The Central Securities Depositories Regulation (CSDR) has been at the top of many agendas in the asset servicing industry for some time now. The regulation addresses Europe’s settlement systems, to create a smarter and more efficient industry best practice.
CSDR will require European central security depositories (CSDs) to automatically apply penalties to market participants who fail to complete transactions on the contractual settlement date, with the aim to harmonise aspects of the settlement cycle and settlement discipline.
James Wharton, head of custody operations at Winterflood Business Services, suggests that CSDR is the “latest piece of an epic Europe-wide regulatory push to speed up settlement, but has created disquiet among market participants due to its one-size-fits-all approach – as well as cash penalties which have the ability to impact already under pressure profit and loss”.
The regulation will affect many industry participants including custodians, fund managers, clearinghouses and brokers, and affects any firm that is a registered member of a CSD.
However, the build-up has not been smooth, in February this year, the European Securities and Markets Authority (ESMA) recommended a delay to the Settlement Discipline Regime (SDR) to 1 February 2021, which allows the industry participants extra time to prepare.
This extended deadline came after a multitude of warnings from those in-scope that the rules would damage market stability.
Although there have been delays, Wharton emphasises that CSDR is already in place.
He says: “Companies who are a member of a CSD have to offer clients the choice of having their own segregated accounts for a ‘reasonable fee’. However, alarmingly, most organisations do not have the ability to segregate at the CSD level within their current technology stack.”
Market impact
The main opportunity that is set to sprout from CSDR is the harmonisation of the settlement cycle and settlement discipline, creating a more efficient market by eliminating the inefficiencies and risks in the post-trade operating model. Wharton outlines that the aim is to provide a set of common requirements for CSDs operating securities settlement systems across the EU.
According to Wharton, CSDR will also change the trading landscape, he suggests: “For example, the new regulation will sweep away the era of share certificates as all trades move through the CSD. In a post-CSDR world, all settlements will be fully auditable and transparent”.
Wharton explains: “SDR, an element of the CSDR, binds together the trade and post-trade, aiming to improve the safety and efficiency of securities settlement by ensuring buyers and sellers receive securities and money on time and without risk. Ultimately, the aim of CSDR, in the spirit of the second Markets in Financial Instruments Directive (MiFID II), is providing better transparency and lowering market risk.”
Regulations, such as the European Market Infrastructure Regulation (EMIR), MiFID II, and the upcoming Securities Financing Transactions Regulation (SFTR), have surfaced more vigorously since the financial crisis, which highlighted the importance of transparency in the market.
However, the increasingly complex regulations, which require heavyweight technology, can cause disruption in the market.
For example, as Wharton points out, MiFID II unleashed a wave of disruption on the financial markets, and while it has been burdensome on wealth and asset managers, it is also beginning to yield positive results for investors. According to the UK Financial Conduct Authority, the research unbundling rules are working well for investors.
Wharton also argues that with MiFID II now implemented across the industry, firms must now be alive to the next wave of regulatory challenges.
“The [FCA] recently stated the fall in research spending shows unbundling rules have improved asset managers’ accountability over costs, ‘saving millions’ for investors. In many ways, orderly settlement and CSDR is the last evolutionary piece of this regulatory puzzle,” Wharton cites.
Daniel Carpenter, head of regulation at Meritsoft adds that CSDR not only needs to be seen as need to understand failures reasons and costs, but as a chance for operational departments to help COOs drive operational improvements around penalties and buy-in processes, making the front office and the board take notice.
Delayed
CSDR’s delay came after a storm of suggestions and alarm bells, such as the letter composed by fourteen trade associations, including the International Securities Lending Association, the International Capital Market Association, Association for Financial Markets in Europe, called for radical amendments to the settlement discipline regime of CSDR.
A letter from the group was sent to Steven Maijoor, chair of ESMA, and Valdis Dombrovskis, executive vice-president at the European Commission, which highlighted the scale of the concern from affected parties that CSDR’s mandatory buy-in regime and cash penalties for settlement fails will significantly damage market liquidity and stability.
