recommend that future policy initiatives should directly address the issue of how buy-side firms 3 will adopt harmonised practices. Prior to commenting on specific questions we would also like to comment on the related legislative proposal for short selling of securities in Europe (published on 15 th September 2010). The proposed legislation overlaps in many ways with the provisions in the CSD Regulation especially with regards to settlement discipline. Our opinion is that having two pieces of legislation covering the same issues could lead to confusion in the market. Our 3 The Buy-side are not typically members of exchanges; CCP s or CSD s and therefore not subject to the rules and market practices of infrastructures. 3
recommendation is that settlement specific issues should be legislated solely within the CSD Regulation. Responses to specific European Commission questions Q44. According to you, is the above described harmonisation of key post trade processes important for the smooth functioning of cross-border investment? Yes? No? No opinion? If yes, please provide some practical examples where the functioning of the internal market is hampered by absence of harmonisation of key post trading processes. If no, please explain your reasoning. Yes we broadly agree with your analysis. As stated above middle-office processing in Europe is significantly affected by a lack of harmonisation. The existence of three different settlement cycles for equity markets is an example. Q45. Do you identify any other possible area where harmonisation of securities processing would be beneficial? We believe that middle-office processes, where operational risk is managed, should be explicitly addressed as much as CSD processes. In particular, we recommend focussing on the concept of SDA (trade date matching) as a condition precedent to the effective implementation of a new T+2 settlement cycle across the EU. As further evidence of how middle office processing changes can improve processing efficiency, we would also point to the experience in Canada driven by the regulatory initiative National Instrument 24-101. In this instance the Canadian authorities were the first market to impose on a national basis new deadlines for trade confirmation processing, which, in turn, lead to a significant reduction in trade failures. We have previously provided detailed information on this project to Commission staff and are ready to discuss in more detail at any time. Q46. According to you, is a common definition of settlement fails in the EU needed? Yes? No? No opinion? Please explain why. If yes, what should be the key elements of a definition? We believe a common definition of settlement fails would be beneficial to the market. Additionally it would be useful to know how many trades would have failed without an autolending programme covering the short position. Whilst securities lending is an established and reliable method of avoiding a trade failure, it increases costs and operational complexity. Q47. According to you, should future legislation promote measures to reduce settlement fails? Yes? No? No opinion? If yes, how could these measures look like? Who should be responsible for putting them in place? If no, please explain. Settlement failures are clearly an indicator of process inefficiency and they add cost and risk. They are therefore an appropriate area for regulatory scrutiny. Many markets outside the EU operate a penalty regime for failed trades. These models clearly lead to a higher level of operational rigour. We would also encourage further analysis of the work involved in avoiding failed trades. In terms of STP there are three categories in this area: fully automated trades that need no manual intervention; trades that need some limited intervention (often referred to as repaired trades ); and fully manual trades (typically faxes and emails). The cost differential between these three categories is high. Omgeo s broker/dealer clients consistently report that about 20% of their trade volume drives about 80% of their costs. Settlement efficiency statistics on their own, do not highlight these cost issues. The cost of analysing and solving a failed trade may be very high industry estimates vary but the cost could be 100-300 per trade. A very small proportion of trades that fail therefore can produce an inversely high level of excess cost. 4
Therefore we suggest that further analysis on the cost of remediating failed trades is warranted. Q48. What do you think about promoting and harmonising these ex-ante measures via legislation? We broadly agree with your proposals in particular with harmonised monitoring and reporting. We very much agree that early matching of transactions is vital to an effective STP process. Clients of Omgeo s core European trade-processing platform (Omgeo CTM) typically complete their trades within the Omgeo environment in less than 3 hours. (Approximately 70% of the trades we process). This indicates to us that full automation by the two counterparties to a trade can produce a highly efficient process. Other vendors operating in the same segment report similar outcomes. We believe there are no real technology, or operational barriers to achieving early trade matching. In fact this model has been adopted by the majority of market participants for many years. The real barriers in this area appear to be behaviourial. Q49. What do you think about promoting and harmonising these ex-post measures via legislation? Omgeo data published in the 2010 SDA report previously mentioned indicates a high correlation between markets with a strict penalties regime and high rates of SDA. The penalties appear to work as a strong incentive to improve processing standards. This situation already exists in many Asian markets and also in Spain. In principle we believe that both exante and ex-post measures are required, but they should be co-ordinated and be applied to all market participants. The market agrees in principle with the concept of penalties for failure. However our clients are concerned about who pays for the inefficiency. As stated above our experience indicates that broker/dealers generally have efficient automated processes and instruct trades to a CSD in a short timeframe. The majority