CSD’s are financial institutions of systemic importance for financial markets and play a crucial role in the primary market, by centralising the initial recording of newly issued securities (‘notary service’). They operate the infrastructure (‘securities settlement systems’) that enables the completion of a securities transaction (‘settlement’). Furthermore, they maintain securities accounts that record how many securities have been issued by whom and each change in the holding of those securities (‘central maintenance service’). CSDs are essential for the financing of the economy. Apart from their role in the issuance process, securities collateral posted by companies, banks and other institutions to raise funds flows through securities settlement systems operated by CSDs. They are also integral for the implementation of monetary policy as they settle securities in central bank monetary policy operations.
Central Securities Depositories Regulation (CSDR) played a pivotal role in the post-trade harmonisation efforts in the EU by introducing:
- shorter settlement periods; (since 2015 it is a T+2 environment in Europe);
- settlement discipline measures (mandatory cash penalties and ‘buy-ins’ for settlement fails, settlement fails reporting) scheduled for 1st of February, 2022;
- strict organisational, conduct of business and prudential requirements for CSDs;
- increased prudential and supervisory requirements for CSDs and other institutions providing banking services that support securities settlement;
- a passport system allowing authorised CSDs to provide their services across the EU under a specific procedure.
Especially the settlement discipline measures, so the cash penalties and the buy ins, are at the focus of attention of many market associations. Since this part of CSDR has a planned implementation date of 1st of February, 2022, time is quickly running out.
The common interest of all is clear, an efficient and stable European capital markets which attracts investors and promotes economic progress. Whether the CSDR settlement discipline regime, with no changes to its current design, will achieve this considering the concerns around costs for investors, market liquidity, pricing and legal drafting deficiencies, remains to be seen.
The CSDR settlement discipline regime, sets out several requirements that are likely to have a substantial impact in post-trade situations. In a nutshell, CSDR settlement discipline regime contains rules that both aim to prevent settlement fails (those differing at trading venue level, CSD level and investment firm-level) and to address settlement fails. The biggest concern in the market is the measures to address settlement fails, more precisely whether such measures will indeed address the fails or whether the regulation, as it stands, creates more problems than solutions.
Of all the measures to deal with settlement fails, one particular measure has attracted the greatest attention and looks like it will retain such position for months to come: ‘the mandatory buy-in mechanism’. Unlike the established market practice, the CSDR settlement discipline sets out a buy-in process which has to be applied once the conditions are met, i.e. a settlement fail has occurred at an EEA CSD and the subject financial instruments are not delivered at the end of the extension period.
If a buy-in is unsuccessful or impossible, it may either be deferred, or a cash compensation paid by the failing party. It is worth adding that cash penalties accrue during this entire flow between intended settlement the actual settlement date, functioning as a deterrent for failing parties.
Whilst the objective of the mandatory buy-in is to ensure that a recipient of an in-scope financial instrument receives the instrument it has contracted to receive under an original agreement for a trade, lots of questions have arisen as to whether the regulation will yield such outcome with little or no damage to the markets.
No lack of challenges
An impact study conducted by ICMA in 2019 shows that the settlement discipline regime will have significant negative impacts on pricing and liquidity. While these detrimental impacts will affect all classes of bonds, they will be more significant with respect to less actively traded corporate and sovereign bonds, high yield, and emerging markets. Furthermore, the regime will indirectly deter lending of securities, again with the least liquid bond classes being most significantly impacted.
Besides an adverse impact anticipated on pricing and liquidity, the mandatory buy-in mechanism is also likely to expose market participants to challenges for engaging a buy-in agent particularly in the case of failing transactions non-cleared by a CCP where a buy-in is required (and possibly) a buy-in agent appointed by the initiating party. However, until now, only one firm has put itself forward to act as a buy-in agent under the CSDR framework. Looking back on the market practice, there were grounds for the firms to refrain from providing buy-in agent services, such as time/gain ratio being outbalanced and reputational risk attached to such role. It is clear however, that a healthy range of buy-in agents needs to exist for the proper fulfilment of this regulatory requirement and it raises concerns as to whether such requirement can in fact be implemented otherwise. In conclusion, the result may be that many buy-ins in illiquid securities will be unsuccessful, resulting in mandatory cash compensation.
This year, on the 1st of July the European Commission published its long-awaited report to Parliament and Council on the CSDR Review.
The report is relatively high-level with respect to Penalties and Buy-in, but it does state that it is appropriate to consider proposing certain amendments, subject to an impact assessment, to avoid potential undesired consequences. There is no direct indication of what these amendments could be. It is also not clear whether the conclusions of the report form a strong enough legal basis for ESMA to propose a delay to the existing implementation schedule. This may require concrete legislative proposals from the Commission, following the cited impact assessment, and cannot be expected before late 2021.
It is unfortunate that looking at the planned implementation date of 1st of February, 2022, we still have no clarity on certain amendments. Obviously CACEIS is continuing its preparations on the underlying platforms. We will keep you posted on further developments.
Please note that we have used the appropriate channels i.e liasing with several associations since the imminent clash in timing creates major legal and operational uncertainties for industry participants, specifically on the implementation of mandatory buy-ins.
