This article is the fifth 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.

 Marcello Topa, Director, Market Policy and Strategy, Direct Custody and Clearing, Citi

Moving with the times: Updating the SFD 

Introduced in 1998, the EU’s 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 as they relate to cash payments and securities settlements. In short, SFD provides extensive protection for financial institutions by stipulating that settlements which are processed through “designated” systems (i.e. infrastructures that respect certain SFD requirements) benefit from settlement finality – meaning they cannot be unwound during insolvency proceedings. By providing legal certainty and mitigating systemic risks, SFD allows market participants to better manage their risk exposures; reduce the size of the credit facilities granted to clients for settlement and payment services, and to contain the overall costs paid for by the end users.

However, the SFD was first transposed into national law almost a quarter of a century ago – a full decade before the advent of the financial crisis and the market reforms which subsequently followed. To a growing number of industry participants – including the European Commission (EC) – the SFD’s provisions are in need of an urgent updating.

Facilitating greater harmonisation 

Firstly, the SFD is a Directive and not a Regulation, meaning member states have a certain degree of autonomy in terms of how they implement the rules within their domestic legislative frameworks. This has led to different EU markets adopting their own unique interpretations of the SFD’s provisions, which is especially problematic for cross-border transactions. In some instances, markets have different definitions of “participants”, different rules on “irrevocability” and different protections in case of interoperable third-country systems. This uncertainty creates all sorts of problems, not least because it means that an insolvent financial institution and their settlement counterparties risk being subject to an eclectic mix of insolvency laws across the EU jurisdictions in which they operate, the outcome of which could potentially be quite unpredictable and unfair in some cases. In addition to providing more clarity to financial institutions, the harmonisation of pan-EU settlement finality measures and the related insolvency practices will be critical to the success of the Capital Markets Union (CMU).

Shortcomings on insolvency protection need ironing out 

Owing to this lack of standardisation, the SFD regime has some glaring gaps in its protections, which need remedying, otherwise there could be scope for serious systemic risk and legal uncertainty. SFD’s insolvency safeguards only apply to transfer orders undertaken between two central securities depository (CSD) participants which meet the SFD’s definition of ‘participant.’ Unfortunately, this definition is quite narrow, meaning that some holders of securities and cash accounts at CSDs may be inadvertently excluded. Similarly, the absence of EU-wide harmonisation also means that SFD’s finality protections are not necessarily guaranteed for indirect participants either (i.e. the clients of direct CSD participants). Put simply, any revisions to the SFD need to ensure that settlement finality protections apply to all transfer orders settling at SFD-designated CSDs. A failure to do so not only exposes CSD members to greater risks, but also the CSDs themselves. There is still an element of uncertainty as to how settlement finality applies during the intervening two-day period between trade date and settlement date. Given how volatile markets have been and the suddenness at which institutions can find themselves in serious trouble, this lack of clarity and harmonisation is creating added systemic risk and higher costs. An urgent resolution of this issue would minimise risks for the intermediaries that facilitate access to the SFD-designated market infrastructures and would promote the development of a single capital market in the EU.

Other SFD protections – including the enforceability of collateral security during settlements at CSDs – also need amending. Right now, the rules give protection to collateral takers, namely the CSDs and their direct participants. It is true that SFD permits, albeit under quite restrictive circumstances, for indirect participants (principally clients of CSD participants) to benefit from these collateral security protections. However, the provisions have not been applied consistently by EU members. As a result, the collateral security protections are fairly uneven across the EU, meaning lower level intermediaries are often disadvantaged. The rules are discriminatory in other areas as well. For instance, an intermediary may hold securities on behalf of a client in a single securities account in what would make it a direct CSD participant, enabling it to benefit from SFD protections. However, that exact same intermediary might also use a sub-custodian to look after other securities in other markets, in which case it would not be directly covered by the SFD’s protections. Again, these shortcomings require fixing.

Move with the times 

SFD was a product of its time 25 years ago and it needs to be updated to properly reflect today’s market structure. Back then, central counterparty clearing houses (CCPs) were far less critical to market stability, but this has since changed, especially following the introduction of the European Market Infrastructure Regulation (EMIR). It is crucial that SFD’s settlement finality rules correctly capture the specificities of CCPs’ clearing activities, which are different from payments and settlements. Similarly, SFD needs to take into account other major changes, such as the introduction of Target2-Securities.

Harmonisation of the enforceability rules for collateral should aim to achieve the highest possible degree of protections. For example, the Italian SFD transposition law gives settlement agents an immediate right of sale over the securities that it has settled on behalf of a client, if that client becomes insolvent while a securities transfer order is pending. This right of sale can be exercised without the need to wait for authorisation for such a disposal of collateral by the insolvency liquidator. This provision greatly reduces the exposures that are faced by intermediaries between the time of irrevocable commitment for a settlement and the actual settlement being concluded.

SFD revisions will also need to factor in the impact which technological innovation will have on market practices. Previously, SFD was designed to be technologically neutral, but industry figures say this is potentially no longer the case in light of the growing adoption of innovative technologies, such as distributed ledgers, smart contracts or asset tokenisation. It is vital – given some of the innovations taking place in post-trade – that the EC ensures that the SFD is future-proofed.

Taking stock 

In 1998, SFD laid the foundations for settlement finality putting checks in place to mitigate systemic risk. Since then, circumstances have changed dramatically. Post-crisis structural reforms– including the ascendency of CCPs, together with the growing importance of new technologies – means that the SFD needs amending. Equally, the different interpretations of the rules by EU member states have created all sorts of uncertainties and risks, which could hamper the success of CMU. Citi is working closely with various industry associations including the Association for Financial Markets in Europe (AFME), the European Banking Federation (EBF) and the International Capital Markets Association (ICMA) by engaging with the EC on the future direction of the SFD. Through this regular industry engagement, it is hoped that any material changes to the SFD will help enshrine market best practices and ensure that systemic risks around settlement finality are largely mitigated.

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

• The fourth article in the series 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 second article in the series is CSDR: The saga continues, by Marcello Topa.
• The series began with Post-trade in Europe – a 20 year harmonization journey, by Marcello Topa.