The CSD Regulation has been a slow burn. Conceived after the financial crisis and enforced legally since 2014, it’s been a very long time coming. To most of us CSDR has had – so far – no direct impact. European CSDs, of which there are still about 40, have had to register and comply; however, this largely has been a technocratic exercise.
This will all change in September 2020, when the wider impact of CSDR will become apparent. Following a two year lead-in, the Settlement Discipline Regime (SDR) will come into force. The SDR is the CSDR component that aims to improve settlement efficiency in Europe, and its scope is wide.
CSDR is designed to harmonise settlement standards and promote competition, plus a key objective is to improve settlement efficiency. As the CSD market in Europe is not at all homogenous, there is no official data designated to quantify settlement rates for the region as a whole. Individual markets do publish their own data; however, the methodologies used to gather the data are not harmonised and therefore, the data is not suitable to create a blended figure.
CSDR’s unofficial — but obvious — aim is to raise settlement rates from about 97.5% to more than 99%. This target has never been explicitly stated in the legislation or any of its accompanying documentation, probably because it’s hard to manage what can’t be measured. The numerous structural differences between Europe and other — supposedly similar — markets result in invidious comparisons, but the policy objective is for settlement efficiency rates to match those achieved in the US. Some markets in Asia present another target as settlement fails are almost unheard of in that region.
So, how ready is the market for CSDR? With 15 months to go, it may seem like there’s plenty of time to prepare, but this is probably a false assumption. Market change of this scale requires industry collaboration. It’s always valuable if an individual firm improves its processes, but when the market as a whole works together, the benefits are exponentially more powerful. The successful move to T+2 in 2014 was a similar initiative which required industry collaboration; and since the financial crisis, there have been several examples of positive change facilitated by a collective approach in the derivatives markets.
The most productive way to prepare for the SDR is an analysis of the causes of failed trades. If a trade does fail, there are three issues that will arise: financial penalty, the management of a possible buy-in process and relationship fall-out. Regarding penalties and buy-ins, there is no discretion allowed and no size thresholds apply. The penalties may not be large in value, but the administrative burden will be high. But perhaps the biggest issue is the potential impact on relationships, because when a trade fails, someone has to take responsibility for the failure. This could lead to some difficult conversations between clients and their brokers and custodians about who should cover the cost of a failed trade.
So, what are we hearing from our clients about industry readiness? It is alarming that some buy-side firms, even in Europe, still have no awareness of the SDR, and in the Americas and Asia-Pacific there remains very limited awareness of the regulation’s global reach. Like MiFID II, the SDR is extra-territorial, meaning anyone holding European stocks is impacted. Similar to T+2, the SDR has no centralised project management, and there exists no coordinated campaign to raise industry awareness. Preparations are entirely left to market participants, to educate and coordinate amongst themselves.
Some buy-side firms have stated that they are looking to their brokers and custodians to come forward with solutions, indicating a failure to acknowledge the community aspect, and of even more concern is that this passive point of view demonstrates that buy-side firms do not recognise their role in collaboratively tackling CSDR’s directives. We are also hearing from multiple investment managers that they view inventory management by broker dealers as the root cause of failed trades and it is widely believed that securities lending is mostly to blame.
The truth is, the market is highly interconnected and all participants are responsible. With not much more than a year to go before the implementation deadline, now is the time to start analysis and preparation. There is some evidence that broker dealers have started industry outreach; however, this is less visible amongst the custodian community. An optimistic view would be that collaboration and preparation are happening behind closed doors, but with little evidence of this, it appears that the industry has a long way to go to close the gap by September 2020.