Published: Tuesday 23 March 2021

 

The European Central Securities Depositories Regulation (CSDR), which entered into force on 17th September 2014, continues to present challenges for the industry as concern continues around the broad application of the settlement discipline regime. 

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The aim of CSDR is to harmonise aspects of the settlement cycle and standardise requirements for Central Securities Depositories (CSDs) operating across the EU[1].  Among other things, CSDR mandates authorisation and supervision of CSDs by their National Competent Authority and introduces a shorter settlement cycle. 

The third phase of CSDR introduces a settlement discipline regime which aims to improve settlement efficiency and prevent settlement fails. Originally due to go live in September 2020, the implementation deadline has been postponed twice, primarily due to the impact of COVID-19. Currently, the deadline for implementation is 1st February 2022, however there continues to be much concern not just around the timing of the implementation, but also the application of the regime.

Summary of the key features of the settlement discipline regime

Settlement discipline is outlined in Title II of Regulation (EU) No 909/2014 [2]. Obligations fall broadly into two categories – measures to prevent, and measures to address, settlement fails.  

Measures to prevent

Investment firms and professional clients are obligated to take measures to limit the number of settlement fails, including:

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• Client confirmation of the acceptance or rejection of terms in good time

• Prompt communication of an allocation of securities to the transaction

• Investment firm to confirm receipt of confirmation and allocation messages

 

Measures to address

CSDs shall establish a system to monitor settlement fails and provide regular reports to the competent authority. In addition, failing participants shall be subject to cash penalties, and a mandatory buy-in process is introduced:

 

• Cash penalties calculated and applied daily until settlement or conclusion of buy-in process

• Buy-in process initiated following the relevant ‘extension period’. Whereas buy-ins are typically an optional remedy, they will be mandatory under the settlement discipline regime.

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European Commission consultation

 
To address the ongoing industry concern about its broad application, in December 2020 the EC launched a targeted consultation on the implementation of CSDR. Feedback was sought on a range of areas to ensure objectives are met in a “more proportionate, efficient and effective manner" [3]. Of the 42 questions, six invited feedback on specific aspects of the settlement discipline regime. 

Industry bodies and participants continue to express concern at the potential consequences of the regime. There has been particular industry scrutiny on the mandatory nature of buy-ins, the lack of a pass-on mechanism, and the need to instruct a buy-in agent. 

ICMA’s response to the consultation focused on mandatory buy-ins, predicting damage to EU bond market pricing and liquidity, increased costs for investors and issuers, and the potential for further destabilisation in times of market turmoil [4].

 

ICMA has also requested greater flexibility on the buy-in agent requirement and called for the incorporation of a pass-on mechanism which is critical to support circumstances where there is a chain of linked securities transactions and a fail in one would trigger the mandatory buy in process for all subsequent transactions in the chain.

ISDA and the FIA once more highlighted the “detrimental effects” of mandatory buy-ins for derivatives markets. They continue to lobby for the exclusion of margin transfers (arguing this introduces more risk to derivative counterparties), physically settled derivatives and emission allowances from the buy-in rules [5]. 

With any proposed amendments to the settlement discipline regime not expected until Q2 2021 at the earliest, and final amendments unlikely to be published before Q4 2021, the 1st February 2022 implementation deadline is under threat. Nevertheless, consistent across the market is the view that sweeping changes to the rules are improbable and unduly optimistic. This could pose a very significant remediation burden on market participants who currently have high regulatory remediation workloads around IBOR transition and the next phases of the Uncleared Margin Rules.

Remediation strategy

The regime is broad in nature. All parties involved in the European securities markets (including those based outside the EEA) will be impacted. There is a risk that banks, securities firms and asset managers based outside Europe will be caught off guard by the regime.

Ongoing market uncertainty around the scope and substance of the rules has led to a divided industry approach. While some firms await further clarity from regulators, others are stepping up preparations to implement rules fundamentally consistent with those currently published and the February 2022 deadline is, as yet, unmoved.

Implementing the settlement discipline regime will require extensive bilateral contract remediation, with securities repurchase transactions, securities lending transactions and derivatives heavily impacted. CSDR will further stretch firms already tackling IBOR transition and the final phases of the uncleared margin rules. The potential for parties to overlook their obligations coupled with the ongoing uncertainty over the rules calls for timely preparation.