The European Parliament has adopted regulation for securities settlement and central securities depositories (CSDs). The main objective of the CSD Regulation is to increase the safety and efficiency of securities settlement and settlement infrastructures (CSDs). While the regulation is yet to be published, a major question on the minds of industry participants relates to the practicalities—such as the costs—of the new settlement discipline regime, says Tony Freeman, executive director, industry relations, Omgeo.
What are the next steps in the regulation of CSDs?
TF: The remaining political stream in the passing of the CSD Regulation (CSD-R), which is publication of the rules in the official European Journal, is basically a formality. We are expecting the regulation to become law 90 days after the official publication, which is most likely to be in September or October.
Until the regulation is published, we won’t have a full understanding of what exactly was agreed in the level one triologue discussions.
Now we’re moving onto level two, which is where the rubber hits the road and the discussions will focus on actual practicalities of CSD-R, for example, how much things will cost, which is what everyone is desperate to find out.
Is there any guidance on some of the costs?
TF: No, not yet. The costs primarily relate to the settlement discipline regime, which is a big part of the CSD Regulation and is expected to be in place in mid 2015. The CSD Regulation in terms of its content is dominated by the rules around CSDs themselves. What is of interest to the much wider community is the settlement discipline regime, which is very closely associated with the T+2 settlement, because there is this prospect of much more extensive rules about fail trades in terms of when buy ins take place and what the cash penalties would be for a failed trade and the regulatory scrutiny of how many trades are failing.
This is a new thing. A CSD will have to report to its regulators how many trades are failing and who the failing participants are. The indications are that the settlement discipline regime will be modeled on markets that have already implemented this type of thing, particularly the Asian markets where there are prescriptive rules for buy ins, as well penalties and transparency about the number of fails.
This is making quite a number of people nervous and they really want to know how much that cost is going to be because if you are a large broker dealer, a large custodian, or a member of a CSD and a trade fails, they will get fined for it. They will show up in the list of participants who fail those trades.
There are a number of aspects that they need to discuss with their customer, who may have caused the failed trade by being late or incomplete or inaccurate in its instructions. Brokers will have to decide whether to absorb extra cost of the penalty or pass it down to their customers. They will have to develop plans for how to address or resolve the issue of appearing in the charts reported to the regulator as participants failing a large number of transactions. Clarity on the settlement discipline regime is something everybody is looking forward to.
What happens if your name is on the list in relation to failed trades?
TF: If you are a large global custodian your name is inevitably going to be on the list because you have a lot of customers. What the regulators might do with customers who are coming up on that list is an unknown. The CSDs have to deal with their local regulators so there might be differences in approach in Belgium, the U.K., Germany etc.
But what I think will happen is that it will act as a useful spur to encourage custodians and their brokers to educate and work with those clients to try improve processes because they are members of the CSD and their name goes to the regulator if a trade fails. They need to be more demanding of their clients and educate them clients on the importance of sending accurate and complete and timely settlement instructions.
This will get more difficult when T2S goes live in mid 2015 – potentially around the same time as the settlement discipline regime – because it introduces an additional layer of complexity and add an extra step in the process life cycle.
If you’re a buy side firm and you’re executing a trade with a broker, you may have an outsourcer who needs to get that instruction to the outsourcer, who processes it and sends it to a custodian. The custodian will send it to the sub-custodian, who will then send it to the CSD, and the CSD sends it to T2S. There are six steps in the chain by the evening of T+1. So those underlying clients who are not efficient in gathering together the necessary information and processing it along that flow will cause problems. So it’s actually beneficial in some respects that there is a delay in the implementation of T+2 and the imposition of settlement discipline regime some point later. It gives people time to adapt to the settlement environment and it’s also helpful that T2S comes later as well, particularly for the major markets. When T+2 goes live in October this year there is wide spread expectation that there will be problems particularly in the non-automated client segment and the number of fails is likely to rise at least temporarily.
So the delay in the legal application of the CSD-R is actually beneficial in some respects.
Are custodians willing to foot the costs of failed trades?
TF: Every custodian has a mixture of some very efficient clients and some that are less efficient. Additionally, there are large numbers of buy side firms that use cut off deadlines given by the custodians as a target rather than as a backstop. If the cut off time is 10am on T+2 today for a market, which, today, has T+3 settlement, custodians will have a client that sends in a vast majority of its trades just before that deadline. That’s not helpful but it is a deadline that some clients actually adhere and work towards.
Now, the move from 10am to 3pm on T+1 to enable the custodian to get that trade through the process chain down towards T2S for the end of day T+1 (for it to settlement over night on T+2) is a significant time change for clients. Custodians have to completely rethink their operational process. If they’re working on a batch basis and if they’re end of day orientated, that process is probably not going to work. They need to do multiple batches or process things near real time. There is a considerable amount of educational work going on by custodians individually with their own customers. There are plenty of discussions happening around world as to how to cope with the implementation of T+2. A lot of U.S. managers would normally finish their instruction processing on T+1. They’re hours behind the European markets so they may have to look at re-engineering their operations process because at some point the U.S. market will move to a shorter settlement cycle as well. So an educational process is required there, which is happening but there is low visibility on it.
Who will collect the data on failed trades and what will they do with it?
TF: The settlement discipline regime is going to require a substantial amount of reporting and there is no template for it right now. I expect ESMA, as part of their development of the Level 2, technical standards will define what information needs to be reported. It requires some pretty basic work because there is no standardized version of a failed trade. Different CSDs treat them in different ways. So the first thing that needs to happen is a definition of what is a failed trade and what data needs to be reported. We really have no idea at the moment how granular this information needs to be, whether it’s just a statistic on how many trades failed, what they will be worth or whether it go into more details on which participants in the CSD are responsible for the fail trade. ESMA has an open consultation on the subject right now but it’s very unclear as to what the level of detail will be, who will receive the information and what they will do about it.