A moveable feast
January 06 2018
As the implementation of CSDR in the EU introduces new challenges for investors, more clients are becoming aware of the issues involved
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The Central Securities Depository Regulation (CSDR), currently creeping into institutional consciousness throughout the EU, throws up a range of challenges.
Pierre Colladon, senior adviser in strategy for Markets Infrastructures at Societe Generale Securities Services (SGSS), ticks off a list of other items covered by CSDR, including the freedom around choosing a central securities depository (CSD) for issuers, harmonisation of settlement cycles and the immobilisation or dematerialisation of securities.
All pose a challenge of one kind or another, he stresses. Potentially all stakeholders from the investor to the issuer will feel some impact, through all the intermediaries and market infrastructures affected by the regulation. He believes that competition should increase, especially due to the conjunction of both CSDR and Target2 Securities (T2S), the latter being a strong catalyst for harmonisation.
He explains: 鈥淭he new context, characterised by increased harmonisation and standardisation, but also weight of implementation costs and increased competition should foster consolidation among CSDs. Let鈥檚 remind ourselves that there are about 42 CSDs and securities settlement systems in Europe, while there is only one in the US.鈥�
He views the opportunities that this situation presents for consolidation as a positive.
While consolidation in itself would be a positive regarding economies of scale and increased efficiencies, some market participants question whether it will ever happen. In all cases, it is up to individual local regulators to regulate their relevant local entity and rather than see consolidation, fragmentation is more likely to occur as local regulators insist that the destiny of its local CSD should remain in the CSD鈥檚 own hands. As with airlines, there is a lot of flag-waving national pride involved for countries in having their own CSD.
Not all challenges are equal, as Marc Robert-Nicoud, CEO of Clearstream Holding, explains. He characterises the objectives and impact of CSDR as either fundamental or marginal, depending on the nature of the entities involved.
鈥淔or CSDs it is big,鈥� he says, 鈥渋t touches everything we do from governance to reconciliation, so it has massive implications regarding management time and the scale of investment needed.鈥�
According to Robert-Nicoud, clients, too, are becoming more aware of the issues involved.
He adds: 鈥淚f, for example, you are an issuer and you want to be part of the system, you will need a legal entity identifier. If you are a transfer agent, you鈥檒l need to do daily reconciliation. And if you are a client using a CSD鈥檚 banking services, you will see changes in the way your CSD is providing the services regarding credit, collateral and haircuts on that collateral. I don鈥檛 think it is a piece of legislation that will create significant new costs for clients, but they will certainly see change.鈥�
The provision for a CSD to acquire a banking licence remains controversial, as Colladon, makes clear.
He suggests: 鈥淐SDR, unfortunately, has opened the possibility for CSDs to provide custodial services and apply for a banking license, and become what is called 鈥淚nvestor CSDs鈥� aside from their traditional status of 鈥榠ssuer CSDs鈥�. We, as do other global custodians, consider this situation as potentially damaging for the industry. It distorts both the risk profile of financial market infrastructures (FMIs) that are at the same time designated as systemic and the level playing field as it allows CSDs to compete with their participants, without having to always comply with the same constraints.鈥�
Robert-Nicoud points out that a detailed, comprehensive summary of the main elements of CSDR can be found in a Clearstream customer briefing brochure, produced in May last year as a guide to what it sees as the key features of CSDR.
Ina Budh-Raja, head of regulatory affairs for securities finance Europe, the Middle East and Africa (EMEA), State Street, directs the attention towards the impact of CSDR on participants in the securities lending and repo markets, including agent lenders and possibly broker-dealers. The impact on securities lending is broadly twofold, she says.
Budh-Raja explains: 鈥淔irstly the proposed settlement regime imposes penalties on fails and a mandatory buy-in regime. We are of course supportive of the objectives of this regulation, seeking to streamline settlement processes and reduce the number of fails in the market, thereby improving market efficiency.
