Volcker casts long shadow over settlement efficiency

Nestled in the weeds of the 50 pages and more than 2800 footnotes of this infamous regulation is a very specific requirement in relation to fixed-income securities. It states that if a firm holds any fixed-income security for longer than 90 days, then it needs to hold more capital in reserve. 

So why does this esoteric line under Volcker, which was drawn up well over a decade ago, remain relevant in today’s capital markets? Well, according to recent data from the Federal Reserve, constrained inventories for both corporate bonds and US treasury securities have been linked to a jump in settlement failures both for outright bond transactions and repurchase agreements. Back in March, the number of repo and outright bond trades where one counterparty failed to deliver a security hit its highest level in at least nine years. Average weekly failed delivery volumes have stayed elevated since, with the year’s weekly average up a staggering 57% compared with the same period last year.

The reality is that, since Volcker came into play, investment banks have been effectively discouraged to hold long inventory as it was deemed as choosing to profit from market-making activities at the expense of clients. Therefore, it should hardly be surprising that there has been a spike in settlement failures since Volcker, essentially, disincentivised dealers from holding longer positions. As a result of the rule, dealers must churn inventory more frequently than they would otherwise ideally like to. If a dealer’s inventory, for example, was say only turning over half of the time (e.g., sold 50 million of the 100 million bonds on its books) then they would be punitively charged under Volcker.

Consequently, dealer arms of the investment banks have got into the habit of holding less inventory, which means they have less capacity to fill orders. The fact is that the fixed-income market is inherently inefficient by its very nature, and there is clearly massive room for improvement when it comes to settlement efficiency. The market structure issues experienced across the corporate bond and US treasury markets over the past few months simply exacerbate the problem of settlement efficiency. The question now must now be: what can be done to make the market more efficient when it comes to settlement?

Partial settlement?

Many would argue that if the entire market moved to something called ‘partial settlement’ then this would go a long way to plugging the efficiency gaps. Picture two firms agreeing to a fixed-income securities trade for $50m. One firm, say a dealer, is due to deliver the $50m but can only deliver $30m. The sensible approach in this situation would be to break the trade up into $30m and $20m, respectively. If the firm in question delivers $30m, then only $20mn fails to settle. The trouble is that asset managers are against this partial settlement approach due to the fact that if they have $50m split across five funds with $10m allocated to each, but the dealer can only deliver $30m, then two of the five funds could end up with nothing. Hence the asset management industry has not really been clamouring to embrace the concept of partial settlement. 

Others would argue the case for borrowing more. The trouble is that firms do not want to reduce their trading profit and loss by having to pay increasingly higher interest rates on a borrowed fixed-income security. So instead, they let the trade fail to settle. Ultimately, firms are left with letting the trade fail, borrowing or running more inventory. Invariably, most firms are going to let the trade fail because the cost of failing to settle pails into insignificance compared with borrowing in a rising interest rate environment or running more inventory which is restricted under Volcker. This is not to say that, even though letting trades fail might be best of three unattractive options, that the industry cannot make massive improvements when it comes to settlement efficiency. Firms can still put a greater emphasis on getting settlement operations right so that fail rates for outright bond transactions and repos at least fall below the 50% mark. After all, financial institutions have to prepare for one of the most significant market structure changes in recent memory: the slashing of settlement timelines from T+2 to T+1. Let’s face it, no firm will want to be continuing to fail on more than half their fixed-income trades in the run-up to this cut in the settlement lifecycle.

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