Upgrade to CSDR penalty mechanism under scrutiny
07 January 2025
Daniel Tison explores how the proposed changes to the Central Securities Depositories Regulation could improve the EU鈥檚 settlement efficiency ahead of the shift to T+1
Image: stock.adobe.com/Alice a
In the complex landscape of securities finance, settlement efficiency is the backbone of stability. Over the past decade, the European Securities and Markets Authority (ESMA) has been on a mission to reduce settlement fails 鈥� a challenge that continues to test the resilience of Europe鈥檚 capital markets.
With the publication of its final report providing technical advice on the penalty mechanism under the Central Securities Depositories Regulation (CSDR), ESMA aims to help the European Commission sharpen its tools to ensure a smoother, more reliable settlement process. However, how effective can penalties be in driving real change?
Framing the challenge
Every failed settlement has a ripple effect. In its report, ESMA explains that beyond the immediate impact of delayed transactions, persistent settlement fails negatively affect the functioning and competitiveness of the capital markets.
This contradicts the objectives of the Savings and Investments Union, which is an EU concept aimed at strengthening the union鈥檚 financial ecosystem by improving the connection between savers and investors.
CSDR, also known as Regulation No 909/2014, includes a set of disciplinary measures to prevent and address settlement fails, consisting of reporting requirements, cash penalties for participants, and mandatory buy-ins.
The vision is simple 鈥� not only should cash penalties deter participants from causing settlement fails, but also incentivise failing parties to rapidly resolve the issue through a daily penalty running from the intended settlement date.
In accordance with the Commission Delegated Regulation 2021/70, central securities depositories (CSDs) across the EU have been operating these cash penalties for nearly three years, which has seen a drop in settlement fails 鈥� both in value and volume.
鈥淪ince its application in February 2022, the penalty mechanism under the CSDR has improved settlement efficiency in the EU by ensuring that participants failing to deliver securities or cash by the intended settlement date incur a penalty,鈥� says ESMA.
Data collected by the authority suggest that the overall decrease in settlement fails is particularly noticeable for bonds, shares, and money market instruments (MMIs), but remains more modest for units in collective investment undertakings (CIUs), sovereign bonds, and exchange traded funds (ETFs).
From consultation to action
ESMA鈥檚 latest report builds on three months of public consultation, during which industry stakeholders shared their views on the effectiveness of the current penalty mechanism in discouraging settlement fails.
Although most respondents said it was premature to review the penalty mechanism, as it had only entered into force recently, ESMA notes that most of them welcome the introduction of the cash penalty mechanism as an incentive for the industry to enhance settlement efficiency.
The majority of respondents also argued against any substantial changes to the current cash penalties framework, but around a third stated that the current penalty rates are too low, and a recalibration could be considered.
Participants generally agreed that CSDs should use a 40-day threshold beyond which more recent reference data shall be used for the calculation of the related cash penalties to prevent degradation of the system鈥檚 performance.
Most respondents were also against differentiated rates by transaction type due to the complexity and costs of such a change. As a potential unintended consequence, they highlighted that participants may choose specific transaction types solely based on their penalty implications.
In addition, participants mentioned the discrepancy between the cost of incurring the penalty for failing to deliver a security and the costs of borrowing the same security to resolve the settlement fail.
What is new
Designing a penalty system that strikes the right balance between fairness and effectiveness is no small feat. ESMA鈥檚 approach aims to reflect this delicate balancing act, ensuring that penalties are proportionate and that market participants have clear guidance on how to avoid them.
While introducing an overall moderate increase in the penalty rates, the EU鈥檚 financial market regulator and supervisor proposes to maintain the design of the current penalty mechanism.
On the request of the European Commission, the report also outlines ESMA鈥檚 advice to improve the application of the current penalty mechanism, including the treatment of historical reference prices for the calculation of late matching fail penalties, as well as alternative methods for calculating cash penalties.
In cases where overnight interest rates are unavailable due to central bank policies, ESMA suggests using other comparable interest rates of the European Central Bank and the relevant central bank to calculate a proxy which a CSD can use to calculate the cash penalties due to lack of cash.
This flexibility, coupled with the regulator鈥檚 focus on transparency and consistency, is expected to boost market confidence.
