CSDR: When trading meets post-trade
The arrival of the Central Securities Depositary Regulation, which is likely to come into effect in November 2020, heralds a potential headache for brokers, stemming from regulation’s mandatory buy-in rules, which are designed to reduce settlement failure, but do so in a punitive fashion.
Failed trades are a headache for all parties, and so the rules under the new reform are designed to incentivise the right kind of behaviour by putting mandatory performance parameters around the settlement of different types of instruments, starting with fines for late delivery and culminating in a mandatory buy-in process to close out the trade.
This all sounds very logical and sensible, in theory; pay what you owe and deliver what is due on the intended settlement date. However, reality, as is often the case, is less black and white, and more shades of grey. While buy-ins exist today, for example, under ICMA rules, the mandatory buy-in under CSDR creates a straightjacket which some firms are not happy to wear. The argument, as they see it, is that the cost of buy-ins and fines will outweigh the fees that they get for making markets in less liquid securities. Today, brokers provide two-way prices for illiquid securities that they do not have in their inventory, knowing they have some leeway to buy-in or borrow those assets. Under CSDR, they will lose that discretion, and, with already paper-thin margins, the juice, as they say, may not be worth the squeeze.
What the change means
The assessment of liquidity for instruments will be annual, however that ignores the episodic nature of liquidity in many instruments; bonds typically have a liquidity curve that reduces after issuance, only to pick up again during market/credit events and again towards the end of their tenor. Many illiquid equities will respond to quarterly or even annual reports with limited ranges of movement in between, but can also become significantly more or less liquid within a single trading period.
There is some trepidation among brokers around managing the effect of these incoming changes. Bilateral waivers between sell-side firms have been considered, however these are unlikely to be viable where a CSD is involved. Custodian banks will need to ensure they have the right processes and systems in place to manage any buy-ins and fines, along with reconciliations. Traders may see orders cancelled more frequently as firms seek to avoid a failure triggering a buy-in.
This is not just a concern for brokers. At the Fixed Income Leaders’ Summit in Barcelona this year, buy-side traders also expressed their fear that access to credit markets, might be impacted. As liquidity is already a challenge in secondary corporate bond trading, a further reduction in liquidity could be a serious blow.
European Commission rules mean cash penalties are tied to the value of financial instruments that fail to be delivered, which in turn should be based on a single reference price using “objective and reliable data and methodologies”, however that can be challenging for over-the-counter products.
Increasingly, banks that are able to use the data they hold for clients in a dynamic way will find new opportunities arising, either by increasing the quality of the services they offer, or by offering data as a service directly. Specific events such as CSDR are increasing the value of a single, dynamic back office environment, which creates the ability to move data within the firm, and to manage it through multiple analytical processes.
With 12 months to go before the CSDR rules are expected to go live, there is still time to assess the risk based on an operational review. The capacity of a broker to predict the likelihood of default on settlement will be invaluable. This requires reliable back office processes, with a strong data architecture, in order to track trading and settlement activity, inventory and the time parameters required by the new rules.
If fines are required by the CSD itself as a result of a delayed settlement, sell-side firms will potentially need to handle client money and so the ability to segregate cash and process it appropriately will be a prerequisite for compliance.
Asset managers will need to have confidence in their sell-side partners’ ability to make markets across assets, with those able to reach across both liquid and illiquid instruments having a competitive advantage. As a consequence, building back office efficiency ahead of the CSDR implementation could prove an invaluable investment.
Firms will also gain an advantage if they can make an assessment of which assets, counterparties or markets may increase the likelihood of a failed trade. Not only will that be useful in making an evaluation of risk for themselves, but also for clients. Custodian banks with the capacity to provide a historical analysis of trade failures for the firms whose assets are entrusted to them can create an additional layer of trust.
The capacity to create these advantages is dependent upon a flexible data architecture, that enables the enterprise to move data between operational siloes and functions. Investment in post-trade technology will always yield real returns, and under CSDR, those investments will deliver for the trading function as well as the back office.
December 4, 2019
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