In our July blog on transaction tax processing, we reminded readers of an old adage – that nothing is certain but death and taxes. When it comes to interest claims on settlement fails, another proverb is perhaps more fitting: forewarned is forearmed.
A maelstrom of regulatory, market structure and economic factors has led to a rise in both fails and interest claims over the last year, a trend that looks set to intensify. Here we examine the drivers of this and outline why financial institutions must quickly enhance their approach to managing interest claims.
Several economic factors are driving the number of interest claims higher. Firstly, the volume of instruments traded globally is steadily rising. For example, in the first half of 2023, the number of exchange-traded derivatives contracts continued double-digit growth, amounting to 56bn in total. A higher volume of instruments traded inevitably means greater numbers of trades failing to settle.
At the same time, we have witnessed a departure from the historically low interest rate environment of the last decade. Given rates could remain elevated for the foreseeable, there is greater revenue on offer for banks through the issuance of interest claims. Previously, banks seldom prioritized interest claims, as there was little financial incentive to do so. The flip side of this, however, is the greater potential for banks to incur payables as counterparties issue claims against them for failed trades.
The European Union’s implementation of the Settlement Discipline Regime of the Central Securities Depositories Regulation (CSDR) in February 2022 has also brought settlement failure penalties front of mind for many companies. With CSDR having normalized the payment of penalties for failed trades, banks are increasingly seeking payment for non-CSDR eligible items, which is contributing meaningfully to the rise in interest claims.
While it was hoped CSDR would incentivise banks to make substantial improvements to their settlement operations and thus reduce their fail rates, research suggests that this has not been the case, with €1.7bn paid in penalties since February 2022. The upcoming transition to T+1 in North America in May 2024, and any subsequent country adoptions, is likely to exacerbate the problem. As shown by CSDR, many institutions have been unable to make meaningful progress on their settlement efficiency goals. This suggests a substantial increase in fails and interest claims is likely within the shorter settlement window.
A complex blame game
This is concerning for banks given the complex and time-consuming process of resolving interest claims. Fault attribution lies at the heart of this complexity. Often, both parties involved in a trade are responsible for the settlement failure to some degree, over different days. For instance, the bank issuing the interest claim may have been at fault for two of the five days in which the trade failed to settle. This means a reduction of the sum owed is necessary, which can drag out the reconciliation process considerably.
The procedure can take longer still when a disagreement arises over which benchmark interest rate should be applied, be it the custodian overdraft rate, internal funding rate, interbank rate, or other. Naturally, the party issuing the claim will seek to apply the most favourable rate, which can be contested. There are several other factors that can protract the resolution process, and before long the opposing parties can become locked in a lengthy negotiation, all the while new interest claims could be piling up.
Aside from the financial drawbacks, this can be extremely detrimental to counterparty relationships. These factors only become more problematic as the number of interest claims rises – which is exactly what is in store for banks worldwide.
High time to act
We are speaking with a growing number of client banks that have seen significant increases in the number of interest claims issued against them over recent months, with some seeing a tenfold increase. Many banks’ processes are simply not equipped to manage these levels of interest claims, whether on the payables or the receivables side.
There has been little investment in digitizing and automating key post-trade processes like interest claims management over recent decades, with the bulk of investment going into the revenue-generating front office. As a result, most firms still rely on multiple and disparate data sources and outdated and cumbersome processes to manage interest claims, with spreadsheets still predominantly the norm.
The manual labour required to complete a claim via this approach can be substantial. The ops team must first identify a failed trade, along with the number of days it has failed for. They must then determine who is at fault, select the relevant benchmark interest rate, and calculate the interest cost. An interest claim letter must then be drafted and disseminated to the counterparty. After all that, the counterparty may contest the claim, and any necessary amendments will have to be made. A revised interest claim is then sent to the counterparty, who might raise another issue, and so it goes on. Of course, all the above must also be fully auditable.
While this may have been a viable approach for banks tackling a handful of interest claims each day, tracking the lifecycle of interest claims numbering in the thousands in this manner is both complex and wildly inefficient. This is especially true given interest claims on partial settlements are anticipated to rise meaningfully over the coming months. The interest cost calculation on these adds to the complexity and can further protract any dispute.
A smarter solution
All this underlines a growing need for financial institutions to enhance their interest claims management capabilities. They must be able to handle exceptions, validate and reconcile claims, and efficiently attribute fault. By drawing on cutting-edge API-first technology, data digitization and process automation, the optimal solution can deliver straight-through processing and manage interest claims receivables and payables faster and more cost-effectively, as well as provide the necessary level of accuracy to support calculations.
Aside from the financial rationale for deploying such a solution – including the ability to generate greater income and challenge interest claim payables – there are the many advantages that come with more efficient fault attribution and claims handling. These include significant operational efficiency gains and reduced people costs. Moreover, greater digitization of this process and enhanced data aggregation capabilities facilitates the use of innovative artificial intelligence programs that can help to identify and unlock additional value opportunities.
Building and maintaining stronger counterparty relationships is another advantage, with a reputation for swift claims resolution being a highly attractive trait for prospective and existing counterparties. It can also assist in making more informed decisions around which counterparties to trade with. If one counterparty is found to be at fault for settlement failures on a regular basis, and therefore expensive to service, it may be prudent to cease activities with this firm and initiate a relationship with another.
Lastly, enhanced fault attribution enables operations teams to better allocate costs internally. For example, particular trading desks may be consistently responsible for a substantial portion of late settled trades. Gaining greater visibility into this can subsequently help executives make more informed decisions around budget allocation – a hugely positive advantage in an environment of squeezed margins.
In this context, it would be short-sighted for financial institutions not to bolster their internal capabilities to support their interest claims payables and receivables operations. Those that do nothing look set to face a growing mountain of complex interest claims to manage while, at the same time, forgoing a host of advantages afforded by more accurate fault attribution, greater operational efficiencies, and cost versus revenue optimizations.
If the challenges outlined here resonate with you, and you would like to learn how we can help with your interest claims management operations, get in touch with us at MeritsoftCapMarkets@Cognizant.com.