CSDR: The future settlement discipline regime
Further confirmation that the road to hell is paved with good intentions! 14 professional associations sound the alarm about the future settlement discipline regime
In the summer of 2014, the regulation on CSDs (CSDR) instituted the principle of a settlement discipline regime including the application of penalties, and above all "mandatory buy-in for all". The objective was clear: to encourage compliance with the settlement date agreed between the parties at the time the transaction was concluded by any means possible and thus significantly increase the rate of transactions that were actually settled on time1.
Six years later and just a few months before the new regime comes into force – set, for the moment, for 14 September 2020 – what is the state of play?
Despite a dedicated delegated regulation2 and the start of Qs&As3, many questions, including some fundamental ones, remain unanswered. This state of affairs led 14 professional associations to send a letter to the European Commission and ESMA at the end of January 2020 in order to alert them to the potential consequences of the regime as envisaged by the legislation and to propose ways to improve it4.
While the letter focuses on the readiness of the industry as a whole (from the CSD to the end customer) for the penalty component, and above all asks for sufficient time to carry out end-to-end testing, the same cannot be said for the mandatory buy-in part of the legislation. Given the potential highly negative impacts of this new requirement on certain markets/activities, and the extreme complexity of its implementation, the associations advocate postponing it indefinitely to allow time to observe the effects of the new penalties on the settlement rate beforehand, and also to conduct a more in-depth assessment of the potential impacts of a mandatory buy-in. In any event, they are arguing for the adoption of at least a model in which the buyer would have the choice of triggering the buy-in and the seller the obligation to comply with it.
What is a mandatory buy-in?
The mandatory buy-in is now mainly applied by CCPs56. It consists of closing a settlement fail that continues by buying the undelivered securities, with the costs incurred being borne by the defaulter. To do this, the CCP either has its own auction market or mandates a third party (buy-in agent) to find the missing securities.
Extension of the principle ... is a good idea only at first sight
Since the principle of a mandatory buy-in for CCPs has proven its worth, it might be tempting to extend it to any failed delivery. This would be to forget its four main characteristics:
- The CCP is a party to the transaction
- The buy-in affects only one fail - the delivery of the securities by the CCP clearing member; any other fails, whether initial or subsequent, will be closed by simple propagation of the result of the buy-in triggered by the CCP.
- Only the CCP is subject to the obligation to close a fail with a buy-in.
- The CCP is of systemic importance and therefore cannot allow settlement fails to persist.
Of course, the mandatory buy-in will ultimately rest with the parties to the transaction (in this case the "buyer") instead of being imposed as initially planned on the CSD participants and the stakeholders of the single settlement. Nevertheless, its starting point remains a settlement fail, taken singly. It is clear, however, that the settlements are interconnected. They may be the expression, at the level of the CSD, of a chain of transactions concluded between buyers and sellers or, for example, they may be linked to a simple intermediated transaction executed on a market. In other words, a simple lack of securities will lead to numerous fails, and thus to mandatory buy-ins impacting all the buyers in a chain (potentially including one or more CCPs).
Consequently, it will be less a question of a buyer knowing how to trigger a buy-in, than of avoiding triggering one or more unnecessary buy-ins, while complying with CSDR requirements.
While the work carried out by ICMA78 (for uncleared transactions) and AFME9 (for those involving a CCP) has been presented to ESMA, which has been receptive, discussions are only just beginning. Whether ESMA's response will be in the form of a Q&A document or guidelines, it will, in any event, be essential that it acts in such a way as to ensure that the buyer is not in breach of the regulation.
Extending the mandatory buy-in to any fail may also lead to grotesque situations. Take, for example, the transfer of a portfolio between two custodians. By applying CSDR, the "buyer" should trigger a buy-in procedure against the "seller", in other words against the customer himself! More generally, a number of transactions in the scope today do not correspond to a real transaction between a buyer and a seller and therefore should not be likely to trigger a buy-in.
Finally, requiring a buyer to mandate a third party to buy-in undelivered securities presupposes the existence of third parties ready to assume this role. But what do we know today about the rights and obligations applying to this third party? Compliance with Best Execution within the meaning of MiFID2, a reference to (undefined) conflicts of interest... In other words, little is known. Moreover, few stakeholders are ready for such an offer.
