Matt Johnson, DTCC Associate Director, ITP Product Management
CSDR’s Settlement Discipline Regime could expose Asian firms to settlement failure penalties on their trades with EU counterparties, writes DTCC’s Matt Johnson.
The Central Securities Depositories Regulation (CSDR) entered into force in 2014, with the aim of harmonising the authorisation and supervision of central security depositories (CSDs) across the EU and to improve settlement discipline in the securities settlement systems that CSDs operate.
Come February 2021, however, when the Settlement Discipline Regime (SDR) component of CSDR is due to go live, some firms in Asia and other regions will come into scope as well. This includes those that trade with firms in the EU and those that trade in EU-domiciled securities. SDR primarily affects non-EU/EEA-domiciled trading entities in Asia such as investment and asset managers, hedge funds, banks and broker-dealers.
SDR is designed to make settlements more efficient and will include cash penalties for trade fails. This means that CSDs will have to pass failed trade penalty charges on to their participants – the custodians or the broker-dealers. At the same time, mandatory buy-ins mean that firms are now legally obligated to buy-in a failing party should a transaction fail over a specific period.
In the coming months, it is important that firms in Asia assess their exposure to SDR and prepare for its implementation. This includes assessing their level of exposure to European markets in terms of concentration of assets in the region and evaluating the impact of mandatory buy-ins while keeping in mind the contextual differences between the ESMA-decreed CSDR and Asia’s traditionally strict culture of settlement discipline.
Asia’s strict culture of settlement discipline
Before examining the factors that influence the exposure of Asian buy-side firms to SDR, it is useful to delve into how SDR will benefit buy-side firms in Asia and how SDR’s implementation will differ from the existing culture of settlement discipline in the region.
CSDR’s unofficial – but obvious – aim is to raise settlement rates from the current 97% to 97.5%, to more than 99%. This would bring Europe closer to the prevailing rates in Asia, where fails are almost unheard of. By raising these rates, Asian firms that trade with counterparties in the EU or that trade in EU-domiciled securities stand to gain from greater settlement efficiency.
To maximise these benefits, however, it is necessary for these firms to keep in mind that CSDR emphasises self-regulation.
What this means in effect is that Asian firms will have to rely on counterparties in Europe to be fully compliant with SDR and could face settlement failure penalties on their investments from Asia if this is not the case. This contrasts with what Asian firms are used to in their own markets, where domestic CSDs or stock exchanges typically take ownership of processing buy-ins.
CSDR imposes a mandatory buy-in process on any financial instrument which has not been delivered within a set period after the intended settlement date. In the event of a settlement fail, the buy-in process mandates the buyer to source the securities elsewhere, cancel the original instruction(s) and settle with the new counterparty. Any difference arising from the net costs of the original transaction and the buy-in transaction will be passed onto the original failing party.
Under CSDR, firms (or purchasing counterparties) cannot rely on the infrastructure (i.e. a CSD or stock exchange) to handle buy-ins for them. Rather, they will have to execute buy-ins through an execution or buy-in agent. In effect, CSDR pushes the buy-in obligation on to the trade participants.
While there are different extension periods before a buy-in is effective – seven to 15 days for illiquid instruments and four days for liquid instruments – the purchasing counterparty will have to buy-in the selling counterparty through a buy-in execution agent.
What this means for parties such as Asian fund managers is that by trading in a security that settles on a European-based CSD, they will potentially need to engage in buy-ins as a result of the selling counterparty’s failure to settle the trade.
With only one execution agent currently available in Europe there will be significant concentration risk for Asian firms, especially considering that there are 2,500 to 3,000 buy-side firms in Europe that would also be relying on the same agent. That aside, there are also potential complications arising from time differences.
Understanding exposure to Europe
For an Asian asset management firm trading in EU-domiciled instruments, the post-trade network for the firm can vary in complexity. The firm might potentially rely on: 1) a single custodian; or 2) a network of sub-agents that report into a single custodian for compliance with SDR.
For example, an asset management firm in Tokyo might rely on a global custodian to handle stock trades but that custodian might not have the necessary clearance to conduct business in Europe. As such, the firm would have to turn to a sub-agent to handle the final settlement. Each time an additional party is involved, it’s an additional spoke in the wheel that adds greater complexity, potential delay and points of failure to settlements.
With just a few months to go, therefore, it would be a useful exercise for Asian firms to examine what their current fail rate looks like, determine where fails with EU counterparties are occurring and identify whether responsibility for these failures lies with them or with their European counterparty. This way, a firm should be able to assess the risk and potential fines and penalties it is exposed to when SDR goes live.
Technical readiness cannot be ignored
While, so far, the case for operational readiness – insofar as understanding a firm’s own settlement efficiency, underlying requirements of the regulation and the regulation’s impact on a firm’s operations is concerned – has been outlined, technical readiness is another area in which firms have to consider.
Technical readiness for CSDR means ensuring one’s IT systems are equipped to handle the requirements of SDR, including being able to accept changes to SWIFT messages and reporting requirements being implemented to support the new regulations.
Ultimately, if a firm prevents trades from failing, it has nothing to worry about with regard to SDR. Many institutional trade processing and automation tools are available that can help optimise clearing and settlements and prevent failures, and there is no better time than now – with months left to go before the expected implementation of SDR – to explore these tools.