She adds: 鈥淏ut what is potentially concerning is how the impact of the new settlement regime will play out in practical terms and whether certain unintended consequences of the regulation could obstruct the intended objectives aiming to reduce fail rates. By way of example, if the penalty regime is implemented as proposed, the cost of failing imposed by the regulation may well be significantly lower than the cost of buying in. Commercially it may, therefore, appear more attractive to face a penalty for a failed trade, rather than execute a buy-in, by factoring in penalty costs into the price of loans at the outset.鈥�
鈥淚ronically, rather than increasing market efficiency, the regulation could be rendered ineffective in this space, resulting in no decrease in failed trade rates and potentially an increase, where participants seek to incorporate fail penalties into the cost of doing business.鈥�
鈥淭his is only a potential outcome, however, and the commercial choices need to be balanced with the realities of regulatory expectations, reputational risk and the standards of conduct expected of the market. In December 2017, State Street鈥檚 securities finance business in EMEA adhered to the Bank of England鈥檚 Money Market Code of Conduct, which sets out an ethical and conduct based framework for UK market participants in the securities lending and repo markets.鈥�
Budh-Raja says: 鈥淭he code is principles-based and provides practical examples of the standards to be maintained by UK participants, of these, it stipulates that the market should be seeking to minimise and avoid fails. It would be hard to argue in practice that a commercial strategy pricing fails into the business would viably fall within the cultural and market conduct expectations on market participants operative in the securities market today.鈥�
鈥淔urthermore, agent lenders have a duty to act in the best interests of their clients, so from a regulatory and conduct perspective, adherence to the Bank of England Code and other relevant regulations is paramount; therefore a mandatory buy-in process may be more costly than failing and could appear in the short term to generate lower revenue for clients, but compliance will lead ultimately to the more regulatory-robust outcome, enhancing market stability and creating longer-term benefits to clients.鈥�
The mandatory buy-in regime has also given rise to market concerns around liquidity, according to Budh-Raja. While intending to improve settlement efficiencies and harmonise settlement discipline across the EU, she says it is feared that the mandatory buy-in regime may inadvertently result in a material shortage on liquidity in the market, leading ultimately to potential market strain and a reduction in securities lending, if indeed participants choose to withdraw from the market.
Mark Jones, the new head of EMEA securities lending at Northern Trust, broadly agrees: 鈥淭he primary challenge [of CSDR] probably comes from the proposed settlement discipline regime including mandatory buy-ins and settlement penalties.鈥�
鈥淲hile settlement efficiency and minimising impact to our client鈥檚 investment activity is already a key aspect of the way we manage our lending programme; there will need to be an increased focus on this. One potential unintended consequence could be a decrease in liquidity in the lending space as agents take a more conservative view and hold larger 鈥榖uffer鈥� positions to protect against sales, or in a worst case, beneficial owners regard the increased risk as significant enough to withdraw their assets from lending programmes. This could be to the detriment of the settlement efficiency that is one of the aims of the regulation.鈥�
Budh-Raja also suggests that the settlement internalisation regime, as proposed under the draft regulation, could present significant challenges for securities lending. She points out that the scope of this regime is not yet confirmed and publication of the final guidelines by ESMA is expected imminently.
She explains: 鈥淎t present, the draft regulation includes lending transaction reallocations and collateral reallocation within the scope of the reporting regime. While we support the enhanced transparency which this reporting will bring, it is not yet clear where the delineation with the forthcoming Securities Financing Transactions Regulation (SFTR) lies.鈥�
鈥淕iven that SFTR article 4 transaction reporting requirements will be active in 2019, the same proposed timeline as CSDR implementation, the securities lending and repo market are undergoing significant transformation as firms now invest large amounts of resources to address the technology build required to meet very extensive SFTR transaction reporting criteria. Amongst the 150 plus data fields, which make up SFTR reporting, all collateral and lifecycle events will be reported on a T+1 basis, and therefore, competent authorities would have detailed visibility of these transactions.鈥�
鈥淐apturing this data in the CSDR regime could result in duplicative reporting requirements, with firms having to increase spend on building systems which provide essentially the same information to the same competent authority as will be provided for SFTR purposes, but in a different reporting format. In an already resource-stretched market, duplication of this nature may have a material impact on the cost of doing business going forward,鈥� she says.
Robert-Nicoud brings the current conversation to a close with his own words of caution: 鈥淭here are a lot of moving pieces within CSDR, and if we become more efficient, this will take cost and risk out of the market. But there are certain elements yet to be decided. Like every European regulation it has to be turned into technical standards and a few points of interpretation remain open for discussion. Regulators are currently aligning their views, and it is important that we do not introduce conflicting requirements during that process.鈥�
Implementation is a moveable feast, and Clearstream says its CSDs have submitted their applications for the relevant CSDR operating licences. The process involved each of the Clearstream CSDs applying for authorisation to the relevant National Competent Authorities in Germany or Luxembourg. It expects to receive its authorisation in early 2019, says Robert-Nicoud.
