Bob Currie gauges industry reaction to recent dialogue on CSDR settlement discipline and assesses how well market participants have adapted to the cash penalties regime
The European Central Bank has recommended that the mandatory buy-in (MBI) component of the Central Securities Depositories Regulation (CSDR) should be dropped from the CSDR settlement discipline regime.
This follows an announcement in June from the European Securities and Markets Authority (ESMA) that application of the MBI element of CSDR will be postponed for a further three years.
The MBI rules refer to a mandatory obligation for settlement parties to execute buy-ins against counterparties that fail to settle their trades within a required period.
ESMA’s decision to postpone the MBI was intended to give co-legislators, the European Parliament and EU Council, additional time to determine the best course of action to improve settlement efficiency while avoiding duplicative implementation costs for market participants — pre-empting the cost and inconvenience to market participants should the MBI regime be introduced and then be subject to multiple amendments.
In a proposal released in March 2022 (amending Regulation [EU] No 909/2014), the European Commission put forward a “two step approach” to finalising CSDR settlement discipline provision, combining steps to clarify settlement discipline rules and to revise the timeline for implementation of mandatory buy-in provisions.
In this proposal, the Commission indicated that the implementation of MBIs will be dependent on the progress of efforts to reduce settlement fail rates in the EU. It did so in the expectation that cash penalties would “incentivise improvements in settlement efficiency” without endangering market stability and liquidity. After assessing the impact of cash penalties, it intends, in step two, to evaluate how best to apply the MBI regime in light of the progress that has been made in improving settlement efficiency.
Significantly, in advancing this proposal, the Commission rejected the option to suspend the MBI framework entirely. It highlighted that settlement fails in the EU remain “consistently higher than those in other major financial markets” and that MBIs may still have a role to play in reducing this settlement inefficiency.
The European Central Bank’s (ECB’s) recent ‘Opinion’ paper marks a departure from this proposal, recommending that the MBI component of CSDR should be removed since, in the ECB’s view, the introduction of MBIs would lead to “significant interference in the execution of securities transactions and the functioning of securities markets”.
The ECB has also recommended that, should MBIs come into force, securities financing transactions should be excluded from coverage under the MBI regime. In the ECB’s words:
“An SFT does not generate an outright open position between the trading parties such as to justify a buy-in against the failing party. Consequently, this would not align with the EU legislator’s intention to reduce the number of settlement fails through mandatory buy-ins” (ECB ‘Opinion’, July 2022, parg 1.6).
Going into more detail, the ECB indicates that it welcomes the EU legislators’ intention to create a more targeted scope for the CSDR settlement discipline regime — one that tackles the market behaviour that perpetuates settlement inefficiency, but without penalising every individual settlement fail regardless of the context and the parties involved.
With this in mind, the ECB advises that the settlement discipline regime should not apply to all securities settlement fails, but only when this has negative financial impact for the settlement counterparties of the failing party (parg 1.1)
The ECB has also recommended that, should MBIs come into force, securities financing transactions should be excluded from coverage under the MBI regime.
Joint Associations letters
A number of these ECB recommendations will resonate with industry trade associations that have highlighted their concerns about provisions in the CSDR settlement discipline regime, and explicitly the mandatory buy-in component, that they believe may have negative implications for market liquidity and may entail duplicative costs. In January 2020 and March 2021, an alliance of 14 trade bodies wrote to the European Commission and ESMA to share their views.
The Joint Associations indicated that they remain fully supportive of the Capital Markets Union project and steps to improve settlement efficiency in Europe. However, this must be done in a way that protects market liquidity, that does not increase costs for issuers and investors, and does not place European capital markets at a competitive disadvantage.
Following on the back of a targeted consultation process by the European Commission, which ran from December 2020 to February 2021, and publication of its interim report (released on 30 June 2021), the Joint Trade Associations again wrote to the European Commission and ESMA in July 2021 regarding the implementation schedule for mandatory buy-in rules.
Among other recommendations, the associations advised policymakers in this letter against enforcing a set of MBI rules and then revising them at a later point. This, they say, would “risk damaging the competitiveness of EU capital markets and increasing cost for investors, but would also lead to a duplication of efforts and significant unnecessary disruption for market participants”. The letter highlighted that a considerable number of open questions about the MBI regime were still under consideration and these would need to be addressed well in advance of implementation, giving market participants sufficient time to make alterations to their systems, processes and contractual arrangements.
ECB Opinion
Expanding on ISLA’s current position and its reaction to the ECB ‘Opinion’, ISLA’s head of regulation, digital and market practice Adrian Dale says that ISLA supports the advice of the ECB to exclude securities financing transactions, which are a recognised mechanism to enhance settlement efficiency and provide much needed liquidity. “It is important to remember the considerable differences in economic profile between SFTs and outright sales and purchases,” says Dale. “Securities lending is a well-documented tool for reducing settlement failure, with potential fails being avoided through short term borrowing.”
