The European Union’s (EU) Central Securities Depositories Regulation (CSDR) has had a transformational impact on the European post-trade model. To date, it has established a standardized regulatory framework for EU central securities depositories (CSDs), builds on the T+2 settlement cycle implemented across member states, and will be integrated with Target2Securities to further improve the settlement process.
Key insights
- While asset managers are supportive of the need to improve settlement efficiency, they are concerned about the cost and operational implications of mandatory buy-ins
- Mandatory buy-ins could have a destabilizing impact on liquidity in securities lending markets although this could be offset by improved settlement efficiencies and borrower demand
- The delay to the SDR is welcome as it will enable fund managers to implement the necessary operational changes. However, those involved in securities lending are concerned that issues could still emerge unless there is more clarity from the regulators about the rules.
CSDR will now look to capitalize on its earlier successes with an ambitious settlement discipline regime (SDR), an initiative EU regulators believe will result in additional settlement efficiencies. However, some aspects of the SDR could prove to be rather complicated.
Settlement discipline regime takes shape
EU regulators have advised CSDs that they must levy cash penalties on at-fault counterparties to late matches and failed trades with proceeds being disbursed to the institution on the other side of the transaction.1 The rules also pave the way for mandatory buy-ins, whereby the entity procuring the securities will be forced to buy-in their counterpart within a prescribed period (four days for liquid assets and seven days for illiquid assets) after a trade fail.2
In instances where a trade is centrally cleared, the central counterparty clearing house (CCP) will be responsible for executing the buy-in.3 For transactions that take place on a trading venue but not cleared, the relevant participant at that venue must initiate the buy-in. If trades are over the counter (OTC) but uncleared, then the relevant CSD participant will be entrusted with executing the buy-in.4
Further provisions under CSDR will require CSDs to:
- report data on settlement fails to competent authorities
- have a mechanism in place to suspend participants that fail “consistently and systematically”* to deliver securities on the intended settlement date
- publicly disclose participant’s consistent and systematic failure
Asset managers have become accustomed to brokers and custodians assuming responsibility for remediating settlement fails. With CSDR, that onus will shift to investment firms. The impact of CSDR on buy-side firms could be significant, particularly if securities are not delivered on a timely basis, said Ben Pumfrett, Director, Middle Office, Product Management at RBC Investor & Treasury Services (RBC I&TS).
“As interest rates have been so low in recent years, claims for settlement fails have not been as impactful. CSDR will introduce penalties and mandatory buy-ins, which could increase costs for asset managers,” he added. The Depository Trust & Clearing Corporation (DTCC), for example, has estimated that the penalties for trade fails could eliminate buy-side front office commissions within two days.5
The impact of CSDR on buy-side firms could be significant
A brief SDR reprieve for financial institutions
Although industry bodies have not taken umbrage at imposing cash penalties for failed trades, several groups including the Association for Financial Markets in Europe (AFME), the International Securities Lending Association (ISLA) and the Investment Association (IA) have expressed concern about the risks posed by mandatory buy-ins.
In a letter signed by 14 interest groups, the European Securities and Markets Authority (ESMA) was advised that the rules risked creating additional barriers and costs for market participants trading European securities. The letter also cautioned that CSDR could potentially conflict with some of the objectives laid out in the Capital Markets Union (CMU).6
Shortly after the publication of the letter, ESMA announced that the SDR would be delayed from September 2020 until February 1, 2021. The regulator said the deferral would allow market users to implement technology changes and update relevant ISO messages.7
The recent market volatility triggered by the COVID-19 pandemic, which has, in turn, increased transaction volumes, may provide a window into processes and operational practices that could be improved in advance of the settlement discipline regime
Asset managers may want to use this time to review their transaction flows and take steps towards improving settlement efficiencies. Pumfrett suggests that asset managers consider implementing best practices and ensuring they have better pre-matching of trades, and enrichment of standard settlement instructions to help reduce potential settlement fails.
“The recent market volatility triggered by the COVID-19 pandemic, which has, in turn, increased transaction volumes, may provide a window into processes and operational practices that could be improved in advance of the settlement discipline regime.” Pumfrett further notes that, “When it’s appropriate, asset managers should consider reviewing and refining their trade workflows to help minimize the impact of the regulation.” This may include using outsourcing providers who have technology solutions, scale, and best practices to support asset managers.
The impact of SDR on securities lending
While buy-ins may create challenges from a market liquidity perspective across many asset classes8, there is also an impact on securities financing transactions such as securities lending and repos.
As securities lending is largely an OTC activity, settlement fail rates tend to be higher than in cash markets.9 That means the sector could be vulnerable to CSDR fines.
“At present, buy-ins do not apply to securities lending, securities borrowing or repos so CSDR may be problematic for the industry. It could also lead to cascading buy-in regimes as securities lending is not a one-stage event,” explained Donato D’Eramo, Head of Securities Lending at RBC I&TS.
Several unanswered questions remain about the SDR’s impact on securities lending and the nature of the transactions which are likely to fall in scope. Greater clarity from regulators would help to further advance preparations, although the recent delay has mostly been welcomed.
The market is likely to become much more efficient from a settlement perspective with the adoption of enhanced processes/technology to manage the transaction lifecycle and business best practices
“The industry has been working on compliance with the reporting requirements under the Securities Financing Transaction Regulation (SFTR) concurrently with CSDR, so the delays to both provide some relief. However, CSDR could be quite beneficial for the securities lending industry in the long-term. First, the market is likely to become much more efficient from a settlement perspective with the adoption of enhanced processes/technology to manage the transaction lifecycle and business best practices. Moreover, we could also see an uptick in demand as increasing numbers of financial institutions borrow more securities to avoid penalties,” said Kyle Kolasingh, Associate Director, Securities Lending at RBC I&TS.
While the industry has been generally supportive of CSDR’s introduction of cash penalties for settlement fails, there is some reticence about the impact of mandatory buy-ins. Although market participants are concerned about the potential for buy-ins to drive up costs and reduce liquidity in securities lending markets, it could also yield some positives including greater settlement efficiencies and increased borrower demand.
* A participant is considered to be consistently and systematically failing to deliver securities if it has a settlement efficiency at least 15% lower than the general efficiency rate in the securities settlement system (SSS) during at least 10% of the number of days of that participant’s activity in the SSS over the 12 previous months.