There is no time like the present. But when it comes to standardizing regulations for the way central securities depositories across all EU markets operate and improving trade settlement timeframes, the present is as important as the past in shaping the future. The EU’s Central Securities Depository Regulation (CSDR) is constantly evolving.
Adopted in 2014 with strict prudential and conduct rules for some CSDs in Europe, CSDR has taken effect over time, with the last stage of implementation – the so-called Settlement Discipline Regime (SDR) – only having taken effect on February 1, 2022. SDR aims to prevent and address settlement fails by imposing new requirements through CSDs operating across the European Economic Area (EEA), including (most notably):
- Cash penalties for failed settlements, with a basis point-based penalty applied depending on the type of asset involved. The party at fault of a failing trade - through either a Late Matching Fail Penalty or a Settlement Fail Penalty - will be responsible for paying the accrued charge. Penalties are to be calculated by CSDs daily and collected monthly. Reporting of penalties will be provided by the CSDs to their direct participants, and on through the chain of custody to the custodians and their clients.
- A mechanism for imposing mandatory buy-in (MBI), which would take effect four business days after the intended settlement date (ISD) for liquid shares and seven business days after ISD for bonds and all other instruments (the interim before buy-in is required is referred to as “the extension period”). This remediates the buyer of securities when the selling counterparty fails to provide settlement of the purchased securities on time. The buying counterparty obtains the securities from a third party, and if the price is higher than at the time of the original sale, the selling counterparty must make up the difference.
CSDR SDR also contains requirements for trade allocation, confirmation processes, monitoring, and reporting.
SDR was initially supposed to bite on September 13, 2020, but the European Securities and Markets Authority (ESMA), the EU’s securities markets regulator, wanted to ensure better operational readiness and so postponed implementation. The authority said it took the decision “due to the impact of the COVID-19 pandemic on the implementation of regulatory projects and IT deliveries by central securities depositaries and a wide range of market participants and follows a request from the European Commission (EC).1”
Both buy-side and sell-side trading desks, including non-EU counterparties, have been in preparation mode for SDR. In fact, all parties in the chain, including investment firms, should have measures in place to mitigate fails. From functions such as fund accounting and securities lending to firms trading debt and equities and exchange traded funds, CSDR affects all market participants and, due to pending updates highlighted in this article, additional, new impacts are likely to be felt in the near term and the long term.
Temporary Reprieve of Mandatory Buy-Ins
In November 2021, Mairead McGuinness, European Commissioner for Financial Services, Financial Stability and Capital Markets Union, announced a political agreement the European Parliament and the Council to delay the MBI regime under CSDR. ESMA followed up in December, issuing a statement to the effect that while ESMA and “national” regulatory authorities lack formal power to “disapply” the MBI regime (since it is set out in EU legislation), ESMA nevertheless assumed that the application date of the MBI regime would eventually be formally “decoupled” from the rest of the SDR.
In a public statement on the MBI regime, ESMA encouraged national regulators to take this into account “when applying the CSDR settlement discipline regime until the provision postponing the application of the buy-in regime is formally in place” and added that it expected them “not to prioritise supervisory actions in relation to the application of the CSDR buy-in regime”.2 Certain national authorities in turn followed suit, issuing statements indicating their intention not to enforce MBI for the time being.3 Joint industry associations4 welcomed this clarification.
Regulators Seek Further Improvements, Making Further CSDR Updates Likely
On July 1, 2021, the European Commission issued its Report on the outcome of the consultation on the CSDR Review: the Report summarised the main areas to be made subject to the future Commission proposals (“CSDR REFIT”). In the context of SDR, these areas included possible amendments to MBI rules, making them more “proportionate” (subject to an impact assessment) as well as providing various important clarifications to the penalties regime. The Commission’s proposals in connection with the CSDR REFIT are expected before the third quarter of 2022, possibly earlier. Consideration of how to deal with a postponed MBI regime and what further review might be needed relating to it are expected to be included.
Among other things, the REFIT proposals could provide for a new date for MBI to take effect, albeit in revised form. Market participants have expected that any changes would not take effect for 24 to 36-months.
In the meantime, public authorities expect market participants to make improvements in settlement timeframes and explore what can be done to avoid penalties and other impacts. The Commission’s approach regarding the MBI regime can be expected – at least in part – to depend on its assessment of the effectiveness of the penalty regime in improving settlement discipline.
Penalties Dry Run Testing
To that end, to prepare for cash penalties, CSDs and market participants conducted a “dry run” of penalties, with testing beginning during Q4 2021. This began with CSDs calculating and releasing penalty messages and then releasing samples through the custody chain to allow different parties to take in the messages, test the penalty flows and then prepare for how they will handle the messages or pass them on further for reviews.
The outcome of this testing period has been used to concentrate minds, facilitate dialogue across industry segments and prioritize measures to improve performance.