ICMA continues to engage with the co-legislators on the proposed revisions to the CSDR MBI regime. In particular, ICMA is recommending greater flexibility in the assessment process for the “two-step” approach, including the possibility to recalibrate penalties. It also recommends excluding SFTs from the scope of MBIs and, in the event that MBIs are applied, implementing this through market regulation rather than CSDR.
Elaborating on these points, ICMA director of market practice and regulatory policy Alexander Westphal says that the Association welcomed the Commission proposals back in February, especially the proposal for a revised MBI framework which took on board a number of concerns previously raised by ICMA and the wider industry. “This is certainly a major improvement compared to the previous version of the rules,” he says. In particular, the “two-step approach” on MBIs proposed by the Commission is important as it recognises the potentially disruptive impact [of MBIs] on the market, as well as allowing for more proportionate and targeted initiatives to improve settlement efficiency rates (including the CSDR penalty regime) to be implemented first.
This said, Westphal believes there is definitely scope for further improvements and, with this in mind, ICMA submitted detailed comments on the proposals back in May. “The ball is now in the court of the European Parliament and the EU Council which have both started their respective discussions based on the Commission proposals,’ he says. As a result, each will adopt their own position on the CSDR review. “The discussions are still at a very early stage and will only properly kick-off after summer, but we are certainly keen to engage with policymakers on both sides to support the discussions and share our perspective on the proposals,” says Westphal.
Gilbert Scherff, senior product manager for securities finance at Broadridge, observes that market participants already have a toolkit in place to address settlement fails for securities financing transactions, given the existing provisions of the Global Master Repurchase Agreement (GMRA) and Global Master Securities Lending Agreement (GMSLA) documentation along with wider market best practice for SFTs. Against this background, he believes that MBIs could have a negative impact on liquidity such that the possible consequences, and unforeseen effects, may go far beyond what the regulator initially intended. “In this context it is encouraging to see a reconsideration of the MBI,” says Scherff.
Specifically, given the nature of SFTs and the associated collateral, Scherff believes it would make sense to exclude these transactions from the MBI, especially given the instances where a securities finance transaction is often employed to remedy an operational or liquidity issue.
Flexibility in MBI application
The European Central Bank has recommended that the mandatory buy-in component of the Central Securities Depositories Regulation should be dropped from the CSDR settlement discipline regime.
In the event that an MBI regime does come into force, however, the ECB proposes that legislators should consider an approach where, rather than legislation prescribing the exact method of executing the buy-ins, this should provide greater flexibility to the counterparties to contractually agree on buy-in details among themselves. This might include an option where the non-failing party can decide whether or not the buy-in process would be triggered (ECB, July 2022, parg 1.5).
Asked whether ISLA would be supportive of a regime that offers this discretion to the non-failing party, ISLA’s director of regulation and sustainability Farrah Mahmood points out that ISLA’s GMSLA has contained contractual remedies for many years that provide the non-failing party with this optionality. “We support the right of trading parties to execute their own buy-ins, based on their underlying contractual requirements, which provides flexibility to act in the best economic interest of the failed-to party,” she says. “This allows for loan termination and replaces the delivery obligations with payment obligations — a process commonly referred to as a ‘mini close-out’.”
Similarly, ICMA’s Westphal indicates that this is an important point that ICMA fully supports. This, he suggests, would be fully in line with current market practice and the ICMA buy-in rules which are applied in the OTC bond market. Under the ICMA rules, buy-ins are triggered at the discretion of the failed-to counterparty. “The fact that the [CSDR] MBI provisions do not provide this level of flexibility has always been one of our key concerns,” says Westphal.
ICMA and ISLA has been active alongside other industry associations — through the Joint Associations’ letters of March 2020, January 2021 and July 2021, and through wider canvassing — in calling for amendments to the original provisions of the CSDR settlement discipline regime, particularly relating to MBIs. SFT asked these associations how far they believe that their concerns and recommendations have been addressed in responses so far from policymakers.
For ICMA’s Alex Westphal, the fact that the implementation of MBIs has been suspended and the topic is currently being reconsidered as part of the ongoing CSDR review is already a major achievement and shows that policymakers have taken the concerns that ICMA and other stakeholders have raised very seriously. “We appreciate that it was not easy to get to this point and required a lot of flexibility and pragmatism from both the Commission and ESMA,” he says.
ICMA notes that although the ECB does not have a decision-making role in the ongoing legislative discussions in the Council and the European Parliament, the opinion is a positive and important step that it hopes will be influential among co-legislators.
