CSDR: let’s get digital
30 august 2022
Ted Allen, director of business development, securities finance and collateral at FIS, discusses why moving to a DLT and smart contract future is a better fix for settlement risk
Image: Ted Allen
Death and taxes are two certainties of life. Certainties, even when unattractive, give confidence and assurance that an action, or indeed inaction, will achieve a given result, whether that result is dictated by nature, circumstance, or government. Timely settlement, by contrast, is hardly a certainty in securities finance. Regulations, market behaviours and client expectations have been moving increasingly toward a risk-minimised environment with ever improving levels of certainty.
If this is indeed a desirable end-state, how can the desired levels of certainty really be achieved? In delaying, and perhaps abandoning, mandatory buy-ins while a distributed ledger technology (DLT) pilot is given the chance to prove its mettle, the EU has been bold. We will discuss why we think mandatory buy-ins was a flawed approach and why the DLT pilot, if adopted, can address not only settlement risk, but also a host of other shortcomings.
Controllable risks
Mandatory buy-ins were mooted because markets require confidence to function: confidence in prices, liquidity, and certainty of transactions in terms of commitment to deliver what was promised. Regulators balance free, open and transparent markets with providing sufficient safeguards for controllable risks.
Controllable is the key word because there needs to be some level of risk to justify the returns on offer. No legislation can or should eradicate risk and retain some degree of return; markets cannot exist without a certain amount of both. They must rely on some degree of ‘caveat emptor’ — let the buyer beware — as there will always be investors or traders that cannot be protected from themselves, as many on the losing side of the Terra Luna debacle will attest. So, what are the controllable risks for securities finance, and should we be addressing the symptom or the cause?
Why buy-ins?
The safety net of a buy-in has long been a market feature, but not one that is applied lightly. There are two key reasons for this. The first is that relationships still matter. Undertaking a buy-in has ramifications for future trading, more so in the still relationship-driven world of securities finance compared with the relative anonymity of some other markets. In securities finance, your counterparty is known to you, and it is likely that future trades will be proposed and others in place already. That issue works both ways, of course. Lenders that enact a buy-in too quickly can be just as unpopular as borrowers that fail to return a security on time.
The second reason is market impact. Buy-ins are less likely to occur in a liquid security easily available on the open market, whether to borrow or buy. They are more likely when a security is already difficult to obtain either through an alternative borrow or purchase in an already frothy market. Adding a mandatory buy-in would have simply added to the supply-side pressure with potentially little advantage to the instigator.
These issues are why many market participants and trade associations pushed the European Commission to reconsider the CSDR rules, and in particular mandatory buy-ins. With discretion, market participants can make a call based on the circumstances of the failure to deliver and the prevailing market conditions to determine whether a buy-in is the right path to resolution, or indeed even possible without actually making the overall situation worse.
Understanding the concerns
CSDR already seeks to increase the certainty of settlement through the fines for poor performance or behaviour. The buy-in proposal itself does include criteria upon which it cannot be actioned, such as the bankruptcy of one party or the issuer of the security in question. However, the lack of discretion and self-regulation absent from the buy-in mandates were particularly troubling.
So of the three pillars of CSDR — transaction reporting, cash penalties for settlement fails and mandatory buy-ins — only the first two remain for now. As the CSDs took on reporting, FIS as a primary technology and market data provider to the securities finance markets built our solutions for the second pillar.
On the basis that prevention is always better than cure, we worked hard on integrating these two weapons in our armoury to identify and mitigate failure risks wherever possible. That effort ranges from working with other market infrastructure providers to increase the accuracy of standard settlement instructions, errors of which cause many of the far leg settlement fails in the market, to integrating our intra-day market data into all our systems. This provides early warnings of short squeezes and other liquidity crunches that can bring destabilising effects to the market.
We are now investigating enhancing that with AI-driven predictions for settlement fails. Getting ahead of the game reduces the causes of failures and brings benefits to the broader financial market and all its stakeholders as a result.
We have also provided more automation around partial settlements and holds to ensure these can be accepted, and the fines therefore minimised, if both parties agree. We have added the ability to import and process the fines for maximum straight-through-processing (STP). Some argue that mandating partials would go further to alleviating the problem and our clients can support this right now with automated STP.
Enter the DLT pilot
The third pillar of mandating buy-ins has been delayed, partially in favour of a DLT pilot regime announced by the EU in June. This scheme will test the capabilities of secondary market infrastructure for digital securities covering tokenised traditional securities as well as digital native securities.
The key provisions of this regime are that investment firms can operate a DLT-based multilateral trading facility (DLT MTF) and CSDs can operate a DLT securities settlement system (DLT SS). Interestingly, both can also create a combined DLT trading and settlement system (DLT TSS). The scheme will commence in March 2023 and run for six years. There are limits on the size of the individual securities and issuers and the overall size of the markets, so it really is a pilot — but this kind of adoption would create a technical solution not only for the settlement fails, but for a host of other causes of friction, inefficiency and costs in the current market.