of failed-trades appear to be caused by late or inaccurate trade instructions from a small minority group of clients or their agents. Many of our broker/dealer customers state that they are unable to impose the extra costs on the minority group of clients that cause the problems and they have to absorb the extra cost themselves. Broker/dealers distribute these additional costs across all their clients. This results in the minority inefficient segment having no cost incentive to improve their processing standards. Q50. According to you, is there a need for the harmonisation of settlement periods? Yes? No? Please explain why. Yes. Whilst the market has become accustomed to divergent settlement cycles, there is substantial evidence that non-harmonisation in this area increases risk. Areas such as corporate action processing are significantly more risky because of a divergent settlement cycle. It is also widely agreed that a reduction to T+2 will reduce risk and lower collateral costs although a precise business-case has proved hard to define. As stated above, we believe that SDA is an essential prerequisite to T+2 but other areas also need to be addressed: for example, securities lending processing, trade processing for clients outside Europe (especially Asia-Pacific) and harmonisation of fails processing are also essential. We also suggest that a T+2 settlement cycle can act as a general driver of improved posttrade efficiency. Enhanced operational processes and better STP will be required to achieve T+2. A wider benefit will therefore accrue. Q51. In what markets do you see the most urgent need for harmonisation? Please explain giving concrete examples The equity market would benefit most from a harmonised cycle. Fixed-income markets would also benefit. 5
Q52. What should be the length of a harmonised period? Please explain your reasoning. It is widely agreed that the time-frame between trading and settlement should be minimised to reduce counterparty default risk. The T+3 settlement cycle has been in place since the late 1990 s and Giovannini Barrier 6 has now been in existence for almost 10 years without resolution. We believe the market can operate in a T+2 settlement cycle, many markets already do have a 2 day cycle and work well. However it is essential that a move to T+2 is accompanied by the appropriate building blocks such as Same Day Affirmation. Q53. What types of trading venues should be covered by a harmonisation? Please explain your reasoning There should be no differentiation between types of trading venue. Whichever harmonised cycle is adopted should apply to all equity and fixed-income transactions irrespective of venue. We also recommend that no differentiation be made by participant type broker/dealers (sometimes referred to as direct participants ) and the buy-side ( indirect participants ) should operate by the same rules. Q54. What types of transactions should be covered by a harmonisation? Please explain your reasoning. As per Q53 we suggest that differentiation is an unsuitable concept in this area. To promote maximum levels of harmonisation all trades should be covered by the same regulations. Q55. What would be an appropriate time span for markets to adapt to a change? Please explain. We suggest that a move to a harmonised settlement cycle would deliver maximum benefit if it is achieved prior to the implementation of Target2 Securities. Industry consultation is obviously required to determine if this is feasible. It is likely that if T2S is implemented with multiple settlement cycles, impetus towards a harmonised cycle will be lost and the current situation would remain in place. We believe that there is also industry consensus with our position that to achieve T+2 significant further progress towards universal attainment of SDA is essential prior to implementation of T+2. Q56. According to you, how should the principles examined in the communication on sanctions apply in the CSD and securities settlement environment? We have no response to this question. Please do not hesitate to request clarification on any of the points above. We look forward to further discussions and wish you every success in the project. Yours faithfully Tony Freeman Executive Director, Industry Relations Omgeo Europe tony.freeman@omgeo.com +44 (0)20 7369 7473 6
Appendix Key findings of the 2008 Omgeo/Oxera report: Building Efficiencies in Post-Trade Processing: the benefits of Same Day Affirmation. 1st Key Finding Automation & SDA lead to reduced operational risk & improved settlement efficiency - settlement failure rates for clients with automated trade verification processes can be 50% lower than for non-automated clients! - Direct correlation between SDA, automation and reduced failed trades 2nd Key Finding Significantly reduced operating costs through Automation & SDA - Automation enables larger volume of trades to be processed without a corresponding increase in costs and risk Firms maintain the same level of staffing in the middle office irrespective of trade volumes - SDA enables reduced failed trades & fewer costs downstream 3rd Key Finding - - Efficiency gains translate into lower transaction costs for end-investors - Reducing risk and costs translate into lower prices and lower transaction costs for end-investors - There is a beneficial effect on liquidity Key findings of the 2010 Omgeo report: Mitigating operational risk and increasing settlement efficiency through same day affirmation SDA is a critical component for mitigating operational risk and increasing settlement efficiency. The direct correlation between high SDA rates and high settlement scores is compelling as data shows that trades affirmed the same day have a much higher chance of settling on time and are less likely to fail. Settlement efficiency is 26% higher in countries with SDA rates over 90 percent. SDA is an essential building block for successfully moving to shorter settlement cycles. Countries which have imposed shortened settlement cycles while embracing SDA are achieving higher settlement efficiency and lower operational risk. The industry is engaged and preparing for what many consider the inevitable to further minimize operational risk: a future of shorter settlement cycles facilitated by SDA. 7