According to Adrian Dale, ISLA is pleased that its concerns have been recognised and it strongly welcomes the corresponding recommendations of the ECB. However, while raising concerns is an appropriate first step, he believes this must be quickly followed by pragmatic and practical solutions on how to address the fundamental objective of the regulation, to improve settlement rates.
Although regulators can in some ways formalise this challenge, Dale suggests that market participants should also consider the plethora of available solutions that facilitate settlement, including distributed ledger technology. “On considering available technologies, many firms agree that distributed ledgers, with their instant communication of an undisputed ledger, will undoubtedly form a large part of the solution,” says Dale.
Westphal reminds us that it is still too early to comment on the final outcome as the CSDR review discussions are still ongoing. However, he suggests that the latest developments certainly provide grounds for optimism. “In our view, there are more effective and less disruptive means than MBIs to improve settlement efficiency and there are a number of meaningful industry initiatives under way, for example ICMA’s guidance related to settlement optimisation tools which we published both for repo and cash bonds,” says Westphal.
Cash penalties
SFT asked ICMA’s Westphal how effectively market participants have adapted to the introduction of the settlement fails reporting and cash penalties regimes that were enacted in February, and how much impact these changes have had in promoting improvements in settlement efficiency for securities financing transactions (SFT).
The roll-out of the penalty regime has not been an easy exercise, responds Westphal. ICMA is monitoring feedback from members and there are still some ongoing challenges with CSD and custodian reports and underlying data quality. But members are observing a steady improvement in accuracy and the reconciliation process.
In the aftermath of the go-live, Westphal notes that there has been a high degree of coordination across the relevant trade associations, and with the CSDs, to address the initial issues. ICMA has established a separate workstream to help tackle key challenges and provide some further clarity through detailed Q&As and best practices which are available on the Association’s website.
Similarly, ISLA has dedicated considerable effort to preparing for CSDR penalties, particularly in identifying the causes of settlement failures and developing best practices to ensure market alignment. This initial work generated two papers that evaluate the causes of settlement inefficiency and a range of proposed solutions (available on ISLA’s website). Farrah Mahmood indicates that the Association’s work is continuing on topics such as sale notification, auto and manual partial delivery, and auto-borrowing. “Preparations within member firms have resulted in improved monitoring and management of settlements, which we see mirrored in feedback at ISLA working groups,” says Mahmood.
On the basis of evidence from ISLA’s working groups, Adrian Dale indicates that there was evidence of a discernible improvement in settlement rates during the first half of 2022 but, with the cyclical increase in volumes, those rates have declined somewhat as we move into the busiest period of the year.
For ICMA’s Alex Westphal, the impact that the CSDR fails reporting and cash penalties regime has had on settlement efficiency rates is not easy to evaluate, given that data on settlement efficiency is very limited — especially when it comes to granular information, and for SFTs specifically which are currently not even distinguishable from cash bonds at CSD level. “From what we have seen so far, there has not been a significant uptick in settlement efficiency rates since February,” he says. “However, it is still relatively early days as the new regime takes time to fully bed in. In addition, it is not easy to disentangle any direct effects of cash penalties from the impact of the general market conditions which, of course, have not been easy either.”
Broadridge observes that clients are starting to mine data with regards to CSDR penalties and to find ways to translate these findings into improvements in how they conduct their business. Gilbert Scherff notes that this may include reviewing matching and settlement fail rates to the specific trades and analysing return on investment by considering both operational and reputational cost and risk. “We expect this will be a catalyst for innovation and improvement with regards to post-trade processes, for SFTs and more broadly,” he says. “We are already observing this through combining management information (MI) from the Securities Financing Transactions Regulation and the CSDR regime.”
Nonetheless, feedback from Broadridge clients has identified some challenges with regards to data quality, reconciliation and timeliness of the fines and penalties process. Scherff indicates that there is certainly a lengthy road ahead to ensure that the basic processes mature and that clients can take appropriate action to address settlement inefficiency — the rationale which underpins the implementation of the CSDR fines and penalties regime in the first place.
Recognising this complexity, it is heartening to note provisions in the Commission’s March 2022 proposal (op.cit., referenced above) that indicate that it is listening to at least some of the industry’s recommendations and seeking ways to streamline application of the MBI regime, should this be implemented.
One noteworthy development is the proposed inclusion of a ‘pass-on mechanism’. Under a new paragraph 3a in Article 7 of CSDR, the Commission proposes enabling each participant in a chain of transactions to pass-on a buy-in notification to the participant failing to them — with this being passed along the chain of transactions until this reaches the “original failing participant” (European Commission, March 2022, parg 6, p 210). This pass-on mechanism is designed to prevent a cascade of failed settlements, each requiring a separate buy-in process, by enabling one single buy-in to resolve the full chain of settlements.
