The Settlement Discipline Regime (SDR) component of the Central Securities Depositories Regulation (CSDR) requires investment firms to implement measures designed to mitigate settlement fails, and so it is unsurprising that much of the conversation around preparation has focused on the buy-side. Now, with less than a year to go until the SDR deadline, custodians are emerging as another group expected to be significantly affected once the regulation goes live.
At this stage, the challenge for the custodian community is encouraging their clients to prepare well in advance while communicating the ways their relationships with their clients will likely evolve, specifically around new services SDR compels custodians to provide.
There are two services that are currently offered at the discretion of the custodian that will be made mandatory by SDR: account segregation and partial settlement. An increase in the number of segregated accounts on offer results in a need for custodians to manage an increase in documentation, even for existing clients/funds that currently form part of a custodian’s omnibus account. The creation of these newly-segregated client accounts will require onboarding and new client/fund documentation. SDR also mandates partial settlement at central securities depositories (CSDs) to help minimise financial penalties and to ensure they are paid only for the outstanding amount of the trade which has failed to settle. The new mandatory nature of this service will require custodians to develop an entire process which will necessitate technology spend and additional human resources.
As a result of SDR, there are further compulsory services that custodians will need to perform for buy-side clients should trades fail to settle on the mandated T+2 settlement timeframe. Via custodians, CSDs will pass all late settlement penalties onto custodians, who must then establish which party is responsible for a failed trade – themselves or the buy-side. If the buy-side is at fault, the custodian is responsible for communicating that to the buy-side and passing on the fine, which over time has the potential to negatively impact a relationship, especially if the problem is ongoing or if the client disputes the cause of the settlement fail.
Furthermore, SDR’s mandatory penalties for trade failure could require custodians to extend services to assist the buy side with late settlement penalty reconciliations, a service that will require a daily update on the status of financial penalties being applied. Custodians will need to untangle a potentially complex web of credit/debits for different counterparties, apportioning them accordingly and then passing on those costs. Further, the custodians may be pressured to provide the buy-side with daily, weekly and monthly reports on their penalty exposures, an even heavier administrative burden.
Another penalty-related service that custodians will need to provide relates to transparency about the daily reference price for penalty calculations. In order to create a level playing field, the SDR states that the CSD determines the daily reference price for each security, acting as the benchmark to calculate the amount of the failed settlement penalty. While the rate is not expected to deviate significantly from the execution price, under the regulation, the CSD is not required to publish the daily reference price. Therefore, the buy side is likely to ask for their custodians’ assistance in determining the rate by working backwards from the level of the fine, once the buy side has incurred it. As the custodian will already be managing settlement penalty reconciliation, they may expect the custodian to provide this daily reference price determination as part of their wider service.
In addition to the late settlement penalty, SDR requires that all CSDs charge penalties for late matching, a fee that is currently discretionary. Similar to SDR’s failed trade rules, the custodian must determine the reason for the late match and if it is a result of the buy side failing to share details of a transaction on time, then they will incur a late matching penalty. Mandating late matching penalties will lead to a significant increase in the volume of fees charged by CSDs, and custodians are responsible for managing this process, which is likely to require the allocation of additional resources. Again, much like the new mandates around failed trades, the custodian and the buy-side client will need to augment communication in the event of late matching that is determined to be the fault of the buy-side, a potentially difficult conversation.
SDR’s demands on the custodian community also include greater transparency and increased performance reporting around the rate of failed trades and late matching in a standardised format to their National Competent Authority (NCA). Custodians will need to obtain their clients’ LEI codes to track the performance of individual clients, as opposed to the BIC codes currently used for identification. This requirement effectively makes LEIs a necessity for custodians so they can identify clients with a poor track record of settlement and matching.
In the short to medium term, SDR will significantly evolve the role of custodians in relation to their buy-side clients. Where the buy-side is the cause of inefficiency in the settlement and matching process, that evolution may lead to challenging conversations between custodians and their clients. Early preparation and custodians’ pro-active education of buy-side clients are key to ensure that they are equipped to cope with the new SDR requirements, mitigating their impact on custodians as a result.