Why CSDR is a Tough Sell
The Central Securities Depositories Regulation (CSDR) will be a far reaching piece of legislation designed to improve the functioning of Europe’s post-trade environment, by harmonising settlement, and enhancing the safety and efficiency of transaction settlement. The draft Level 2 Technical Standards will be made public on 18 June 2015. Firms will then have less than 18 months to make all the necessary adjustments to their operations in order to fully comply with CSDR when it enters into force in November 2016. This article explores some of the major concerns with certain provisions of the CSDR and the preparations that firms should be making now to help mitigate some of the costs likely to be incurred as a result of the regulation.
The CSDR will require firms to settle their trading obligations on intended settlement date, and requires CSDs and other market infrastructures to prevent and address settlement fails. This brings with it the implementation of a buy-in regime and a settlement discipline regime across a wide range of securities. This will affect all clients of every European CSD and will have a widespread market impact, including increased costs if a trade fails to settle. CSDR has been widely accepted as beneficial to the market. However, there are two fairly contentious parts of the regulation related to settlement discipline that are causing concern for many market participants.
The first relates to cash penalties payable by failing counterparties. To give an example, a market maker or broker dealer has a legal obligation to make a price on a stock or a bond as requested by their buy-side client and then deliver that security within an agreed timeframe. As proposed under the CSDR, illiquid securities must be delivered in seven days while liquid securities must be delivered in four days. If these deadlines are not met, the trade will be deemed a failed trade and a penalty must be paid by the market maker or broker dealer. This failed trade would then trigger a buy-in, which, under CSDR, would need to be conducted by a third party agent, appointed by the buyer, who would purchase those securities at a higher market price for guaranteed delivery to the buyer. As the seller, the market maker would then be legally obliged to pay the difference.
The concept of a buy-in is not a new one; it currently takes place on a discretionary basis. However, the CSDR will make this process mandatory – making it extremely costly for the broker dealer. This problem is exacerbated when they are required to deliver illiquid securities. Unsurprisingly, many fear that they will be forced to cease market making activities altogether. If this happens, then under the current rules, smaller companies who wish to raise equity finance through an IPO may find it much harder to find an appropriate broker.
In spite of these concerns, there are a number of changes and preparations that firms should be making now, to ease the burden of compliance with CSDR.
Firstly, they should ensure their back-office systems are operating efficiently and are able to monitor in real-time when trades are approaching the buy-in limit. Many firms are currently using outdated, legacy systems that do not provide updates in real-time which can lead to error and increased risk. An alerting system would enable firms to either prevent trade failure, and subsequently a fine, or implement the necessary steps to prepare for a failed trade.
It is also important that firms implement calculation tools that allow them to calculate and evaluate the penalty that has been issued for the failed trade. Our experience has shown that many firms are willing to pay the fine issued without analysing its details or reasons as to why they have been fined. Calculation enabling solutions would allow firms to better prepare for potential fines or indeed avoid being overcharged.
Lastly, if a trade still fails despite the use of these tools, allocation tools will be essential in helping a firm to establish which counterparty was responsible for a trade fail. A trade may, at times, have a very long cycle and involve a variety of participants. One counterparty’s failure may disrupt the entire chain and cause trade failure for which another firm may be fined. However, solutions are available that can assess individual position levels relating to the resulting fine and determine which counterparty in the chain is responsible for the failed trade. Allocating all settlement costs to counterparties and/or trading desks may also help firms identify costly areas of their business that require improvement.
There has also been discussion among market participants about the benefits of a standardised code that could be applied to each failed trade which would help market participants and regulators to analyse the causes of its failure. This would ultimately lead to remedial measures being put in place to stop these trades from failing. At present, failure codes vary by CSD or custodian – this requires a back office solution capable of mapping these codes onto a standard set before proper analysis of failures and costs can be performed.
The last few years have certainly been a period of lobbying and debate; we have reached a point where we have a clear idea of what the new CSDR framework will look like and the impacts it will have on the market. In fact, there is widespread consensus that the Level 2 Technical Standards will largely remain unchanged when they are presented by the European Securities and Markets Authority (ESMA) to the European Commission in the coming weeks. As such, firms would be wise to give due consideration to their back office processes, evaluate what their needs are in this area, and select the appropriate tools for their settlement needs.