The letter, from 24 January, read: “We [the associations] are extremely concerned that if the buy-in regime is implemented as it stands, there will be a significant negative impact on market liquidity, operational processes, and ultimately, end investors.”
In light of this, ESMA explained that it is proposing a delay to the entry of the regulatory technical standards (RTS) on settlement discipline, “having taken into account the additional time needed for the establishment of essential features for the functioning of the SDR, such as the necessary ISO messages, the joint penalty mechanism of CSDs that use a common settlement infrastructure, and the need for proper testing of the new functionalities”.
Discussing the implications of the delay, Heiko Stuber, senior product manager at SIX, urges market participants to not waste the additional time afforded to them by ESMA, and to use it wisely.
Stuber says: “The main challenge is that custodians are struggling to access the granularity of information needed to assess the financial instruments that could fail to settle under CSDR.”
“While they may be able to get cash amounts from CSDs, a custodian can’t easily get hold of the reference and price data being used to work out exactly how the penalties were calculated. This includes really important insights such as how to determine the market valuation of any given instrument, not to mention the closing price of the most relevant market within the EU,” Stuber adds.
Meanwhile, Carpenter comments: “A delay was being talked about previously, but many participants had already planned their CSDR project delivery to take place in 2020. As a result, this short extension doesn’t affect their preparations, with houses focused on finalising their projects before the end of the year.”
“The houses we are speaking to have ramped up their resources, as well as their plans, and are focused on parallel runs to improve fails management processes and client engagement, well in advance of this new date.”
While numerous market participants are affected differently, Carpenter adds that the regulation “needs to be seen by all of them not only as a need to understand the reasons and costs for trade failures, but as a chance for operational departments to help COOs drive operational improvements around penalties and buy-in processes, making the front office and the board take notice of the operational costs”.
No place to hide
Firms have a lot to organise before the implementation date of CSDR, but this new delay might give them a boost. In terms of what they must do between now and the enforcement date, Carpenter highlights that multiple CSDs need to work out a standardised way for calculating fines and penalties.
Meanwhile, custodian banks need to figure out a more efficient way of validating penalties and passing on key information to their clients, all while investment banks and brokers adopt new settlement processes, and fund managers start trying to deliver securities on time, according to Carpenter. In terms of where people should be at present, Wharton notes that as of 12 July, wealth managers and platforms should have started reporting all internal transfers, including spousal gifting. The last phase will arrive with mandatory cash penalties and buy-ins for settlement failures.
Discussing one significant implementation hurdle, Wharton cites: “Firms with a large proportion of high-volume settlement fails are more at risk. Fortunately, outsourcing can diminish the risk of impact.”
Wharton continues: “Working with a third-party proven expert that, firstly, has a track record of implementing robust frameworks to comply with the regulatory challenges, and secondly, can offer a CSDR-compliant service delivering contractual settlements, will ensure the firm gets to grips with CSDR and mitigate risk.”
As for smaller firms, Wharton identifies that those with less settlement must ensure they have fewer failures. According to Wharton, this is because a CSD participant will be deemed to consistently and systematically fail when its settlement efficiency is 10 percent lower than the market average.
The impact and related damaging scenarios must be assessed, Wharton stresses. For example, is there a potential for a firm to be suspended from a CSD?
“Custodians and investment firms, in the context of securities settlement, have one year to implement and fully comply with the technical standards. After MiFID II, some may be feeling regulatory burn-out, but the outcome is stark. Those who fail to comply will face penalties and the potential revocation of CREST or another CSD membership,” Wharton says.
He adds: “Ultimately, firms that take the long view will realise while CSDR is onerous, it creates a settlement discipline framework that improves transaction settlement rates and boosts transparency. For firms concerned with inadequate processes, collaboration with proven partners can ensure a smoother journey ahead.”
Carpenter warns: “There is, literally, no hiding place for any of these market participants. For those that act now, there is an opportunity pre-regulatory go-live to deliver benefits and reduce the financial impact of the regulation. But for those that fail to act, they will quickly find that this particular law costs them much more than they initially thought.”
