This article is the sixth 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.

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

CSDR: The Road to Readiness 

Since it was first introduced, the Central Securities Depositories Regulation (CSDR) has compressed settlement cycles across the EU to T+2 and imposed a common regulatory framework for central securities depositories (CSDs). However, challenges continue to persist. Most notably, the latest phase of CSDR – the imposition of the Settlement Discipline Regime (SDR) - is proving to be the most contentious aspect of the regulation to date.  Industry experts at Citi’s EMEA Securities Leadership Forum (ESLF) shared their insights into some of the outstanding issues now facing CSDR.

Progress to date

A “Report on the Settlement and Central Securities Depositories Regulation” recently produced by the European Commission (EC) concluded that CSDR continues to achieve its original objectives by enhancing EU-wide settlement efficiencies and improving the overall soundness of CSDs.  “This will be vital towards facilitating seamless cross-border investment across the EU – a critical tenet of the Capital Markets Union (CMU) project,” said Stella Kaltsouni, Policy Officer, Financial Markets Infrastructure Unit at the EC. However, despite CSDR having achieved a lot since it was first introduced, others note that further work is still required.

Anna Kulik, Secretary General of the European Central Securities Depositories Association, highlighted that, although CSDR brought significant benefits, the regulation had in fact saddled CSDs with additional compliance costs. “One of the biggest challenges – and despite all efforts – is that we are functioning in an environment where corporate and securities laws at a local member state level continue to be divergent. This does not help in terms of facilitating standardisation under CSDR,” she continued. Perhaps ironically, some of CSDR’s complexities have opened up opportunities for CSDs as well. Kulik added a lot of the data which some CSDs are collecting internally for regulatory purposes is now being shared with CSD participants. “Clients appreciate this as the data does provide a value add, namely in terms of insights on settlement efficiency and liquidity,” noted Kulik.

Buy-ins: A recurrent headache

CSDR’s SDR – as the name suggests – is designed to strengthen settlement discipline by imposing cash penalties and mandatory buy-ins on market participants responsible for trade settlement fails. While few in the industry oppose the idea of levying cash penalties for settlement fails, there are concerns about the implications of mandatory buy-ins - with some warning it could exacerbate volatility and undermine liquidity, especially for non-centrally cleared transactions. A handful of industry associations have also said buy-ins could worsen systemic risk – especially during volatile periods such as in March 2020 – when settlement fails reached extraordinary highs. 

Accordingly, many industry bodies have urged the EC, ESMA and other EU legislators to reconsider mandatory buy-ins in favour of a voluntary buy-in arrangement. After the European Securities and Markets Authority (ESMA) issued a letter in September 2021 with a recommendation for a delay to the imposition of mandatory buy-ins, the European Parliament and EU Council have finally acquiesced to a postponement. Some have speculated that buy-ins could now be delayed by anywhere of up to two to three years, which would allow sufficient time to define and approve a revised and more effective buy-in framework.

Marcello Topa, Director, Market Policy and Strategy at Citi, welcomed the delay although he acknowledged the cash penalty rules should be introduced on time as planned. This would allow EU legislators and market participants both to evaluate the effects of the fail penalties on the overall settlement efficiency, and to have more time to devise an appropriate recalibration of the buy-in rules against the market efficiency needs.

Navigating the dry-runs: Preparing for the next stages of CSDR

A number of market participants – including CSDs – are already conducting dry runs of the cash penalty regime ahead of its implementation early next year. “The dry runs are proving critical ahead of the cash penalty implementation date. Since the initiation of the cash penalty dry runs, the complexity of the sources from which the market reference data is derived from is leading to delays in the calculation and reporting of penalties at a CSD-level,” said Alexia Kazakou, Director, Custody Product Development, Securities Services at Citi. In some cases, the use of erroneous reference data is resulting in penalties not being reported on time.   However, Kazakou noted that identifying such flaws and learning from mistakes ahead of future rule-changes such as SDR are exactly why dry-runs are undertaken in the first place. According to Kulik, the CSD industry has been engaging with ESMA on the pressing issue of data.    

There are also mounting concerns about the state of readiness of CSDs in some of the non-TARGET2 Securities (T2S) markets. “Certain non-T2S CSDs have yet to communicate their testing plans and intention to support dry-runs. This is an issue of concern,” cautioned Kazakou. While Kulik conceded that some non-T2S CSDs had yet to conduct any testing or dry-runs ahead of the imposition of the penalty regime, she stressed that most CSDs are planning to do so either imminently - or within the next few weeks.

Other risks are also being flagged ahead of SDR’s go live date. “The launch of SDR in February 2021 without the mandatory buy-ins in practice means that clients will be inundated with fails as the penalties will apply for a longer period. It is vital that clients manage their trade instructions so that they do not become liable for penalties,” said Kazakou. As a result, legacy trades in the system will need cancelling if penalties are to be avoided. Service providers are conscious of the risks clients are facing, which is why some – including Citi – are launching settlement KPI dashboards in what will enable users to review their settlement rates along with the reasons for failures. Similarly, the bank is also developing estimated penalties dashboards to help clients prioritise their actions based on the projected financial impact of the penalties. Such services will be crucial in protecting clients when the rules take effect from next year.

SDR is on the horizon, yet lingering uncertainties persist. It is vital market participants engage with regulators on some of the data pain-points, and that CSDs – including those in non-T2S markets - continue to conduct dry runs if implementation of SDR is to be done seamlessly. “More work is needed to adapt and integrate existing processes to the new reality of the post-trade industry, with enhanced collaboration amongst all stakeholders. This is the greatest lesson learned and the most beneficial effect of the work on CSDR implementation. Coordinated market advocacy is a critical element to achieve a proportionate and pragmatic approach towards CSDR’s settlement efficiency goals.” concludes Topa.

This is the sixth 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 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.