Pierre Colladon, senior adviser in strategy for Markets Infrastructures at Societe Generale Securities Services (SGSS), ticks off a list of other items covered by CSDR, including the freedom around choosing a central securities depository (CSD) for issuers, harmonisation of settlement cycles and the immobilisation or dematerialisation of securities.
All pose a challenge of one kind or another, he stresses. Potentially all stakeholders from the investor to the issuer will feel some impact, through all the intermediaries and market infrastructures affected by the regulation. He believes that competition should increase, especially due to the conjunction of both CSDR and Target2 Securities (T2S), the latter being a strong catalyst for harmonisation.
He explains: 鈥淭he new context, characterised by increased harmonisation and standardisation, but also weight of implementation costs and increased competition should foster consolidation among CSDs. Let鈥檚 remind ourselves that there are about 42 CSDs and securities settlement systems in Europe, while there is only one in the US.鈥�
He views the opportunities that this situation presents for consolidation as a positive.
While consolidation in itself would be a positive regarding economies of scale and increased efficiencies, some market participants question whether it will ever happen. In all cases, it is up to individual local regulators to regulate their relevant local entity and rather than see consolidation, fragmentation is more likely to occur as local regulators insist that the destiny of its local CSD should remain in the CSD鈥檚 own hands. As with airlines, there is a lot of flag-waving national pride involved for countries in having their own CSD.
Not all challenges are equal, as Marc Robert-Nicoud, CEO of Clearstream Holding, explains. He characterises the objectives and impact of CSDR as either fundamental or marginal, depending on the nature of the entities involved.
鈥淔or CSDs it is big,鈥� he says, 鈥渋t touches everything we do from governance to reconciliation, so it has massive implications regarding management time and the scale of investment needed.鈥�
According to Robert-Nicoud, clients, too, are becoming more aware of the issues involved.
He adds: 鈥淚f, for example, you are an issuer and you want to be part of the system, you will need a legal entity identifier. If you are a transfer agent, you鈥檒l need to do daily reconciliation. And if you are a client using a CSD鈥檚 banking services, you will see changes in the way your CSD is providing the services regarding credit, collateral and haircuts on that collateral. I don鈥檛 think it is a piece of legislation that will create significant new costs for clients, but they will certainly see change.鈥�
The provision for a CSD to acquire a banking licence remains controversial, as Colladon, makes clear.
He suggests: 鈥淐SDR, unfortunately, has opened the possibility for CSDs to provide custodial services and apply for a banking license, and become what is called 鈥淚nvestor CSDs鈥� aside from their traditional status of 鈥榠ssuer CSDs鈥�. We, as do other global custodians, consider this situation as potentially damaging for the industry. It distorts both the risk profile of financial market infrastructures (FMIs) that are at the same time designated as systemic and the level playing field as it allows CSDs to compete with their participants, without having to always comply with the same constraints.鈥�
Robert-Nicoud points out that a detailed, comprehensive summary of the main elements of CSDR can be found in a Clearstream customer briefing brochure, produced in May last year as a guide to what it sees as the key features of CSDR.
Ina Budh-Raja, head of regulatory affairs for securities finance Europe, the Middle East and Africa (EMEA), State Street, directs the attention towards the impact of CSDR on participants in the securities lending and repo markets, including agent lenders and possibly broker-dealers. The impact on securities lending is broadly twofold, she says.
Budh-Raja explains: 鈥淔irstly the proposed settlement regime imposes penalties on fails and a mandatory buy-in regime. We are of course supportive of the objectives of this regulation, seeking to streamline settlement processes and reduce the number of fails in the market, thereby improving market efficiency.
