Japan looks to DLT to combat rise in settlement fails

Decision to shorten settlement cycle likely to hike fails caused by confirmation mismatches

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As Japan moves to shorten its settlement window for cash equities, dealers are hoping that distributed ledger technology can reduce the probability of failed trades between domestic and foreign investors.

Given the difference in time zones – Tokyo is nine hours ahead of London and 13 hours ahead of New York – investors in Europe and the US will have just one day to settle trades from July 16, when the local settlement window is shortened from three days (T+3) to two days (T+2). Overseas clients of Japanese dealers account for 60% of equity trades in the market, according to the Japan Securities Dealers Association.

“Failures are expected to increase due to offshore clients that reside in different time zones, since they have a much narrower window to send instructions, match and correct them,” says the head of operations at one global investment bank in Tokyo.

Although the overall level of failures is expected to be small compared with the US and Europe, the operations head says any rise will be “noticeable” for Japan’s markets, which are used to operating at a zero-fail rate for domestic trades.

Settlement failures occur when the delivering counterparty in the transaction doesn’t hand over securities ahead of the settlement cutoff time. Participants fear that any rise in the failure rate could increase market liquidity risk, escalate costs if buyers of the failed trade are unable to cover an existing short position as a result, and may lead to contagion during times of low volumes.

The main bottleneck to the settlement process is trade confirmation matching, which requires both counterparties to verify details of the transaction before it can be settled. Concern over the effect of failed matches has given rise to a working group in Japan including Daiwa Securities, Goldman Sachs, HSBC and the Depository Trust and Clearing Corporation. The group is exploring how distributed ledger technology can improve the way that firms exchange and match trade information.

The European securities markets moved to the T+2 settlement cycle in 2014 while the US switched over in 2017. In Asia, Hong Kong adopted the T+2 cycle in 2011, Australia in 2016 and Singapore from December last year.

While fears of an increase in settlement fails were expressed when the cycle for cross-border trades of Japanese government bonds was shortened from T+3 to T+2 last year, the operations head says in equities where volumes are “much, much higher” the failure rate is likely to be more significant.

The only step that is not centralised in securities post-trade processes is trade confirmation

Masafumi Kondo, Japan Exchange Group

There could be added pain if a settlement failure occurs at the same time a company is determining dividend payments for shareholders – known as the record date – since this will undermine the rights of those who are not in possession of the securities on the date they expected.

Japanese securities houses have been updating their technology and processes, and prioritising settlements to make sure that failures do not occur on the record date. But solutions for cross-border trades still remain patchy.

“Without changing the system then I am sure that settlement failure will increase,” says So Kawanami, part of the strategy group at Fintertech, a wholly owned subsidiary of Daiwa Securities set up last year to develop applications for digital technology. “The domestic market operates on a same-day settlement principle, but cross-border trades are a bit different. The overseas custodian needs to send instructions to the local custodian, and the local custodian needs to talk with the local brokers. It can all get fairly complicated.”

The service providers involved in the confirmation process have different systems and specifications, which are tweaked for individual customer needs. This can slow the process down, says Masafumi Kondo, senior business analyst at Japan Exchange Group.

“The clearing process is centralised through the Japan Securities Clearing Corporation. The settling of securities is centralised via the Japan Securities Depository Center,” he says. “The only step that is not centralised in securities post-trade processes is trade confirmation.”

Daiwa Securities, along with other working group members, is developing a decentralised database solution – essentially a form of DLT – to help standardise parts of the matching process. The project aims to unify calculation methods for components such as unit price, commission and settlement price. It will address the inconsistent use of instrument codes, and attempt to draw up a unified contingency plan for fails.

“[DLT] promises to act as a trigger in standardising specifications and achieving more efficiency in data sharing while preserving the existing competitive landscape,” says Kondo.

The proof of concept has already been trialled in Myanmar, following a tie-up between Japan Exchange Group, Daiwa Institute of Research and Myanma Economic Bank for use on the Yangon Stock Exchange, he says.

Still, it may take time for Japanese companies to adopt DLT for settlement as it may impact business models, Kondo says. Added complications for cross-border trades are that many more dealers with different systems plug into the technology. Organisations are likely to have concerns over cyber security and the risk that data held outside the firm could be compromised.

“There are confidentiality issues surrounding this – hedge funds aren’t going to want to reveal how many of a particular stock they are holding,” says Michael Reeves, a Tokyo-based financial markets consultant. “Some clever thinking is going to have to take place as to how that’s dealt with, especially where these systems could conceivably cross borders as well.”

But the risk of having to deal with many more failed trades may prompt firms to embrace such technology solutions. Australian exchange ASX is experimenting with blockchain to reduce settlement times for cash equities in its local market.

“The question of improving the efficiency of cross-border settlement has been talked about for more than 20 years,” Kondo says. “It’s a very tough challenge, but one of the biggest achievements of DLT is that it has reignited the discussion about how we can achieve this.”

Editing by Alex Krohn