Questions of settlement
16 April 2024
When CSDR was first introduced, it led to ongoing debate and revisions. Where does the question of settlement stand now? Sophie Downes reports
Image: stock.adobe/Calima
The Settlement Discipline Regime, implemented on 1 February 2022, saw the introduction of cash penalties and settlement fails reporting — with mandatory buy-ins being postponed until 2025. Two years later, various elements of the settlement cycle remain contested topics of discussion.
Most recently, this issue was illustrated by the contrary opinions of two industry associations. In December, the European Securities and Markets Authority (ESMA) published a series of proposals, predominantly concerned with increasing penalty rates for settlement fails.
The damning response of the International Capital Market Association (ICMA), in return, highlighted both the intricacies of enforcing new regulation and the vital need for industry collaboration.
As the US market prepares to move to T+1 – and with Europe eagerly looking to follow – the new proposals offer a valuable opportunity to tease out inefficiencies in the settlement cycle.
Timeline
Implementing the Central Securities Depositories Regulation (CSDR) has been a protracted process.
Originally introduced in 2014, CSDR aimed to increase settlement efficiency by providing common requirements for central securities depositories (CSDs) operating settlement systems across the EU.
These stipulations were amended in March 2022, when CSDR Refit was issued to simplify the application of the regulation. However, in the typically deliberative method of implementing regulation, CSDR Refit only entered into force on 16 January 2024, with its provisions being staggered until 2026.
How has this affected market players?
For Gabi Mantle, global head of post-trade solutions at EquiLend, the impact of the framework was tangible. “We have noticed a huge shift in the lead up to CSDR, as the focus on intraday risk has landed in the front office,” she says. “If the exception is not managed quickly enough, there is now a true impact to their profit and loss with the CSDR penalty.”
The shift in responsibility has meant EquiLend has had to evolve to work in line with the back and front office, as demonstrated by its suite of solutions. The firm launched its risk resolution suite, R2S, in 2023, consolidating its Recalls, Returns and Settlement Monitor services into one platform. Mantle highlights the extensive attention the product was given because of the way in which it helped its clients to identify risk of CSDR penalties and prevent them from happening.
However, CSDR Refit was not the last of the subject. With many of its stipulations being staggered in implementation, consultations among market participants are a pivotal part of the puzzle.
In December 2023, ESMA published its Consultation Paper on Technical Advice on CSDR Penalty Mechanism, with the purpose of collecting views and data from stakeholders on the effectiveness of the current CSDR penalty mechanism, and on ESMA’s preliminary proposals.
The measure inciting criticism was ESMA’s suggestion on penalties, in which it proposed increasing the penalty rates for settlement fails and introducing ‘progressive penalties’ that rose each subsequent day of the fail.
‘Disproportionate and unjustified’
The response from ICMA is frank.
Emphasising the extent of its concern, the association states the proposals are “unsupported by any data or analysis, [are] out of line with any equivalent market rates and are clearly disproportionate in their punition”. ICMA contends that if these proposals were implemented, they would have a detrimental impact on market pricing and liquidity, thereby undermining the competitiveness of the EU as a global financial market.
“While ICMA has always supported the possible justification for a penalty mechanism, particularly in very low interest rate environments, it has equally maintained that there are far more targeted, proportionate and impactful tools for improving and maintaining settlement efficiency in the EU,” reads the association’s feedback.
ICMA warns: “Anything that systematically distorts markets by creating disproportionate costs and risks to participants will also create adverse behavioural incentives.”
In the context of ESMA’s increasing penalties, this would suggest being failed-to would become a more profitable option. As the response highlights, the economic benefit from not receiving a security would often be greater than the returns from the security itself.
Indeed, there would be a strong incentive for the purchasing party not to accept partial delivery, but to wait for full delivery, enabling them to make high returns from the proposed penalty rates. The argument validates ICMA’s belief that extreme penalties could result in greater profits and longer duration fails.