DLT and smart contract-based securities finance markets would benefit regulators as well as market participants. As the trades are agreed, the smart contract is created. With a node on the networks, the regulators could get all the reporting they need directly, rather than rely on the CSDs or transacting parties to report. Transaction reporting would happen immediately as the trade is agreed and settlements completed with a single golden source of truth. Such digital regulatory reporting would eliminate the inconsistencies in current reporting and give regulators the full, accurate, real-time view of the deals generated directly from the smart contracts. The regulators could be proactive in real-time and not have to deal with delayed, inaccurate or wrongly formatted data as is the case now.
The benefits of smart contracts
Smart contracts will also address other sources of risk and friction in the markets. For example, eligibility schedules can sit directly in smart contract in a consistently interpretable manner, as with the Common Domain Model (CDM) currently. Widespread adoption will mean that algorithmic collateral optimisation tools can then really take advantage to allocate collateral globally in the most efficient way.
DLT-based collateral with integrated networks will allow collateral to move instantly between parties regardless of the location. Contrast that with the current situation where, if you want to move collateral from one venue to another, it is slow, costly, inefficient and with potential to fail causing unintended further costs and credit exposures.
Global firms have to keep significant buffers in multiple locations for intraday liquidity risk and they take on the risk of settlement failures for any cross-venue collateral move or substitution. DLT-based networks will allow collateral to be called, moved and optimised in real time. This would benefit participants in enabling a more efficient asset allocation globally, as well as reducing systemic risk and costs arising from the current operational constraints.
There are further potential benefits, such as less need for a post-trade reconciliation or comparison process, and for the processing of corporate actions as well as the obvious benefits of 24/7 trading and settlement capabilities and atomic settlement. Meanwhile, reduced barriers to entry will open up the capital markets to a greater number of institutions and ultimately enhance overall liquidity.
Overcoming the obstacles
The benefits of moving to a DLT and smart contract future are manifold and manifest, but we also must be realistic. These markets are slow to change, and there are obstacles and entrenched interests that can hold things back.
For one thing, the question of public and private chains will need to be shaken out. We are already now seeing all the major custodian banks have some kind of DLT initiative, which is giving rise to multiple private chains. Some are using commercial bank coins to represent cash; others are operating DVD or FOP only. For the global benefits to be realised, these networks will need to interoperate while still providing all the safety features of regulated ecosystems. That may be in the form of permissioned forms of public chains with central bank digital coins.
We are confident the market will get there and are supporting the initiatives, but we will see how things evolve over the next few years. We are finally getting to the point where a wholesale overhaul of market infrastructure is not only possible but probable. We must applaud the foresight of the regulators to put their faith in the potential of these new technologies and, as a key technology provider to these markets, we are adapting our systems and investing in the future. Getting it right will always trump doing it more quickly.
If this is indeed a desirable end-state, how can the desired levels of certainty really be achieved? In delaying, and perhaps abandoning, mandatory buy-ins while a distributed ledger technology (DLT) pilot is given the chance to prove its mettle, the EU has been bold. We will discuss why we think mandatory buy-ins was a flawed approach and why the DLT pilot, if adopted, can address not only settlement risk, but also a host of other shortcomings.
Controllable risks
Mandatory buy-ins were mooted because markets require confidence to function: confidence in prices, liquidity, and certainty of transactions in terms of commitment to deliver what was promised. Regulators balance free, open and transparent markets with providing sufficient safeguards for controllable risks.
Controllable is the key word because there needs to be some level of risk to justify the returns on offer. No legislation can or should eradicate risk and retain some degree of return; markets cannot exist without a certain amount of both. They must rely on some degree of ‘caveat emptor’ — let the buyer beware — as there will always be investors or traders that cannot be protected from themselves, as many on the losing side of the Terra Luna debacle will attest. So, what are the controllable risks for securities finance, and should we be addressing the symptom or the cause?
Why buy-ins?
The safety net of a buy-in has long been a market feature, but not one that is applied lightly. There are two key reasons for this. The first is that relationships still matter. Undertaking a buy-in has ramifications for future trading, more so in the still relationship-driven world of securities finance compared with the relative anonymity of some other markets. In securities finance, your counterparty is known to you, and it is likely that future trades will be proposed and others in place already. That issue works both ways, of course. Lenders that enact a buy-in too quickly can be just as unpopular as borrowers that fail to return a security on time.
The second reason is market impact. Buy-ins are less likely to occur in a liquid security easily available on the open market, whether to borrow or buy. They are more likely when a security is already difficult to obtain either through an alternative borrow or purchase in an already frothy market. Adding a mandatory buy-in would have simply added to the supply-side pressure with potentially little advantage to the instigator.
These issues are why many market participants and trade associations pushed the European Commission to reconsider the CSDR rules, and in particular mandatory buy-ins. With discretion, market participants can make a call based on the circumstances of the failure to deliver and the prevailing market conditions to determine whether a buy-in is the right path to resolution, or indeed even possible without actually making the overall situation worse.