Optimizing Settlement for Preventative Measures
CSDs, custodians, and both buy-side and sell-side market participants have made significant investments to develop their back- and middle-office systems and processes to reduce the chances for a settlement failure and, when failures do occur, to determine liability and ensure cost is attributed to the responsible party. This could be especially difficult when there are multiple parties within a given train of transactions.
The focus has been on trade settlement optimization, where service providers have made trade status reporting available to help clients make those improvements. This includes updating status messages for trade settlements to bring a ‘near real time’ status view of positions to settle in CSDR markets in scope. Allegements reporting, or reporting on instructions for securities transactions, has been rolled out to show where positions have been alleged for European settlements.
Automating Partial Settlement
Partial settlement is another key area to support preventative measures. The legislation specifically mentions the use of partial settlement to reduce the impacts of cash penalties and buy-ins: partial settlement is likely become more of an industry standard expectation when settling in European markets.
To support clients, certain service providers applied an “auto”-partial settlement approach in advance of the February 2022 implementation date of SDR. This means that when a partial position is available to settle, it will automatically do so before the settlement deadline to reduce (or remove) the chance of trade failure and the possibility of penalty or buy-in impact.
Penalty Calculation and Review
The EU regulation made clear that the intention was to impose different cash penalties for settlement failures based on the liquidity of the assets involved. “Where shares have a liquid market and could therefore be bought easily, settlement fails should be subject to the highest penalty rate in order to provide incentives to failing participants to settle failed transactions in a timely manner,” the regulation states. “Shares that do not have a liquid market should be subject to a lower penalty rate given that a lower penalty rate should still have a deterrent effect without affecting the smooth and orderly functioning of the markets concerned.” Further calibration of penalty rates may emerge as part of the CSDR REFIT.
CSDR’s Impact on Market Liquidity
While many market participants have welcomed the efforts to streamline the settlement process, the new rules also have a potential downside: MBI in particular could dampen liquidity in the debt securities market by making it more difficult for borrowers and lenders to efficiently trade bonds. For example, the International Capital Markets Association (ICMA) issued a study of the impact of the MBI provisions which indicated that “liquidity across secondary European bond and financing markets will reduce significantly, while bid-offer spreads will widen dramatically.”
ICMA argued that MBI might cause spreads on liquid sovereign bonds to double and cause secondary markets for less liquid corporate bonds to “effectively close.” ICMA suggested that the rules might force market makers to retrench from providing liquidity to the market. Buy-side traders need to be aware of the possibility that debt market liquidity may be in short supply if MBI goes into effect unchanged. Public authorities, however, have indicated they have heard industry concerns and it is hoped any revised MBI proposals that emerge out of the CSDR REFIT will be responsive to market liquidity concerns.
CSDR is Likely to Impact Products and Strategies Differently
Market participants need to consider impacts beyond mere securities purchases and sales. Functions such as securities lending, for example, are impacted differently: here the regulation will likely necessitate a change in operational procedures to manage shorter time frames. ETFs as well are likely to be heavily affected by the SDR: indeed, the impact to ETFs is expected to be especially noticeable since ETFs typically have a high rate of settlement failure in relation to share creation and redemption combined with delivery of underlying securities: while the ETF shares may settle in two days (T+2), the securities underlying the ETF shares may require five or more days for delivery (T+5).
Increased costs to ETFs for failures could be passed on to investors. Alternatively, the market may be prompted to change the way the system operates, particularly by authorised participants (APs), who create and redeem shares. These impacts may be felt by an ETF holding European securities, regardless of the fund’s domicile.
Impact on UCITS and Alternatives Funds
Another area likely to be impacted is fund accounting, with CSDR penalties possibly needing to be accounted for. For clients that utilise a service provider as a custodian and fund accountant, any cash penalties that are processed through the custody chain to arrive at the fund will need to be considered for inclusion in the fund’s NAV. Through real-time status reporting by the service provider, clients may want to be able to monitor cash movements via a two-day pre-notification. For clients who do not wish to have the cash penalties included in the relevant fund’s NAV, they may utilise this pre-notification period to instruct that the cash penalties (a net debit) be otherwise covered.
Here, the regulatory engagement of service providers has been key, including participation in industry discussion groups such as the Irish Funds Industry Association, the Luxembourg Funds Association (or ALFI) and the European Fund and Asset Management Association.
CSDR: Here Today, And Tomorrow
With the next CSDR review due in five years, and given provisions for reporting and penalty mechanisms, the regulation is subject to continued refinement depending on the extent to which it succeeds in improving settlement timeframes through penalties and possibly MBI (this depends on the outcome of the CSDR REFIT). A full-blown CSDR II is not beyond the realm of possibility. What is certain, however, is that the regulatory space for securities settlement is one to be watched in 2022 and beyond.