By Kerril Burke, CEO of Meritsoft (a Cognizant company)

St George and Shakespeare were born on the same day – who would have thought. Wading through pages of complex text while trying to overcome seemingly insurmountable obstacles, there is more than a hint of poetic irony to this shared Birthday for banks currently grappling with the Central Securities Depository Regulation.

More commonly known as CSDR, this most convoluted of regulations coming into force next year will require European security depositories to impose financial fines on institutions failing to complete transactions on the Contractual Settlement Date. And here’s the catch, these penalties will be awarded to the other side of the transaction. So instead of having a formal agreement between the buyer and seller, there will now be a legal obligation for one side to pay a penalty fee, while the other side receives cash if the trade fail to settle on time.

The trouble is that penalties is just one chapter of this puzzling story. The real sting in the tail for those involved comes in the form of mandatory Buy-ins. This is where the buyer of securities will be obliged to Buy-in their counterpart according to the rules. Crucially, these will not go through security depositories, but instead be direct obligations between the trading counterparts. Therefore, any situation where a counterparty can’t deliver on the trade it has promised starts to unravel the inherent challenges of CSDR.

For example, it is not uncommon for say a hedge fund to sell a security in the hope that the price would fall in order to make profit. But what happens if the price moves in the other direction, and the fund gets caught on the wrong side of the trade? If the price starts to move sharply, say 15% to 20% in the other direction, the firm may get caught in something called a short squeeze under the CSDR mandatory Buy-ins. This is a process where shares are forced to be repurchased if the seller does not deliver the securities in a timely manner.

The problem is that under CSDR buy-ins, what is deemed a liquid security is due to be settled after four days, while an illiquid asset needs to be settled after seven. But how does a firm determine what’s liquid and illiquid? In OTC markets, there is likely to be a wide rage of different judgements based on market consensus.

Instead of the trade being valued at the price on which the deal was struck, firms have to revalue the security everyday that the price falls. This highlights the heightened importance of counterparties doing one calculation based on a joint market view. There is just one issue, there are a more than just a few participants playing their part in CSDR. From fund managers looking for profitability and prime brokers making stock-borrowing changes, to middle office bank client interactions, there are so many different firms involved in the settlement process. And this is where problems will start to occur. After all, one firm’s penalty may be different to another firm’s credit, and perhaps even client money.

Currently, with no standard market infrastructure for dealing with this issue, all participants need to try and figure out a way to share information around buy-ins sooner rather than later. Until a solution is found that generates potential buy-in notifications and validations, European market participants may struggle to manage this regulatory dragon.