Central Securities Depositors Regulation (CSDR) settlement discipline regime which was officially scheduled to come into effect on September 13, 2020, is further postponed for six more months and will now come into effect on Feb 1, 2021. This is welcome news for market participants and buy-side industry as it will give more time to prepare for new regulation. Extension of six more months will help market participants in making IT changes, develop, and amend swift messages and prepare for eligible legal agreements. Before CSDR Is completely functional, European Central Banks needs to make sure respective settlement systems are modified and tested as per CSDR norms. European Central Banks have TARGET2-securities (T2s) settlement system.
The primary objective of CSDR regulation include reducing number of failed securities transactions on actual settlement date and mitigate settlement risks through stringent regulatory monitoring. CSDR regulation will impose financial penalties on failed settlements from failing counterparty via relevant CSD. However the regulatory body will give some more time to failing participants to make settlement. In case the failing participant fails to settle even after allotted extension period, then mandatory buy-in process is initiated by receiving party.
Settlement efficiency needs to be improved through market participants making constant effort to improve matching of settlements and avoid mandatory penalties and buy-ins from CSDR regulations.CSD might take strict decision by suspending the participant for huge number of settlement failures and will report to the regulators on the settlement performance of the participants.
ROLE OF CENTRAL SECURITIES DEPOSITORIES (CSDs)
CSD’s are currently involved in developing solid frameworks for financial penalties regime, establishing systems and processes to adhere to ECSDA CSDR penalties framework, and while CSD’s continue monitoring settlement graph of participants, there is the bigger challenge in setting up models as per new CSDR rules. CSD’s will maintain complete track of collection, payments, and report financial penalties at regular intervals. Firms will largely invest in AI automation and machine learning technologies to make their operational process strong and parallelly educate different departments within the op’s team. Having strong process and workflow will ensure reduction in volume of settlement failures and indeed firms will end up paying fewer financial penalties.
Settlement discipline regime will impose daily financial penalties on participants that fails to settle transaction. Failed counterparty will continue getting penalties till mandatory buy-in process is completed. Due to some reason if securities are unavailable, then cash compensation is paid to receiving party. Participants failing to deliver cash will pay rate of interest on undelivered cash. SWIFT will play important role here for developing standard message types which suits financial penalties regime
ROLE OF GLOBAL CUSTODIAN BANKS
- Analyzing settlement risks of brokers and asset managers
- Implement regulatory reporting required under CSDR and investing in people and systems to anticipate failure early and improve matching of settlements and better inventory management
- Communicating with sub-custodians and deciding on reconciling financial penalties with own accounts
MANDATORY BUY-IN REGIME (Article 7)
Buy-in agents will play crucial role during execution of buy-in process. Receiving party will appoint these agents. Main responsibility of the buy-in agent is to make sure the failing party receives best securities possible against undelivered securities
- Buy-in agent will have 4-7 business days to complete the buy-in transaction and deliver the securities to the receiving party. However the deadline may vary depending on type and liquidity of security.
- In situation where the buy-in agent fails to buy securities within regulatory deadlines, failing party will pay cash compensation based on market value to receiving party
- Failing parties are not entitled to receive the benefit from difference of price (original transaction and through buying agent)
Buy-in process will be initiated on the business day following a defined extension period of a fail. The extension period is four business days for liquid shares, 15 days for securities trading SME growth markets (during MIFID II SME growth market was introduced. Under these multilateral trading facilities (MTF) will be registered as an SME growth market as per Article 33), and seven business days in case of all other securities. Analysis by ECSDA data from 11 European CSDs estimated 1.8 million buy-ins a year, was worth more than €2.5 trillion. Certainly, we might experience growth in buy-ins post CSDR regulation. However, short-dated securities with lifecycle less than 30 days are excluded from buy-ins, e.g. Repo’s.
SELL SIDE IMPACT
Trading desks: In order to accurately price the risk of failure, inventory price sourcing will be dynamically integrated during pre-trade (price formation process) instead of inventory sourcing happening post-trade
Algorithmic pricing engines: New tools will be required to adjust bid/offer spreads to incorporate CSDR risk. Without new tools, automated pricing models could lead to higher failure rates and asymmetric settlement breaks that investment bank management and risk departments will be keen to avoid
Buyside impacts from CSDR perspective are likely in liquidity screening, analysis and investment process including trading. Those areas will need enhanced tools to assess the scale of liquidity impact on fund strategies in light of CSDR on an on-going basis
Fund Managers and Analysts will need to re-assess their investment universe before investing significant time in researching securities for investment into existing strategies
Research indicates, European market participants are better prepared than North American participants, which are in turn better prepared than Asian market participants and buy-side is less prepared for the settlement discipline regime than the sell-side.
The stakeholders (brokers and market makers) need to understand the impact of the settlement discipline regime on their existing business. Investment in systems and related stakeholders will help achieving operational processes which will generate revenues and minimize costs.
Firms need to collaborate with counterparts, CCPs, and CSDs and understand how the financial penalties and buy-ins will work in settlement discipline regime. Early understanding of the regulations will help firms avoid regulatory penalties and future costs.