Review of Settlement Practices for Australian Equities – May 2008 5.3 The settlement fails regime

In discussions with industry participants a frequently raised issue was the incentive that participants have to ensure timely settlement. This is important not only from a stability perspective, but also from a market efficiency perspective. Timely settlement allows market participants to make contingent plans, thereby underpinning trading activity and contributing to the depth and liquidity of the financial markets. In many cases, the failure to deliver securities on time imposes costs on the market that exceed those borne by the entity failing to deliver. This is particularly so if a failure triggers a chain of failed settlements and even more so if it corrodes market confidence.

Notwithstanding difficulties in obtaining comparable data on settlement fails internationally, the headline fails rate in the Australian equity market seems to compare favourably. Less than 1 per cent of transactions in Australia reportedly fail to settle on T+3 due to a participant's failure to deliver securities. Failed trades are rescheduled for settlement the following day, with around 75 to 80 per cent of these then settling on T+4. The majority of settlement fails are for low-value trades, with ASX estimating that 98 per cent of the number of trades account for around a third of the total value of failing trades. However, the headline fails rate does not capture any flow-on effects of settlement failure. For each individual failed settlement, one or more dependent obligations often also need to be rescheduled, so that the true incidence of trades failing to settle on the intended day is in fact higher.

It is worth noting that settlement failures can and do occur in respect of trades cleared via the central counterparty. The guarantee provided by the central counterparty does not extend to timeliness of settlement. Rather, the central counterparty is ordinarily only obliged to perform on behalf of a participant should that participant be declared to be in default.

The rate of failed settlements in Australia would be somewhat higher were it not for the active securities lending market. This market allows participants to borrow securities to prevent a failure to deliver, perhaps in response to the non-receipt of securities/instructions from a client or an offshore custodian. Much of this activity appears to reflect efforts by market participants to prevent chains of settlement failures.

Internationally, a variety of approaches are taken to promote timely settlement, ranging from market monitoring to centralised arrangements for securities borrowing or buy-in.^[14] One common approach is to impose a penalty on participants for failed deliveries, with this sometimes applied in combination with disciplinary procedures.

Under current arrangements at ASTC, a fail fee of 0.1 per cent of the value of the failing trade applies, with a floor of $50 and a cap of $2,000. In addition, more serious or lengthy fails may be referred to ASX's Disciplinary Tribunal.

A number of industry participants have suggested that, notwithstanding the relatively low headline settlement fails rate, there might be a case for an increase in these fees. It is argued that the current fees provide little incentive to ensure that trades are settled on time; for example, the fail fee on a trade of $50,000 is only $50. Further, it is understood that in some cases these fees are not passed on by settlement participants to end clients that fail to deliver stock, weakening the incentive to deliver on time.

ASX is currently reviewing the adequacy of these fees.^[15] The Reserve Bank supports this review. To the extent that the vast majority of settlement fails are in respect of low-value trades, the minimum fail fee may be set at too low a level. There may also be a case for an increase in the $2,000 cap and the percentage-based fee. While there are relatively few fails among highvalue trades – perhaps reflecting an already strong disincentive associated with reputational considerations – higher fees are likely to improve the incentives to settle on time, reducing risk in the system.

There may also be a case for applying a sliding scale, with significantly higher fees applying for transactions that are settled after T+4. It is possible that the failure to deliver at T+3 may be the result of an operational error by an offshore client which cannot be rectified in time due to time-zone differences. Such transactions would normally be expected to settle the following day. If they do not, a higher fail fee may be appropriate.

Several other possibilities are worthy of further exploration by ASX. These include: more rapid referral to the Disciplinary Tribunal; harsher treatment for persistent offenders; forced buy-in by the participant of a security that it has failed to deliver beyond a specified time-frame after T+3; and automatic recourse to a securities-borrowing or buy-in mechanism.

Both securities-borrowing and buy-in arrangements were previously in place at ASX but were discontinued. In the case of the securities-borrowing facility, this occurred after the withdrawal, for business reasons, of the committed lender. In the case of the buy-in facility, it was the result of the migration of securities settlement to CHESS and the judgment that the functionality of the new system provided adequate protection against settlement fails.

There are arguments for and against such arrangements. On the positive side, they are likely to increase the probability that trades are settled on time, and this should improve the efficiency of the market. They may also assist smaller participants who currently have limited ready access to the securities lending market. On the other hand, such arrangements can be costly to administer and, in the case of a borrowing facility, raise moral hazard issues if the cost of using the facility is not sufficiently high. It might also be difficult to attract lenders willing to commit securities to a centralised borrowing vehicle if there is not a strong business case to do so.

The Reserve Bank encourages ASX and the industry to take steps to strengthen the settlement fails regime. There would seem to be considerable merit in revision to the fee scale, or other penalties, to provide a sharper incentive for timely settlement. There may also be a case to examine the usefulness of centralised securities-borrowing or buy-in arrangements.

Footnotes

For instance, in the UK, Euroclear UK and Ireland assists a market committee to monitor settlement discipline, providing data on participants’ matching and settlement performance vis-à-vis a benchmark. Where centralised securities-borrowing arrangements are in place, a subset of participants (typically custodians) pre-authorise the loan of available securities to the securities settlement system or central counterparty to assist in the completion of settlement. Several overseas securities settlement systems and central counterparties operate such facilities (for example, SIS SegaIntersettle in Switzerland and the National Securities Clearing Corporation in the United States). With the securities settlement system or central counterparty as the borrowing counterparty to the trade in such arrangements, counterparty credit concerns do not pose an issue for the committed lender. Under a buy-in arrangement, the securities settlement system or central counterparty enters the market to buy securities required to complete settlement, passing the costs of doing so onto the party failing to deliver. [14]

ASX launched a public consultation on ‘Short Selling’ on 28 March, inviting comments by 24 April. See <http://www.asx.com.au/documents/public-consultations/short_selling_public_consultation_paper.pdf>. [15]