An old investing adage holds that success has many fathers, but failure is always an orphan. Beginning in 2020, cross-border settlement failures will also come with a new set of potentially costly penalties thanks to the new settlement discipline rules contained in the EU's Central Securities Depository Regulation (CSDR).
Adopted in 2014, CSDR was primarily aimed at harmonizing the way central securities depositories (CSDs) operate across the EU. Some 15 CSDs now have the official stamp of approval and operate with the strict prudential and conduct rules that CSDR established.
But CSDR also contained a provision to establish “settlement discipline” that begins to bite in November 2020. Industry associations are proposing for a further implementation delay, potentially to early 2021, in order to allow for better operational readiness to support the settlement discipline regime. In an effort to reduce the number of settlement failures in the EU, the new CSDR rules provide for two penalties:
- Cash penalties for failed settlements, with a basis point penalty applied depending on the type of asset involved.
- A mandatory buy-in mechanism after four business days of failing.
The new rules are important for both buy-side and sell-side trading desks to prepare for and apply to non-EU counterparties as well.
For the uninitiated, a buy-in is a contractual remedy for a 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. While previously optional, the buy-in process now becomes mandatory for liquid securities four business days after the intended settlement date (ISD+4 in EU parlance) and in seven days for illiquid securities (ISD+7). If the buy-in mechanism is unsuccessful, the selling counterparty must pay a cash penalty to the buyer, equal to the difference between the original agreed price and the current market value of the securities.
The regulation states that third party buy-in agents (most likely brokers and dealers) will support the buy-in and the counterparties will trigger the buy-in by engaging the buy-in agent to source available securities from their failing counterparty. Custodians will manage the communication and operational support needed to facilitate trade settlements.
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.”
How CSDR will play out
Market participants generally communicate their purchases and sales using the European Central Bank's Target2 Securities (T2S) platform or through their CSD. According to the new rules, CSDs will calculate cash penalties daily for each business day that a transaction fails to be settled after its intended settlement date (ISD) and report the cash penalties through the chain of custody. Penalties will not have a minimum threshold. They will roll over from day-to-day until the settlement takes place and will be applied on a monthly basis to respective client accounts. Penalties can be calculated using what are called Late Fail Matching Penalty (LFMP) or Settlement Fail Penalty (SEFP) definitions.
In the case of appeals, there is a 10-business day period after the receipt of the monthly penalty summaries in which a penalty can be appealed and, in some cases, adjusted before final penalty settlement is expected. Appeals can cover scenarios where a penalty is reported against a security which is no longer active, or in the case where the CSD has had a technical failure resulting in inaccurate reporting of penalties.
As a result, CSDs, custodians, and both buy-side and sell-side market participants are making 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.
While most market participants have welcomed the efforts to streamline the settlement process, the new rules also have a potential downside: they 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) said in a study of the impact of the mandatory buy-in provisions that “liquidity across secondary European bond and financing markets will reduce significantly, while bid-offer spreads will widen dramatically.”
ICMA argued that spreads on liquid sovereign bonds may double and secondary markets for less liquid corporate bonds may “effectively close.” It 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.
Based on the push for delay, CSDs may get an extra few months to comply, but that would need be confirmed by ESMA and the EU Commission. Something to watch in 2020.
This article was originally published in the 2020 Regulatory Field Guide. The guide features insights from a number of our experts on key regulatory developments that will have the greatest impact for asset managers in the year ahead. Visit bbh.com/regulatoryfieldguide to explore the guide.
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