ESMA has just proposed10 to the European Commission to postpone the implementation of the new regime until 1 February 2021. This would be good news for post-trade stakeholders since it would give them a few more months to finalise their preparations for penaltymanagement and refine, as far as possible, the operational framework for buy-in transactions in line with the rules currently defined by CSDR and its implementing texts. It now remains to be hoped that the Commission (by adopting) and then the Parliament and the Council (by not objecting) will rapidly transform this proposal into an official date.
For their part, the "CSDR" groups set up within professional associations are continuing their work on the operational implementation of the settlement discipline regime, trying to find solutions for the many points still open that can be accepted by regulators (scope of transactions, definition of a conflict of interest, transmission of the obligation to trigger a buy-in, harmonisation between CCPs, treatment of a fail on the delivery of securities bought in, associated messaging, case of corporate actions, case of open repos, etc.). The industry is eagerly awaiting these developments.
However, this will in no way solve the problems raised by the subject of the mandatory buy-in.
The mandatory buy-in is the nuclear option. As such, its consequences should not have been underestimated. Unfortunately, and somewhat recklessly, the legislators seem unwilling to take this into account. Although the full "radioactive" fallout from this measure is as yet unclear, we can already mention the effect on liquidity, prices and therefore the cost of a transaction, as well as on the supply from market makers (particularly for illiquid securities) ... Cash settlement will also be a source of difficulties because the final buyer expects securities, not euros. Ultimately, if part of the purchases executed on a market are unnecessary buy-ins, this may distort price-setting.
Without being exhaustive, this first inventory presents some areas of concern associated with the effects of this measure for all stakeholders (including the investor). It is also bitter evidence that no lessons have been learned from the misadventures observed as a result of the abrupt implementation and inadequate impact assessment of previous regulations. Therefore, professional associations are planning to hold further meetings with European bodies in order to pursue their action and obtain serious implementation guarantees from them11.
Nothing has yet been finalised and, to paraphrase the maxim from the Game of Thrones series, “Buy-in is coming!”.
Click here to read more about Settlement disciplines, in our SGSS publication.
CSD: Central Securities Depository (Euroclear France, Clearstream Banking Frankfurt, Monte-Titoli, etc.).
CCP: Central Counterparty Clearing House; the CCP is interposed in a transaction between the buyer and the seller. It becomes the buyer vis-à-vis the seller and the seller vis-à-vis the buyer.
MiFID2: Directive 2014/65/EU of 15 May 2014 on financial instrument markets
ESMA: European Securities and Markets Authority
1Between November 2018 and November 2019, the fail ratio in T2S (unsettled transactions) varied between 5% and 6% in volume and 6% and 7% in amount (source T2S).
2 Official Journal of the European Union, 13/09/2018, https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32018R1229&qid=1581348549172&from=EN
3 European Securities and Markets Authority (ESMA),17/02/2020, https://www.esma.europa.eu/sites/default/files/library/esma70-708036281-2_csdr_qas.pdf
4 Valdis Dombrovskis, An Economy that Works for People Steven Maijoor, ESMA, 22/01/2020, https://www.afme.eu/Portals/0/globalassets/downloads/letters/20200122%20Letter%20re%20CSDR%20Settlement%20Discipline%20(redacted).pdf?ver=2020-01-24-091342-630
5 The regulation on short sales (2012) required CCPs to set up this mechanism; the obligation has since been transferred into CSDR.
6 For transactions that do not pass through a CCP, it is possible to voluntarily trigger a buy-in (ICMA rules).
7 ICMA: International Capital Market Association
8 Known as a "pass-on mechanism"
9 AFME : Association for Financial Markets in Europe
10 ESMA, CSDR RTS on Settlement Discipline – postponed entry into force, 04/02/2020, https://www.esma.europa.eu/sites/default/files/library/esma70-151-2895_final_report_-rts_settlement_discipline_postponement.pdf
11 The letters written by the associations were received by ESMA when the proposed new date had already been approved by its internal governance bodies.