Although not many of us regularly think about how cash moves from one bank account to another, it is important to know how Eurobonds move between accounts.
Where cash is held in a bank account, Eurobonds are held in a so-called “custody account”.
Eurobonds are said to “settle” in a custody account whenever a purchase or sale is made. A vast financial market infrastructure is in place to connect custody accounts worldwide for bonds to settle correctly. This infrastructure has historically been built and maintained by International Central Securities Depositories, or “ICSDs”. Such depositories are usually banks that have a single purpose: provide settlement and custody services.
ICSDs function as warehouses for Eurobonds where investors can store Eurobonds for a fee. A custody account can be opened directly with an ICSD, however due to relatively high entry thresholds the majority of (retail) investors will have a custody account with bank who on their turn has a direct relationship with the ICSD.
When a Eurobond is purchased, it is conventional that the buyer and seller agree to exchange the security two business days after the trade date. This is referred to as “T+2” settlement, which is similar to the so-called “spot” settlement in foreign exchange markets.
It is theoretically possible to agree on any settlement date, however, in practice, it is rare to settle bonds more than 5 business days after the trade date (“T+5”). The main reason for securities not settling on the trade date itself itself is to allow for the buyer and seller to make the necessary logistical, funding and system arrangements to ensure smooth settlement.
Eurobonds can be listed on an exchange. The process to list can be lengthy and expensive, however a key factor is that a listing benchmarks the issuer’s governance standards. For this reason, reputational reasons can be a strong incentive to press ahead with a listing.
Furthermore, a listing may help to ensure an active secondary market in the Eurobond. Some institutional investors may have a listing requirement included in their mandates. In other words, such investors can only purchase listed Eurobonds.
International Central Securities Depositories (“ICSDs”) provide a centralised function in order to ensure the movement of Eurobonds from the account of a seller to the account of a buyer. Depositories provide the market infrastructure needed for these transfers and are the focal point for the settlement departments of market participants. ICSD responsibilities are usually taken on by banks who have a single purpose: settlement & custody services.
Standalone software or cloud-based modules are offered by depositories to provide market participants with an easy method to instruct on Eurobond purchases and sales. A matching function is provided where bonds will only exchange if both the buyer and seller have instructed and therefore confirm the underlying transaction. In this way, Eurobonds cannot exchange hands (settle) if instructions do not match. This is one of the key operational risk mitigants of the bond market.
Larger institutional investors and banks usually have an account directly with an ISCD, whereas others may sign up to custody services offered by a bank. A bank, in this case, functions as a sub-custodian on behalf of a depository.
The seller of a Eurobond delivers the security on the settlement date and receives the agreed cash amount in return. This is called a “Delivery vs Payment (DVP)” instruction and the security will only be delivered once the cash has been received.
For the buyer, the opposite happens and is referred to as a “Receive vs Payment (RVP)” instruction.
Most Eurobond transactions settle with a DVP/RVP instruction, however “Free of Payment (FOP)” instructions are fairly common. Internal Eurobond transfers between portfolios within the same fund, in-house retail flows within an omnibus account or clients using a non-proprietary custody account next their bank account are examples of Free of Payment settlements.
Although most bonds settle on their agreed settlement date, late settlements do happen. Late settlements tend to occur more often in times of market stress, around new Eurobond issuance or when transacting with new counterparties.
A late settlement, or the failure to settle on the agreed date, can result in knock-on effects or chain reactions for both buyers and sellers. Failing to deliver a bond to a buyer, may prevent that buyer from delivering the same bond to possible subsequent buyers. On the other hand, a seller aiming to use sale proceeds to fund the purchase of another bond, may suffer from insufficient funds as a result of late settlement of the initial sale.
A delay in covering a short position is one of the main reasons for late settlement. A seller defaults on delivering a security on the settlement date and subsequent buyers will face a delay in receiving the security.
Other reasons for late delivery can include human error by back/front office, delays in repo markets, system issues or the unwillingness/inability to cover a short position.
In order to mitigate late settlement, most investors “cover” failing settlements using other positions they have in inventory. This, however, assumes, the investor already holds a position in the bond. Alternatively, market participants can borrow bonds from other investors assuming the ability to borrow Eurobonds through so-called “repurchase transactions” exists.
It is important to state that no (initial) commercial loss or gain is realised with a late settlement. The main concern for failing entities is reputational damage.
If a bond still has not settled after having allowed a certain tolerance for late settlement, an investor being failed to may decide to issue a so-called “Buy-In Notice”. A Buy-In Notice may have commercial consequences for the failing investor and is widely method of last resort to enforce settlement.
An investor awaiting settlement of a Eurobond may decide to issue a “Buy-In Notice” after a period has passed.
A Buy-In notice is not a legally enforced document, however it exerts pressure on the failing entity to deliver the security within a set time frame. It is common to allow the failing market participant 5 business days to deliver the Eurobond before the Buy-In procedure kicks in. A Buy-In Notice will be issued to the failing entity detailing the details of the trade, the appointment of an agent and a time line.
Since 2018 it is widely accepted that the agent does not necessarily have to be a third party but can easily be the failed entity itself.
The difference in price between the initial execution price and the Buy-In price the agent is able to cover the trade at will be at the failing entity’s expense. Furthermore, any missed accrued interest will be factored in.
A general example of a Buy-In Notice is presented below.
TO: CLIENT BUY-IN DEPARTMENT
FROM: HOWNOWW - TRADE OPERATIONS
WE HEREBY GIVE YOU NOTICE OF OUR INTENTION TO CLOSE OUT THE CONTRACT BETWEEN US OF WHICH DETAILS ARE GIVEN BELOW BY MEANS OF A BUY–IN IN APPLICATION OF THE ASSOCIATIONS BUY–IN RULES.
UNLESS DELIVERY IS MADE ON OR BEFORE THE DATE OF EXECUTION OF THE BUY–IN SHALL BE 22/12/2020 THE DATE OF EXECUTION OF THE BUY- IN SHALL BE THAT DATE.
THE FOLLOWING FIRM WILL BE INSTRUCTED TO AFFECT THE BUY–IN: HOWNOWW (LEI: XXXXXXXXXXX)
DETAILS OF THE CONTRACT BETWEEN US AS FOLLOWS:
TRADE DATE 07/12/2020
VALUE DATE 09/12/2020
SELLER: INVESTOR A
NOMINAL AMOUNT USD 500,000
SECURITY NGERIA 7.696 02/23/38
NET AMOUNT USD 546,420.22
CLEAN PRICE 107.018
SETTLEMENT DETAILS 99999
Settlement discipline is becoming a more important element in a properly functioning market. For years, regulators have lobbied for stronger enforcement related to late settlements which has culminated in draft legislation: Central Securities Depositories Regulation or CSDR. Although CSDR was supposed to be introduced early 2021, it has been postponed.
Penalty fees and mandatory Buy-In Notices are the main takeaways of CSDR in an effort to discipline market participants failing to delivery securities at agreed settlement dates.
Investors holding different currencies usually require multiple cash accounts. For example, a USD account for US Dollars or a EUR account for Euro.
For Eurobonds, however, a single custody account will safekeep any Eurobond purchased. A Nigerian Eurobond denominated in US Dollars, a South African Eurobond in Japanese Yen or a Senegalese Eurobond in Euro can all be held in the same custody account.
It is important to note, that the Eurobond needs to be accepted by International Central Securities Depositories in order to be warehoused. Most domestic securities, such a Nigerian Naira denominated bonds are not eligible and therefore not accepted by ICSDs for custody and settlement.