Mantle sheds light onto the vastly different takes on ESMA’s proposals. “Market participants are built slightly differently. There is also a big difference depending on where you sit in an organisation.”
As a result, the impact to securities finance could be construed as very different to the impact on cash equities.
However, this is not a new phenomenon. As Mantle observes: “It has always been a huge challenge to navigate with any proposals, whitepapers or changes in regulation. There are so many different areas that will be impacted, all of whom have slightly different agendas and viewpoints.”
Be that as it may, ICMA’s opinion is resoundingly clear: the proposals should not be used as a basis for developing policy.
Instead, ICMA says the associations should concentrate on more proportionate and targeted tools – definitely not the “highly punitive and market-distorting ‘settlement discipline’ measures” proposed by ESMA.
An open stance
When Securities Finance Times reached out to ESMA about the conflicting reaction to the proposals, the Authority gave a diplomatic response.
A spokesperson from the market authority described how the proposals outlined in the consultation paper were created “to provoke discussion and encourage stakeholders to provide valuable input for refining penalty rates”.
“It was anticipated that there would be different positions, given the nature of the topic,” they continued. “ESMA maintains an open stance.”
A more comprehensive response can be expected in the longer term, with the association aiming to present the final technical advice to the European Commission on 30 September 2024. In the meantime, the data and feedback provided by market participants will have to be carefully assessed and aggregated.
While September may seem fairly distant, for firms, the focus on CSDR is prevalent and lingering. With questions of T+1 looming, Mantle emphasises the opportunity that the framework provides for increasing settlement efficiency. It is prudent to consider these questions now, she argues, particularly from an economic perspective – “settlement inefficiency equals CSDR penalties”.
The framework allows the UK accelerator settlement task force to see where there are gaps in the market and where improvements can be made within the settlement cycle. For Mantle, this is vital. “The risk is, we move to T+1 with gaps in processing and with challenges that market participants are facing today. And T+1 will not go as smoothly as it should,” she warns.
Such issues could be mitigated by refining CSDR even further — a proposition which Mantle embraces with fervour: "Let us use this as an opportunity to mandate some changes in behaviour, to push the best practices and to really take better advantage of the automation that is there.”
Most recently, this issue was illustrated by the contrary opinions of two industry associations. In December, the European Securities and Markets Authority (ESMA) published a series of proposals, predominantly concerned with increasing penalty rates for settlement fails.
The damning response of the International Capital Market Association (ICMA), in return, highlighted both the intricacies of enforcing new regulation and the vital need for industry collaboration.
As the US market prepares to move to T+1 – and with Europe eagerly looking to follow – the new proposals offer a valuable opportunity to tease out inefficiencies in the settlement cycle.
Timeline
Implementing the Central Securities Depositories Regulation (CSDR) has been a protracted process.
Originally introduced in 2014, CSDR aimed to increase settlement efficiency by providing common requirements for central securities depositories (CSDs) operating settlement systems across the EU.
These stipulations were amended in March 2022, when CSDR Refit was issued to simplify the application of the regulation. However, in the typically deliberative method of implementing regulation, CSDR Refit only entered into force on 16 January 2024, with its provisions being staggered until 2026.
How has this affected market players?
For Gabi Mantle, global head of post-trade solutions at EquiLend, the impact of the framework was tangible. “We have noticed a huge shift in the lead up to CSDR, as the focus on intraday risk has landed in the front office,” she says. “If the exception is not managed quickly enough, there is now a true impact to their profit and loss with the CSDR penalty.”
The shift in responsibility has meant EquiLend has had to evolve to work in line with the back and front office, as demonstrated by its suite of solutions. The firm launched its risk resolution suite, R2S, in 2023, consolidating its Recalls, Returns and Settlement Monitor services into one platform. Mantle highlights the extensive attention the product was given because of the way in which it helped its clients to identify risk of CSDR penalties and prevent them from happening.
