CSDR: what the buy-side needs to know - Settlement Discipline Regime

Buy-side firms, wherever located, trading financial instruments which are either (1) admitted to trading on an EEA trading venue (including where these instruments are traded OTC), or (2) cleared through an EEA central counterparty, should be readying themselves for compliance with the Settlement Discipline Regime under CSDR which is due to apply from 1 February 2022.

While there is hope that the most onerous of the requirements, mandatory buy-ins, will be postponed, it is still expected that requirements on cash penalties and allocations and confirmations will continue to come into effect on 1 February 2022. Although postponement of the mandatory buy-in rules would significantly reduce firms’ CSDR workloads, there is still some work to be done in relation to the other requirements.

What is CSDR and the Settlement Discipline Regime?

The Central Securities Depositories Regulation (CSDR)¹ is an EU regulation intended to increase the safety and efficiency of securities settlement and settlement infrastructure in the EU, replacing national regimes and introducing an EU-wide harmonised framework for: (1) the timing and method of securities settlement, (2) the authorisation, supervision and operational arrangements for central securities depositories (CSDs), and (3) a single market for CSDs and settlement services.

CSDR entered into force on 17 September 2014, with a number of its key requirements being implemented to date (e.g. the T+2 settlement cycle and the authorisation of CSDs). While many of these requirements have had a significant impact on securities markets, they have not generally created issues for the buy-side. However, perhaps the most controversial requirement of CSDR, the Settlement Discipline Regime (the SDR), which is scheduled to apply from 1 February 2022², is expected to have a greater impact. The SDR is contained within Articles 6 and 7 of CSDR and is concerned with transactions being settled on their intended settlement date (ISD), and obligations on market participants and CSDs designed to prevent, address and monitor settlement fails.

This note is an introduction to the SDR and some of the key issues that the buy-side needs to be aware of.

Which of my trading relationships / services and related documentation is this relevant to?

As noted above, CSDR applies to financial instruments which are either (1) admitted to trading on an EEA trading venue (including when these instruments are traded OTC), or (2) cleared through an EEA central counterparty. While not an exhaustive list, key examples of the trading relationships / services and related documentation that a buy-side firm may focus on when scoping the impact of CSDR on its business are listed below:

What are the key requirements of the SDR?

A summary of the key requirements of the SDR is set out below.

Current status of the mandatory buy-in rules

There has been talk across the industry for some time as to whether the mandatory buy-in rules would be postponed from 1 February 2022 to a later date or be removed entirely. However, to date, any such postponement or removal has not materialised. That being said, on 23 September 2021 ESMA wrote a letter³ to the European Commission (the Commission) calling for urgent action on the part of the Commission to “provide a signal that a modification of the current implementation deadline is considered, postponing the mandatory buy-in framework as soon as possible and, ideally, at the latest by the end of October 2021”. In the same letter, ESMA suggested that the SDR requirements on cash penalties and allocations and confirmations should continue to come into effect 1 February 2022 and there is no discussion of these requirements being delayed (only the mandatory buy-in rules).

At the time of publishing this note, the Commission had not clarified whether the mandatory buy-in rules will be delayed. However, it is hoped that the Commission will imminently confirm such. In light of ESMA’s letter, the joint industry working group (comprised of ICMA, ISLA, the FIA and ISDA) that was developing mandatory buy-in provisions for certain trading documentation produced by them (e.g. the ISDA Master Agreement and the GMRA) announced that it was “pausing work on documentation until we receive further clarity from the regulators” (i.e. as to whether the Commission does delay the mandatory buy-in rules).

Given that the mandatory buy-in rules were seen by many as the most controversial requirement of the SDR and the most complex for firms to implement, such firms, already stretched by other regulatory implementation projects (e.g. IBOR reform, SFDR and the uncleared margin rules), will need to decide whether to also pause their efforts in implementing the mandatory buy-in rules requirement of the SDR.

We are monitoring the situation closely, so please contact us directly for the latest.

What is the impact of this on the buy-side?

The SDR is expected to have a major impact on the buy-side. In the table below, we have set out a checklist for a buy-side firm to consider with respect to the impact of CSDR on them and their clients.

What are the requirements on allocation and confirmation?

