The Central Securities Depositories Regulation (“CSDR”) was introduced in 2014 along with MiFID II and EMIR to increase the safety and efficiency of securities settlement and settlement infrastructures within the EU.
As of 1 February 2022, CSDR has introduced a new Settlement Discipline Regime (“SDR”) which is a set of common requirements for central security depositories (“CSD”s) that operate securities settlement systems across the EU. However, SDR impacts all firms no matter where they are in the world if they trade in securities that ultimately settle at an EU domiciled CSD. The application date of the rules was postponed throughout 2021 following industry bodies such as The European Securities and Markets Authority (“ESMA”) and the International Capital Market Association (“ICMA”) voicing grave misgivings around the impact that SDR would have in the form initially drafted by the European Union (“EU”).
SDR is set out in EU Regulatory Technical Standards (“RTS”) and outlines measures for preventing settlement fails (involving automated matching, a hold and release mechanism and partial settlement), and endorses straight through processing (“STP”) to maintain high settlement rates. In the event of settlement failures, SDR provides measures for monitoring and addressing such failures which include SDR imposing daily penalties or charges and a mandatory buy-in idea. Predictions of good improvement to EU settlement efficiency rates earned the cash penalty regime widespread industry support and ICMA endorsed its implementation as soon as possible. However, the mandatory buy in (“MBI”) initiative was heralded not fit for purpose and due to the extent of such objection across the market, the rules were postponed, so that the EU could re-evaluate. Presently, SDR includes only the welcomed cash penalty and while MBI will be considered under the forthcoming 2024 CSDR Refit/Revision, its postponement is likely to be permanent.
MANDATORY BUY IN
ICMA’s objection to MBI, as outlined in its briefing note of July 2021, was predicated on structural flaws which would see it significantly impact the secondary bond market’s liquidity and pricing. Less liquid segments (such as corporate bonds) would be particularly affected and in turn, detrimentally affect the attractiveness of Europe as a centre for capital raising and/or investment. Market confidence would be diminished by the burdensome and costly process of MBI implementation and adverse outcomes would follow, affecting both investors (e.g. pension funds) and liquidity providers (i.e. intermediaries in the bonds markets).
MBI design faults were the subject of a European Commission Targeted Review of CSDR and four critical flaws were identified.
- the requirement to appoint a buy-in agent;
appointment of a buy-in agent (“BIA”), a neutral third-party to execute the buy-in is required at the start of the MBI process. However, buy-side firms expressed doubt that the sole BIA model was compatible from an operational and legal perspective. Since onboarding is at the fund level (not the manager level) potentially thousands of individual funds would be required to be onboarded. Additionally, the sole BIA model would in practice, effect a monopoly. ICMA members who could potentially act as BIAs explained that they chose not to do so as they believed the current buy-in process would be, in light of the effect on illiquid segments, too risky to support.
- the lack of a pass-on mechanism;
pass-on mechanisms exist in the non-cleared market because settlement failures are often in the form of chains, where securities have been traded between several counterparties and a single fail can result in multiple onward fails. Rather than multiple buy-ins being executed between each party, a pass-on mechanism allows the entire chain to be settled using only one buy-in (usually the chain’s final buyer). This is both highly efficient and avoids potential market instability and excessive volatility from multiple buy-ins being attempted at the same time. However, no pass on mechanism is contained in MBI.
- asymmetric differential payments;
to preserve the integrity of the original transaction and to facilitate pass-ons, buy-in mechanisms for the noncleared markets usually provide for the payment of the buy-in differential (the difference between the value of the original transaction and that of the buy-in) to flow in either direction between the relevant parties, depending on whether the buy-in price is higher or lower than the original trade price. As a result of a drafting error in the first proposed draft, MBI only allowed for the payment to be made in one direction (from the original seller to the buyer). This created additional risk to the failing seller, with theoretically open-ended costs, while creating the possibility for windfall profits for the buyer, and results in a structural defect to the framework that could indeed prevent a pass-on mechanism from even being possible.
- an unworkable methodology for cash compensation;
where a buy-in cannot be successfully executed within a prescribed timeframe, the regulation provides that the trade is cash settled via ‘cash compensation’. This requires the determination of a reference price, which for bonds, is expected to be based on the previous day’s closing price on the most active trading venue for the relevant security. However, generally when a buy-in is not possible, it is because there is no available market. Without a price to reference, it was not clear how this cash compensation process would in practice work.
- lack of certainty around scope;
questions arose around whether MBI would apply to certain transactions, particularly such types where a buy-in would make little or no sense (for example intercompany transfers, margin postings, and open-SFTs.)
ESMA SUPPORT FOR POSTPONEMENT
The European Commission (“the Commission”)’s separate consultation regarding improving EU securities settlement is due to be published at the end of Q1 in 2022. This posed further uncertainty around SDR ahead of its implementation in light of how the Commission’s findings are likely to contain proposals for additional legislative changes.
In a letter to Commission, ESMA approved implementation of SDR’s settlement fails reporting and cash penalties but given the “serious difficulties” around MBI, called for further postponement and stated that EU national regulators should not prioritise any supervisory action over it. Instead, the existing settlement arrangements contained in the EU Short Selling Regulation (SSR) should continue to be applied up to and until any revised CSDR MBI regime repeals the SSR buy-in requirement.
SUMMARY FOR SDR STATUS IN THE UK
The UK government on-shored the CSDR into UK law after Brexit, and the SDR’s new fining regime for late settlements came into force domestically in line with the rest of the EU in February. The UK had however, foreseen issues with the buy in and accordingly already abandoned its T+2 settlement and buy-in rules on the basis that there would be a “market solution” (i.e. that the industry would still promote more effective settlements and buy-ins, but that it would be through different route to MBI as initially proposed.) Now that it is evident that the unilateral application of MBI would act to drive business away from the EU, even if settlement would be slightly quicker, it is unlikely to be back on the radar of EU or UK market players to cater for and adapt to, anytime soon.
For more information, and any guidance or advice on EU CSDR or SDR as it applies in the UK, Cleveland & Co External in-house counsel™, your specialist outsourced legal team, are here to help.
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