However, CSDR Refit was not the last of the subject. With many of its stipulations being staggered in implementation, consultations among market participants are a pivotal part of the puzzle.
In December 2023, ESMA published its Consultation Paper on Technical Advice on CSDR Penalty Mechanism, with the purpose of collecting views and data from stakeholders on the effectiveness of the current CSDR penalty mechanism, and on ESMA’s preliminary proposals.
The measure inciting criticism was ESMA’s suggestion on penalties, in which it proposed increasing the penalty rates for settlement fails and introducing ‘progressive penalties’ that rose each subsequent day of the fail.
‘Disproportionate and unjustified’
The response from ICMA is frank.
Emphasising the extent of its concern, the association states the proposals are “unsupported by any data or analysis, [are] out of line with any equivalent market rates and are clearly disproportionate in their punition”. ICMA contends that if these proposals were implemented, they would have a detrimental impact on market pricing and liquidity, thereby undermining the competitiveness of the EU as a global financial market.
“While ICMA has always supported the possible justification for a penalty mechanism, particularly in very low interest rate environments, it has equally maintained that there are far more targeted, proportionate and impactful tools for improving and maintaining settlement efficiency in the EU,” reads the association’s feedback.
ICMA warns: “Anything that systematically distorts markets by creating disproportionate costs and risks to participants will also create adverse behavioural incentives.”
In the context of ESMA’s increasing penalties, this would suggest being failed-to would become a more profitable option. As the response highlights, the economic benefit from not receiving a security would often be greater than the returns from the security itself.
Indeed, there would be a strong incentive for the purchasing party not to accept partial delivery, but to wait for full delivery, enabling them to make high returns from the proposed penalty rates. The argument validates ICMA’s belief that extreme penalties could result in greater profits and longer duration fails.
Mantle sheds light onto the vastly different takes on ESMA’s proposals. “Market participants are built slightly differently. There is also a big difference depending on where you sit in an organisation.”
As a result, the impact to securities finance could be construed as very different to the impact on cash equities.
However, this is not a new phenomenon. As Mantle observes: “It has always been a huge challenge to navigate with any proposals, whitepapers or changes in regulation. There are so many different areas that will be impacted, all of whom have slightly different agendas and viewpoints.”
Be that as it may, ICMA’s opinion is resoundingly clear: the proposals should not be used as a basis for developing policy.
Instead, ICMA says the associations should concentrate on more proportionate and targeted tools – definitely not the “highly punitive and market-distorting ‘settlement discipline’ measures” proposed by ESMA.
An open stance
When Securities Finance Times reached out to ESMA about the conflicting reaction to the proposals, the Authority gave a diplomatic response.
A spokesperson from the market authority described how the proposals outlined in the consultation paper were created “to provoke discussion and encourage stakeholders to provide valuable input for refining penalty rates”.
“It was anticipated that there would be different positions, given the nature of the topic,” they continued. “ESMA maintains an open stance.”
A more comprehensive response can be expected in the longer term, with the association aiming to present the final technical advice to the European Commission on 30 September 2024. In the meantime, the data and feedback provided by market participants will have to be carefully assessed and aggregated.
While September may seem fairly distant, for firms, the focus on CSDR is prevalent and lingering. With questions of T+1 looming, Mantle emphasises the opportunity that the framework provides for increasing settlement efficiency. It is prudent to consider these questions now, she argues, particularly from an economic perspective – “settlement inefficiency equals CSDR penalties”.
The framework allows the UK accelerator settlement task force to see where there are gaps in the market and where improvements can be made within the settlement cycle. For Mantle, this is vital. “The risk is, we move to T+1 with gaps in processing and with challenges that market participants are facing today. And T+1 will not go as smoothly as it should,” she warns.
Such issues could be mitigated by refining CSDR even further — a proposition which Mantle embraces with fervour: "Let us use this as an opportunity to mandate some changes in behaviour, to push the best practices and to really take better advantage of the automation that is there.”
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