In comparison to the US, European corporations tap the capital markets to a much lesser extent, preferring to borrow directly from banks. Settlement inefficiency across the EU is seen as one reason for this and the comprehensive set of measures contained in ESMA’s Central Securities Depository Regulation (CSDR) is an attempt to address this.
This is not a new concept — the drive for reduced settlement cycles and associated sanctions have been gaining momentum for many years. Where CSDR departs from these historical attempts is with the scope and scale of measures to be implemented over multiple years, while attributing significant responsibility to those closest to the process, central securities depositories (CSDs), to police the activity. CSDR adopts an extensive arsenal of “incentives” to motivate market participants to elevate their back and middle-office activities in order to avoid penalty.
This, in turn, could have wide-ranging implications for market participants, particularly in the debt securities market. These regulations could dampen much needed liquidity in this asset class by making it more difficult for borrowers and lenders to efficiently trade bonds, a crucial component for bond market liquidity.
While CSDR will likely achieve improved levels of market settlement, invariably fails will occur. As a result, CSDs, custodians, and both buy-side and sell-side market participants will expend significant effort and investment to develop systems and processes to determine liability and ensure cost is attributed to the responsible party. This is not an insignificant undertaking and is actively ramping up across EU capital markets.
With the reduction of the settlement cycle phase of CSDR under way, assisted with the pan-European T2S initiative, dematerialisation now a household concept, the most significant overhaul of securities settlement will be the new mandatory settlement discipline regime.
Unique Impact on Securities Lending and Borrowing Market
CSDR cash penalties and mandatory buy ins have piqued the interest of the securities lending industry as the market has generally recorded lower settlement efficiency rates than traditional custody. In preparing for CSDR, the industry body International Securities Lending Association (ISLA) conducted a survey which estimated that in 2018, the settlement rates of their membership were between 80-90 percent with the majority of fails being in the return leg of loan. Under CSDR, each of these fails come with additional reporting, mandatory buy in, or even cash penalties. As a result, increasing settlement efficiency across the chain of securities lending has come under increased focus.
While cash penalties, mandatory partial settlements, and buy-ins under CSDR on equity and fixed income cash market transactions have been included in other regulations, the inclusion of securities lending transactions as covered transactions is new to the industry. For the first time in any market, timely settlement of securities loans will be subject to enforcement mechanisms. New loans and loan returns will incur penalties if not consummated on “intended settlement date.” However, there is an exception from the mandatory buy-in regime for loans with a term of less than 30 days, presumably included in the final rule to recognize the importance of securities lending to trading liquidity. As a largely over-the-counter, bilaterally traded product, the securities lending industry may be prone to higher levels of settlement failure and therefore require more extensive remediation than cash market transactions.
CSDR will also bring focus to another area of securities lending operations, the process of recalling loans back from borrowers. In the event the timely settlement of a cash market transaction is reliant on the prompt termination of a securities loan, regulators and market participants will apply greater scrutiny. Ultimately, the alignment of loan return time frames with intended trade settlement dates will be key in ensuring that securities lending does not contribute to sell fails and associated penalties.
With respect to debt securities, CSDR has the potential to reduce market participation both from the lender and borrower perspective. Generally, trading liquidity on corporate bonds is lower than equity shares and therefore they may be subject to higher settlement failure rates. This dynamic, combined with the prospect of cash penalties and mandatory buy in, may result in borrowers deciding to pull back from lending, reducing demand for borrowed bonds and eliminating a revenue source relied upon by beneficial owners. Lower participation in securities lending could further reduce market liquidity and exacerbate failure rates which would be an unintended and ironic consequence given the goal of the regulation. This outcome is by no means certain but is not unrealistic should penalties exceed the aggregate benefits provided by the lending of corporate bonds.
What is the extent of the impact to the Securities Lending Middle Office?
Ahead of implementation, many securities lending operations teams are bracing themselves for the day-to-day reporting requirement changes, voicing potential pitfalls, and advocating for industry best practices.
As the imposition of cash penalties by CSDs will become the norm, the management of the identification, reconciliation, and allocation will become the responsibility of each market participant. Given the prevalence of multiple stakeholders in the lending industry such as the lending agent, borrower, and custodian – the identification of the “offending” participant will not be obvious to a CSD. The ultimate application of penalties and costs will encourage participants to enhance operational processes and ensure systems and data are accurate to ensure that trades do not fail for the most basic of reasons. It is for this reason that many industry participants are advocating for industry best practices to include pre-matching of trades. The use of third-party vendors for such pre-matching services in a consistent manner could address needed standardization to close some settlement gaps that exist today.
Other areas of review currently by securities lending market participants include timing of trade bookings, time zone issues, and collateral management efficiency. This is driving many to review their current operating models to ensure they are efficient and don’t fall foul of delays or errors.
Watch this Space
No doubt there will be extensive consideration and consternation over the next year regarding CSDR, given the broad impact of the regulation – all of which takes effect in 13 months. The key is to start planning early for the application of these settlement discipline rules in mid-September 2020. With research and analysis to be undertaken on current levels of settlement efficiency that will provoke codifying new processes, clarifying responsibilities, and documenting expectations, not to mention any investments in technology that firms may need to consider, the coming months contain a full implementation agenda. The impact is global and as key milestones and deliverables approach, the market may start to adjust itself to prepare for increased buy-in activity as participants brace themselves for unexpected discipline costs. The good news is CSDR is on the front of minds for most market participants and trade associations who are actively working towards the regulatory intention of more efficient market operation.
The article was authored in conjunction with BBH Senior Vice President Tom Poppey.