This article is the second in the series What’s Next in Post-trade Regulation?, a guest column from Citi which will take a look at some of the major regulatory transformations currently underway in Europe’s capital markets. All articles in the series can be found here.

CSDR: The saga continues 

By Marcello Topa, Director, Market Policy and Strategy within Citi’s EMEA Securities Services team 

First introduced in 2014, CSDR (Central Securities Depositories Regulation) has played an integral role in facilitating deeper harmonisation across the EU’s post-trade ecosystem. In addition to creating a common regulatory framework for the oversight of CSDs (central securities depositories), CSDR also implemented an EU-wide T+2 settlement cycle roll-out for equity and fixed income trades prior to adopting Target2Securities, the European Central Bank’s (ECB) pan-EU settlement platform. Despite CSDR’s previous achievements, the regulation is still, however, a work in progress, with many experts warning that some of its incoming requirements could create serious challenges for securities markets.  

Settlement Discipline Regime (SDR): A recurrent challenge

CSDR’s main objective is to drive efficiencies in the EU’s trade settlement processes. As part of this, the CSDR’s Settlement Discipline Regime (SDR) will impose cash penalties – to be calculated by the CSD – on trading counterparties for failed trades. The penalty amounts will range from 0.1 basis points (bps) for sovereign, supranational and agency (SSA) bonds to 1bps for liquid shares. While most intermediaries are generally supportive of SDR’s cash penalties (albeit with various clarifications still missing from ESMA (European Securities and Markets Authority) and the European Commission), they are firmly opposed to mandatory buy-ins for settlement fails. In the case of a failed trade, a mandatory buy-in gives the counterparty purchasing the securities the legal right to enforce delivery by instructing a third party to source the securities from elsewhere for them. Any price differences between the buy-in and the original failed transaction must be paid for by the non-delivering counterparty.

Mandatory buy-ins have alarmed the industry for several reasons. During the COVID-19 volatility in March 2020, settlement fail rates for equities reached 12% while it topped 6% for government bonds, a significant increase in absolute terms. <1>The International Capital Markets Association (ICMA) said that, had the SDR’s mandatory buy-in regime been in place during this period, it would have generated further instability and heightened systemic risk. Although settlement fail rates are now at normal levels, ESMA has agreed to delay the SDR’s go live date for a second time until February 2022, having accepted that infrastructures would not be ready from a compliance stand-point by next year. The market dislocation that would have been caused had mandatory buy-ins been rigorously enforced in March, has prompted industry experts to advocate that they should be made a voluntary practice (or at a minimum, a legal right of the buyer) as part of the EC’s ongoing CSDR review.

Scope of application: CSDR goes beyond Europe

While CSDR is a piece of EU regulation, its impact will be felt well beyond Europe’s borders. SDR, for example, is highly extraterritorial in nature and will be applied to any securities settlement that is processed through an EU-domiciled CSD, including international CSD (ICSD). This would include any third party entity which is trading in EU securities and settling those same securities at an EU CSD or ICSD, either directly or indirectly through an intermediary. In other words, a New York-based fund manager with an EU-domiciled custodian or sub-custodian would be caught out by SDR. The same is true for any non-EU firms transacting in securities issued in third countries but which are traded on EU stock exchanges and settled through an EU (I)CSD. The reality is that only a small number of non-EU financial institutions are actually aware of the impact which SDR will have on their trading operations and middle and back office processes.

Internalised settlement reporting: next steps

CSDR (Article 9) imposes quarterly internalised settlement reporting obligations on intermediaries which facilitate settlement outside of the SSS (securities settlement system). Under the provisions, entities like global custodians and sub-custodians which settle trades on their own books rather than at a CSD must report to the local authorities information related to the value and volume of the securities they have settled. Internalised settlement occurs when two firms settle their trades using accounts at the same custody provider so that there is no change in the total quantity of securities held by that custodian at the CSD level. The first reports were submitted back in July 2019.  Nonetheless, there are concerns among industry practitioners that additional disclosure requirements or even restrictions could be imposed on settlement internalisers once all the reported data is collated by EU regulators.

Should further reporting rules be imposed on settlement internalisers, this could prove onerous and generate yet more complexity and costs for the industry at a time when organisations are desperately trying to obtain efficiencies as revenues are under serious pressure. It would also risk creating an unlevel playing field between the CSDs – who are not subjected to these reporting rules - and settlement internalisers.  Any added regulatory constraints would make it much harder for settlement internalisers to continue providing this service for clients.

What should firms be thinking about?

Although the introduction of the SDR has been delayed until February 2022, the rules are extensive and will be felt across financial market infrastructures, custodians and asset managers globally. A number of industry bodies are, however, hoping that EU regulators think twice about implementing mandatory buy-ins and pursue a policy that is more voluntary in nature, especially following the spike in settlement fails during COVID-19. In addition, it is also crucial that EU regulators take a proportionate approach towards settlement internalisers as any further restrictions will simply add to industry costs and undermine competition.

Other revisions to CSDR could also be adopted as part of the EU’s ongoing Capital Markets Union (CMU) programme. The High Level Forum on CMU, a group entrusted with developing policy recommendations on CMU, recently highlighted there were divergences in CSD licensing rules across member states, and suggested that the EU’s CSD passport be strengthened accordingly. As a result, the next few months could see some significant structural changes being made to CSDR. The CSDR Review, launched by the EC in Q4 2020, is considered by many as an excellent opportunity to broadly enhance the legislation with pragmatic solutions and clarifications around some of the outstanding issues, not least the settlement discipline measures.

<1> Global Custodian (May 29 2020)

This is the second article from the series and here you can find the rest of the published ones, starting from the most recent one:

• The fifth article Moving with the times: Updating the SFD discusses how the Settlement Finality Directive (SFD) has been instrumental in strengthening capital markets and mitigating systemic risk by harmonising - across member states - the legal protections for market infrastructures and their participants. By Marcello Topa.
• The fourth article SRD II – Ironing out the creases discusses the Shareholder Rights Directive II (SRD II) legislation aimed at enhancing shareholder rights. By Marcello Topa.
• The third article Enabling Digitalisation in Europe discusses the major digitalisation process and adopting new innovative technologies, as it looks to improve client experiences and support emerging asset classes. By Marcello Topa and Ryan Marsh.
• The series began with Post-trade in Europe – a 20 year harmonization journey, by Marcello Topa.