The SDR imposes an obligation on sell-side firms to require that their professional buy-side clients send to them written confirmation and allocation of securities or of cash to in-scope transactions, identifying the accounts to be credited or debited. The SDR is prescriptive as to what information must be included in such confirmation and allocation and the timeframes in which they must be delivered (either (1) if the sell-side and buy-side firms are in the same time zone, close of business on the trade date, or (2) if the sell-side and buy-side firms are in different time-zones, 12:00 noon CET on the business day following the trade date).⁴

Sell-side firms will be evaluating whether their existing processes with clients in respect of confirmations and allocations are compliant with the SDR and, if not, considering how such processes may need to be amended and generally whether any amendments to the terms of business with their buy-side clients are required.

What is a settlement fail?

Settlement is the process of transferring the ownership of securities (e.g. shares and bonds) from seller to buyer and the corresponding transfer of the consideration (e.g. cash) from buyer to seller. Occasionally, something in the settlement process can go wrong – a “settlement failure”. Under CSDR, a settlement fail is defined as the “non-occurrence of settlement, or partial settlement of a securities transaction on the intended settlement date [the ISD], due to a lack of securities or cash and regardless of the underlying cause”.

There are many potential causes of a settlement failure – such as, IT problems (e.g. a failure in a dealer’s operational systems) or general liquidity issues in a market (e.g. a security being unavailable for delivery as a result of it becoming hard to borrow in the market generally). Both parties to a transaction may experience consequences as a result of a settlement fail, such as:

1. Liquidity risk as neither party will receive the cash and / or securities on the ISD that they were expecting to receive on such date, which could then result in them failing to settle onward transactions (e.g. if the buyer had entered into a separate transaction with a third party to sell on the relevant security with settlement of such separate transaction to take place on or shortly following the ISD of the transaction which had experienced the settlement fail (therefore potentially causing the buyer fail to settle such separate transaction));

2. Replacement cost risk in relation to the buyer needing to purchase the security elsewhere and the current market price having moved since the ISD; and

3. Credit risk should the transaction be settled by certain settlement methods such as delivery free of payment (where the delivery of the security is not linked to the transfer of the consideration).

What are cash penalties?

From 1 February 2021, CSDs will be required to establish a cash penalty mechanism for participants that cause transactions not to be settled on their ISD (a settlement fail).⁵ Such penalties shall be calculated by the CSDs on a daily basis and then on a monthly basis applied by the CSDs to the participants of the CSDs, who are expected to then pass on the cash penalties to their clients (i.e. the primary counterparties to the transaction that failed to settle on its ISD).

The CSD will calculate cash penalties by applying a penalty rate to the reference price of a failed transaction. The penalty rate is different depending on which party failed: (1) if the seller failed to deliver securities, the penalty rate ranges from 0.10 basis points (bps) to 1.0 bps due depending on the product type, and (2) if the buyer failed to deliver cash, the penalty rate is the official interest rate for overnight credit charged by the central bank issuing the settlement currency (with a floor of zero).⁶ The reference price is equal to the aggregated market value of the financial instrument for each business day the transaction fails to settle. By way of example:

• CSD: Euroclear SA NV
• Securities: Delivery of 10,000 liquid shares against payment of EUR 1,000,000
• Settlement status: The settlement instruction is matched, but fails due to lack of securities for 3x BDs after ISD
• Reference price: Day 1: EUR 100, Day 2: EUR 115, Day 3: EUR 90
• Penalty:
  • Day 1: 10,000 shares x 0.01% x 100 = EUR 100
  • Day 2: 10,000 shares x 0.01% x 115 = EUR 115
  • Day 3: 10,000 shares x 0.01% x 90 = EUR 90
• Total penalty amount: EUR 305

The application of cash penalties presents a number of considerations for buy-side firms, which are considered further in the impact table above. In particular, buy-side firms will want to understand how the responsibility for cash penalties will be allocated: (1) among the various stakeholders in its trading universe (e.g. custodians, depositories, prime brokers and executing brokers) (including the passing on of cash penalties paid by the buy-side firms counterparty where it caused the settlement fail), and (2) among the buy-side firm and its clients and consider whether the existing documentation with its clients works with the firm’s planned approach.

What are mandatory buy-ins?

As noted above, there is talk of the mandatory buy-in rules being postponed from their current application date of 1 February 2022. If they are postponed, firms will not need to consider the below until there is more certainty as to when / whether they will apply in their current form.