Based on its analysis of settlement fails between 2022 and 2023, ESMA found that the penalty rates had indeed been lower than securities lending and borrowing rates for illiquid shares, sovereign bonds, and other financial instruments 鈥� particularly ETFs. Therefore, the proposal will ensure that the costs of penalties will remain on average above the costs of borrowing securities to resolve the fail.
ESMA believes that a moderate increase of cash penalties, based on the average securities lending and borrowing rates, could ultimately lead to an improvement in settlement efficiency while avoiding negative consequences.
At the same time, there will be no minimum penalties or special penalties for participants with high settlement fail rates introduced at this stage.
In light of the emphasis the consultation respondents put on the implementation and maintenance costs, ESMA suggests avoiding any further structural changes to preserve the proportionality of the cash penalties mechanism, but this could be addressed in the next review.
The bigger picture
Following the recent developments, it becomes apparent that settlement penalties are not just about punishing inefficiencies; they are a crucial part of preparing the market for what is next.
In a final report assessing the transition to T+1 in the EU from October 2024, ESMA stated that a successful migration would require a further amendment of the settlement discipline framework to ensure legal certainty and the necessary improvements in post-trading processes.
鈥淎 low level of settlement fails is essential in light of the ongoing discussions about a potential shortening of the settlement cycle in the EU,鈥� says the authority, which proposed the optimal go-live date for a coordinated European shift to T+1 on 11 October 2027.
Although several respondents of the consultation argued that the implementation of T+1 in the EU could mean more settlement fails, ESMA believes that a coordinated transition will help promote settlement efficiency, contributing to market integration and the Savings and Investment Union鈥檚 objectives.
However, the authority also acknowledges that a significant increase of penalty rates may divert resources from expected investments and costs of moving to a shorter settlement cycle. The proposal also raises the possibility of a temporary suspension of cash penalties to support the EU鈥檚 move to T+1, but this will be further considered.
What is next
The European Commission will consider ESMA鈥檚 technical advice when amending the Commission Delegated Regulation 2017/389. Once adopted, the revised penalty mechanism will undergo scrutiny by the European Parliament and the Council of the EU, which can object to a delegated act within three months.
While the European Commission oversees the regulatory framework at a high level, it relies on national competent authorities and CSDs within member states to enforce the rules. This could mean a further delay in implementation.
Looking ahead, ESMA says: 鈥淏eyond regulatory measures that could be taken, we strongly encourage all market participants to continue their efforts to increase settlement efficiency in the EU, also in light of a shortening of the settlement cycle.鈥�
With the publication of its final report providing technical advice on the penalty mechanism under the Central Securities Depositories Regulation (CSDR), ESMA aims to help the European Commission sharpen its tools to ensure a smoother, more reliable settlement process. However, how effective can penalties be in driving real change?
Framing the challenge
Every failed settlement has a ripple effect. In its report, ESMA explains that beyond the immediate impact of delayed transactions, persistent settlement fails negatively affect the functioning and competitiveness of the capital markets.
This contradicts the objectives of the Savings and Investments Union, which is an EU concept aimed at strengthening the union鈥檚 financial ecosystem by improving the connection between savers and investors.
CSDR, also known as Regulation No 909/2014, includes a set of disciplinary measures to prevent and address settlement fails, consisting of reporting requirements, cash penalties for participants, and mandatory buy-ins.
The vision is simple 鈥� not only should cash penalties deter participants from causing settlement fails, but also incentivise failing parties to rapidly resolve the issue through a daily penalty running from the intended settlement date.
In accordance with the Commission Delegated Regulation 2021/70, central securities depositories (CSDs) across the EU have been operating these cash penalties for nearly three years, which has seen a drop in settlement fails 鈥� both in value and volume.
鈥淪ince its application in February 2022, the penalty mechanism under the CSDR has improved settlement efficiency in the EU by ensuring that participants failing to deliver securities or cash by the intended settlement date incur a penalty,鈥� says ESMA.
Data collected by the authority suggest that the overall decrease in settlement fails is particularly noticeable for bonds, shares, and money market instruments (MMIs), but remains more modest for units in collective investment undertakings (CIUs), sovereign bonds, and exchange traded funds (ETFs).
From consultation to action
ESMA鈥檚 latest report builds on three months of public consultation, during which industry stakeholders shared their views on the effectiveness of the current penalty mechanism in discouraging settlement fails.
