CMI In Focus: Fails management in global cash markets

As part of the global regulatory drive to ensure safer capital markets globally, measures to prevent settlement fails in cash markets due to short securities positions are being imminently addressed by two new European regulations. Both the EU regulation No 236/2012 related to ‘short selling and certain aspects of credit default swaps’ applicable from 1 November 2012, and the proposed CSD Regulation (CSDR) provide for harmonised and standardised approaches to buy-in procedures across the region. The CSDR stipulates that buy-in mechanisms should be present in any European market. In the draft report issued by the European Commission it is specified that unified buy-in rules should be provided for all transferable securities, money-market instruments, units in collective investment undertakings and emission allowances, such as the timing (expected to be ISD+4), notice period, pricing and penalties. The EU regulation on short selling goes further by specifying a standard timeframe for buy-ins at every Central Counterparty (CCP) in the European Union, Norway and Switzerland of ISD+4 for notification and ISD+5 for execution of a buy-in. Since, developments in the EU often influence those in other parts of the world, it is not unreasonable to suggest that some harmonisation in buy-in practices may occur globally. Hence, it is worth analysing how far Europe and other regions are currently from this new standard, but more fundamentally, is it a given that all markets operate a buy-in mechanism?

Figure 1: Percentage of markets practising buy-ins in each region.

93% of European markets have already established buy-in procedures, Middle East 86%, Asia Pacific 70.58%, Americas 65%, Africa 64% and Eurasia with the lowest figure at 33.33%. In the 27 markets where buy-ins are not practised (detailed in Appendix 1), other alternate or combination of alternate procedures may be adopted to either provide securities liquidity (e.g. securities borrowing in 3 markets), punitive action (e.g. late settlement penalties in 9 markets), or compensation (e.g. ‘close-outs’ where the failing party pays cash compensation in order to close the position present in 4 markets).   For markets where buy-ins are not practiced, what alternatives are there? Figure 2 illustrates how these markets adopt alternate approaches to fails management, either using multiple or single controls (a riskier approach since the single mechanism must be 100% effective). The most common mechanism is by the ‘tight-coupling’ of exchange trading and settlement, in other words, the pre-funding of positions before trade execution. This has been commonly employed in emerging markets, particularly in Eurasia and Africa where concerns over counterparty risk far outweigh the restraints on trading liquidity this model can cause. Interestingly, the bigger markets employing this model, Russia and Kazakhstan, are moving away from the pre-funded (T+0) model to a T+n model (allowing fails) as liquidity becomes of more concern. Over one-third of the markets analysed (8 out of 27) employ no fails management mechanisms whatsoever, although these are mainly in ‘exotic’ markets with low foreign investment.

Figure 2: Fails management measures in countries where buy-ins do not exist.

Depending on the market, buy-ins can be carried out by a stock exchange, a CSD or a CCP. Where a Central Counterparty (CCP) is present in a market, the power to enforce buy-ins (on their Clearing Members) falls under their remit in order to guarantee their contractual obligations to the market. The below charts can also be seen to illustrate the penetration of the CCP model into different regions. In the absence of a CCP, the Stock Exchange is the next most likely candidate to have the power to enforce buy-ins against its members, and exchanges take the dominant role in this regard in Africa, Middle East and the Americas. The surprise in the results above is the number of CSDs able to enforce buy-ins, and this may be of concern to those who regard CSDs as ‘risk minimising vehicles’. After all, a CSD executing a buy-in is taking a position in the market and is therefore subject to price variation on that position (though this will usually be covered by the settlement guarantee fund). Some of the CSDs in the above sample also operate CCPs/Clearing Houses in the same legal vehicle (e.g. Canada, China, Croatia, Israel, Singapore), a structure that has been previously frowned on by the likes of the European Central Bank (ECB). In other markets though, the CSD has been granted the powers to enforce settlement (e.g. Bosnia, Egypt, Serbia) in the absence of a CCP.

Figure 3: Entities executing buy-ins in respective regions.

According to the pending EU short-selling regulations, buy-in procedures should be initiated no later than on the Intended Settlement Day (ISD) + 4, and European markets are already moving towards harmonising on these timings (e.g. LCH, EuroCCP and EMCF recent changes in buy-in timings).

Figure 4: Timings of buy-ins in the regions.

Figure 4 shows that, so far, Europe has only 12 (out of 25) markets with buy-in timings up to ISD+4, mainly due to Europe historically operating long ‘grace periods’ prior to enforcing buy-ins. Asia Pacific is the region with the most timely buy-in procedures, and most of the emerging markets which have evolved in more recent times have adopted these more stringent buy-in timeframes.

Conclusions

While developed markets, particularly Europe, have embraced the mechanisms for managing fails effectively (particularly by use of CCPs), the application of the practice has often been relaxed in its timing which can lead to additional risk (e.g. price variation risk on an ISD+30 buy-in which was the case in the UK until recently). This may be down to the balance of power between infrastructure and participants which is skewed heavily towards the users in developed markets. Where the market infrastructure is strong in emerging markets, there is much tighter control over closing-out unsettled positions. It is probably about time that regulators intercede to bring greater discipline to those markets that should be leading the way in controlling risk exposures on late settlement, but might not historically have done all they could.

For further information contact:

Jim Micklethwaite
Director, Capital Markets
Thomas Murray Data Services
+44 (0) 20 8600 2309
jmicklethwaite@ds.thomasmurray.com

Appendix 1 – Markets with No Buy-In Procedures

Appendix 2 – Market Alternatives to Buy-Ins

Tags: CCPCSDCSDRCMI in Focus