A buy-in is a contractual remedy for a buyer where, on the failure of a seller to deliver a security on a certain date (this date being referred to under CSDR as the ISD), the buyer can purchase that security from a third-party and a compensation payment be made between the buyer and original seller in respect of any change in the economics since the ISD (e.g. if the price of the security agreed at the time of the trade is higher than the price paid for the execution at buy-in).

Buy-ins are a common existing remedy in the securities market where a transaction fails to settle. To date, buy-ins have generally been entered into on a voluntary basis as agreed between the parties to a failed transaction. The SDR introduces a mandatory buy-in framework which must be used where a CSD participant fails to deliver the relevant securities within a specific period of time following the ISD (this period being, in relation to each of: liquid shares: ISD + 4, illiquid shares and other instruments: ISD +7, or SME markets: ISD +15 (SME markets) (certain exemptions apply)). The mandatory buy-in must then be initiated through a “buy-in agent” appointed by the parties.

Should they be implemented, the mandatory buy-in requirements would present a number of challenges for the buy-side, including:

1. Contractual recognition of mandatory buy-in provisions. Article 25 of the RTS requires that parties in a settlement chain must ensure that they have established contractual arrangements with their counterparties to legally effect mandatory buy-ins. Practically, this means amending the documentation between parties in the settlement chain so as to comply with the requirement.

   The relevant trade associations (ISDA, ICMA, ISLA and the FIA) were developing model contractual mandatory buy-in provisions to be incorporated into the ISDA Master Agreement, the Global Master Repurchase Agreement, the Global Securities Lending Agreement and the FIA Terms of Business 2018 (this project is currently on hold pending confirmation as to whether there is a delay). While it is the intention that such model provisions satisfy the above mentioned requirement under Article 25, the buy-side would need to independently assess and get comfortable with the impact and effect of such provisions on their documentation.

   We also note that the sell-side may require amendments to each of their bespoke dealer terms of business, govern cash trading between the parties in the absence of a specific master agreement (such as an ISDA Master Agreement for trading OTC derivatives). Given the bespoke nature of these terms of business, it is hoped that the sell-side takes an approach consistent with that of the industry approach.

2. Appointment of a buy-in agent. Firms will need to put in place arrangements for their clients with buy-in agents before they experience a settlement fail and they are required to exercise a mandatory buy-in. We understand that there is currently a limited choice of third-party independent buy-in agents. In considering potential buy-in agents, firms should note that Article 24 of the RTS requires that “A buy-in agent shall not have any conflict of interest in the execution of a buy-in” which suggests independence of the buy-in agent from the two parties to a failed transaction. It is hoped that ESMA provides further guidance (perhaps in a Q&A) as to the level of independence that a buy-in agent needs.

3. Internal processes. Buy-side firms will need to refine existing (and potentially put in place new) internal operational processes so that, should a settlement failure occur, they can correctly effect a mandatory buy-in in accordance with the processes prescribed under CSDR.

The UK hasn’t implemented the SDR component of CSDR, what does that mean for UK firms?

While the United Kingdom (UK) government announced that it will not implement the SDR component of CSDR⁷, the SDR has an extraterritorial effect. Buy-side firms (including UK firms) will be caught if they buy or sell financial instruments which are either (1) admitted to trading on an EEA trading venue (including when these instruments are traded OTC), or (2) cleared through an EEA central counterparty, regardless of whether such buy-side firms are themselves EU entities or not.

Steps to compliance with the SDR

Contact details

If you would like further information or specific advice, please see the contacts on the right-hand side.

^{1 Regulation (EU) No 909/2014 of the European Parliament and of the Council on improving securities settlement in the European Union and on central securities depositories and amending Directives 98/26/EC and 2014/65/EU and Regulation EU No 236/2012.
2 February 2022 being the date that the relevant RTS is expected to come into force, Commission Delegated Regulation (EU) 2018/1229 of 25 May 2018 supplementing Regulation (EU) No 909/2014 of the European Parliament and of the Council with regard to regulatory technical standards on settlement discipline, OJ L 230, 13.09.2018 (the RTS).
3 ESMA, Letter – ESMA to EC on CSDR Settlement Discipline on 24 September 2021 (available here).
4 Article 2 of the RTS.
5 Article 7(2), CSDR.
6 Annex, Penalty rates applicable to settlement fails, Delegated Act (EU) 2017/389 on Cash Penalties and Substantial Importance.
7 Statement made by Rishi Sunak (The Chancellor of the Exchequer) on 23 June 2020 (available here).}