She adds: 鈥淏ut what is potentially concerning is how the impact of the new settlement regime will play out in practical terms and whether certain unintended consequences of the regulation could obstruct the intended objectives aiming to reduce fail rates. By way of example, if the penalty regime is implemented as proposed, the cost of failing imposed by the regulation may well be significantly lower than the cost of buying in. Commercially it may, therefore, appear more attractive to face a penalty for a failed trade, rather than execute a buy-in, by factoring in penalty costs into the price of loans at the outset.鈥�
鈥淚ronically, rather than increasing market efficiency, the regulation could be rendered ineffective in this space, resulting in no decrease in failed trade rates and potentially an increase, where participants seek to incorporate fail penalties into the cost of doing business.鈥�
鈥淭his is only a potential outcome, however, and the commercial choices need to be balanced with the realities of regulatory expectations, reputational risk and the standards of conduct expected of the market. In December 2017, State Street鈥檚 securities finance business in EMEA adhered to the Bank of England鈥檚 Money Market Code of Conduct, which sets out an ethical and conduct based framework for UK market participants in the securities lending and repo markets.鈥�
Budh-Raja says: 鈥淭he code is principles-based and provides practical examples of the standards to be maintained by UK participants, of these, it stipulates that the market should be seeking to minimise and avoid fails. It would be hard to argue in practice that a commercial strategy pricing fails into the business would viably fall within the cultural and market conduct expectations on market participants operative in the securities market today.鈥�
鈥淔urthermore, agent lenders have a duty to act in the best interests of their clients, so from a regulatory and conduct perspective, adherence to the Bank of England Code and other relevant regulations is paramount; therefore a mandatory buy-in process may be more costly than failing and could appear in the short term to generate lower revenue for clients, but compliance will lead ultimately to the more regulatory-robust outcome, enhancing market stability and creating longer-term benefits to clients.鈥�
The mandatory buy-in regime has also given rise to market concerns around liquidity, according to Budh-Raja. While intending to improve settlement efficiencies and harmonise settlement discipline across the EU, she says it is feared that the mandatory buy-in regime may inadvertently result in a material shortage on liquidity in the market, leading ultimately to potential market strain and a reduction in securities lending, if indeed participants choose to withdraw from the market.
Mark Jones, the new head of EMEA securities lending at Northern Trust, broadly agrees: 鈥淭he primary challenge [of CSDR] probably comes from the proposed settlement discipline regime including mandatory buy-ins and settlement penalties.鈥�
鈥淲hile settlement efficiency and minimising impact to our client鈥檚 investment activity is already a key aspect of the way we manage our lending programme; there will need to be an increased focus on this. One potential unintended consequence could be a decrease in liquidity in the lending space as agents take a more conservative view and hold larger 鈥榖uffer鈥� positions to protect against sales, or in a worst case, beneficial owners regard the increased risk as significant enough to withdraw their assets from lending programmes. This could be to the detriment of the settlement efficiency that is one of the aims of the regulation.鈥�
Budh-Raja also suggests that the settlement internalisation regime, as proposed under the draft regulation, could present significant challenges for securities lending. She points out that the scope of this regime is not yet confirmed and publication of the final guidelines by ESMA is expected imminently.
She explains: 鈥淎t present, the draft regulation includes lending transaction reallocations and collateral reallocation within the scope of the reporting regime. While we support the enhanced transparency which this reporting will bring, it is not yet clear where the delineation with the forthcoming Securities Financing Transactions Regulation (SFTR) lies.鈥�
鈥淕iven that SFTR article 4 transaction reporting requirements will be active in 2019, the same proposed timeline as CSDR implementation, the securities lending and repo market are undergoing significant transformation as firms now invest large amounts of resources to address the technology build required to meet very extensive SFTR transaction reporting criteria. Amongst the 150 plus data fields, which make up SFTR reporting, all collateral and lifecycle events will be reported on a T+1 basis, and therefore, competent authorities would have detailed visibility of these transactions.鈥�
鈥淐apturing this data in the CSDR regime could result in duplicative reporting requirements, with firms having to increase spend on building systems which provide essentially the same information to the same competent authority as will be provided for SFTR purposes, but in a different reporting format. In an already resource-stretched market, duplication of this nature may have a material impact on the cost of doing business going forward,鈥� she says.
Robert-Nicoud brings the current conversation to a close with his own words of caution: 鈥淭here are a lot of moving pieces within CSDR, and if we become more efficient, this will take cost and risk out of the market. But there are certain elements yet to be decided. Like every European regulation it has to be turned into technical standards and a few points of interpretation remain open for discussion. Regulators are currently aligning their views, and it is important that we do not introduce conflicting requirements during that process.鈥�
Implementation is a moveable feast, and Clearstream says its CSDs have submitted their applications for the relevant CSDR operating licences. The process involved each of the Clearstream CSDs applying for authorisation to the relevant National Competent Authorities in Germany or Luxembourg. It expects to receive its authorisation in early 2019, says Robert-Nicoud.
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