Although most respondents said it was premature to review the penalty mechanism, as it had only entered into force recently, ESMA notes that most of them welcome the introduction of the cash penalty mechanism as an incentive for the industry to enhance settlement efficiency.
The majority of respondents also argued against any substantial changes to the current cash penalties framework, but around a third stated that the current penalty rates are too low, and a recalibration could be considered.
Participants generally agreed that CSDs should use a 40-day threshold beyond which more recent reference data shall be used for the calculation of the related cash penalties to prevent degradation of the system鈥檚 performance.
Most respondents were also against differentiated rates by transaction type due to the complexity and costs of such a change. As a potential unintended consequence, they highlighted that participants may choose specific transaction types solely based on their penalty implications.
In addition, participants mentioned the discrepancy between the cost of incurring the penalty for failing to deliver a security and the costs of borrowing the same security to resolve the settlement fail.
What is new
Designing a penalty system that strikes the right balance between fairness and effectiveness is no small feat. ESMA鈥檚 approach aims to reflect this delicate balancing act, ensuring that penalties are proportionate and that market participants have clear guidance on how to avoid them.
While introducing an overall moderate increase in the penalty rates, the EU鈥檚 financial market regulator and supervisor proposes to maintain the design of the current penalty mechanism.
On the request of the European Commission, the report also outlines ESMA鈥檚 advice to improve the application of the current penalty mechanism, including the treatment of historical reference prices for the calculation of late matching fail penalties, as well as alternative methods for calculating cash penalties.
In cases where overnight interest rates are unavailable due to central bank policies, ESMA suggests using other comparable interest rates of the European Central Bank and the relevant central bank to calculate a proxy which a CSD can use to calculate the cash penalties due to lack of cash.
This flexibility, coupled with the regulator鈥檚 focus on transparency and consistency, is expected to boost market confidence.
Based on its analysis of settlement fails between 2022 and 2023, ESMA found that the penalty rates had indeed been lower than securities lending and borrowing rates for illiquid shares, sovereign bonds, and other financial instruments 鈥� particularly ETFs. Therefore, the proposal will ensure that the costs of penalties will remain on average above the costs of borrowing securities to resolve the fail.
ESMA believes that a moderate increase of cash penalties, based on the average securities lending and borrowing rates, could ultimately lead to an improvement in settlement efficiency while avoiding negative consequences.
At the same time, there will be no minimum penalties or special penalties for participants with high settlement fail rates introduced at this stage.
In light of the emphasis the consultation respondents put on the implementation and maintenance costs, ESMA suggests avoiding any further structural changes to preserve the proportionality of the cash penalties mechanism, but this could be addressed in the next review.
The bigger picture
Following the recent developments, it becomes apparent that settlement penalties are not just about punishing inefficiencies; they are a crucial part of preparing the market for what is next.
In a final report assessing the transition to T+1 in the EU from October 2024, ESMA stated that a successful migration would require a further amendment of the settlement discipline framework to ensure legal certainty and the necessary improvements in post-trading processes.
鈥淎 low level of settlement fails is essential in light of the ongoing discussions about a potential shortening of the settlement cycle in the EU,鈥� says the authority, which proposed the optimal go-live date for a coordinated European shift to T+1 on 11 October 2027.
Although several respondents of the consultation argued that the implementation of T+1 in the EU could mean more settlement fails, ESMA believes that a coordinated transition will help promote settlement efficiency, contributing to market integration and the Savings and Investment Union鈥檚 objectives.
However, the authority also acknowledges that a significant increase of penalty rates may divert resources from expected investments and costs of moving to a shorter settlement cycle. The proposal also raises the possibility of a temporary suspension of cash penalties to support the EU鈥檚 move to T+1, but this will be further considered.
What is next
The European Commission will consider ESMA鈥檚 technical advice when amending the Commission Delegated Regulation 2017/389. Once adopted, the revised penalty mechanism will undergo scrutiny by the European Parliament and the Council of the EU, which can object to a delegated act within three months.
While the European Commission oversees the regulatory framework at a high level, it relies on national competent authorities and CSDs within member states to enforce the rules. This could mean a further delay in implementation.
Looking ahead, ESMA says: 鈥淏eyond regulatory measures that could be taken, we strongly encourage all market participants to continue their efforts to increase settlement efficiency in the EU, also in light of a shortening of the settlement cycle.鈥�
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