Understanding the concerns
CSDR already seeks to increase the certainty of settlement through the fines for poor performance or behaviour. The buy-in proposal itself does include criteria upon which it cannot be actioned, such as the bankruptcy of one party or the issuer of the security in question. However, the lack of discretion and self-regulation absent from the buy-in mandates were particularly troubling.
So of the three pillars of CSDR — transaction reporting, cash penalties for settlement fails and mandatory buy-ins — only the first two remain for now. As the CSDs took on reporting, FIS as a primary technology and market data provider to the securities finance markets built our solutions for the second pillar.
On the basis that prevention is always better than cure, we worked hard on integrating these two weapons in our armoury to identify and mitigate failure risks wherever possible. That effort ranges from working with other market infrastructure providers to increase the accuracy of standard settlement instructions, errors of which cause many of the far leg settlement fails in the market, to integrating our intra-day market data into all our systems. This provides early warnings of short squeezes and other liquidity crunches that can bring destabilising effects to the market.
We are now investigating enhancing that with AI-driven predictions for settlement fails. Getting ahead of the game reduces the causes of failures and brings benefits to the broader financial market and all its stakeholders as a result.
We have also provided more automation around partial settlements and holds to ensure these can be accepted, and the fines therefore minimised, if both parties agree. We have added the ability to import and process the fines for maximum straight-through-processing (STP). Some argue that mandating partials would go further to alleviating the problem and our clients can support this right now with automated STP.
Enter the DLT pilot
The third pillar of mandating buy-ins has been delayed, partially in favour of a DLT pilot regime announced by the EU in June. This scheme will test the capabilities of secondary market infrastructure for digital securities covering tokenised traditional securities as well as digital native securities.
The key provisions of this regime are that investment firms can operate a DLT-based multilateral trading facility (DLT MTF) and CSDs can operate a DLT securities settlement system (DLT SS). Interestingly, both can also create a combined DLT trading and settlement system (DLT TSS). The scheme will commence in March 2023 and run for six years. There are limits on the size of the individual securities and issuers and the overall size of the markets, so it really is a pilot — but this kind of adoption would create a technical solution not only for the settlement fails, but for a host of other causes of friction, inefficiency and costs in the current market.
DLT and smart contract-based securities finance markets would benefit regulators as well as market participants. As the trades are agreed, the smart contract is created. With a node on the networks, the regulators could get all the reporting they need directly, rather than rely on the CSDs or transacting parties to report. Transaction reporting would happen immediately as the trade is agreed and settlements completed with a single golden source of truth. Such digital regulatory reporting would eliminate the inconsistencies in current reporting and give regulators the full, accurate, real-time view of the deals generated directly from the smart contracts. The regulators could be proactive in real-time and not have to deal with delayed, inaccurate or wrongly formatted data as is the case now.
The benefits of smart contracts
Smart contracts will also address other sources of risk and friction in the markets. For example, eligibility schedules can sit directly in smart contract in a consistently interpretable manner, as with the Common Domain Model (CDM) currently. Widespread adoption will mean that algorithmic collateral optimisation tools can then really take advantage to allocate collateral globally in the most efficient way.
DLT-based collateral with integrated networks will allow collateral to move instantly between parties regardless of the location. Contrast that with the current situation where, if you want to move collateral from one venue to another, it is slow, costly, inefficient and with potential to fail causing unintended further costs and credit exposures.
Global firms have to keep significant buffers in multiple locations for intraday liquidity risk and they take on the risk of settlement failures for any cross-venue collateral move or substitution. DLT-based networks will allow collateral to be called, moved and optimised in real time. This would benefit participants in enabling a more efficient asset allocation globally, as well as reducing systemic risk and costs arising from the current operational constraints.
There are further potential benefits, such as less need for a post-trade reconciliation or comparison process, and for the processing of corporate actions as well as the obvious benefits of 24/7 trading and settlement capabilities and atomic settlement. Meanwhile, reduced barriers to entry will open up the capital markets to a greater number of institutions and ultimately enhance overall liquidity.
Overcoming the obstacles
The benefits of moving to a DLT and smart contract future are manifold and manifest, but we also must be realistic. These markets are slow to change, and there are obstacles and entrenched interests that can hold things back.
For one thing, the question of public and private chains will need to be shaken out. We are already now seeing all the major custodian banks have some kind of DLT initiative, which is giving rise to multiple private chains. Some are using commercial bank coins to represent cash; others are operating DVD or FOP only. For the global benefits to be realised, these networks will need to interoperate while still providing all the safety features of regulated ecosystems. That may be in the form of permissioned forms of public chains with central bank digital coins.
We are confident the market will get there and are supporting the initiatives, but we will see how things evolve over the next few years. We are finally getting to the point where a wholesale overhaul of market infrastructure is not only possible but probable. We must applaud the foresight of the regulators to put their faith in the potential of these new technologies and, as a key technology provider to these markets, we are adapting our systems and investing in the future. Getting it right will always trump doing it more quickly.
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