Unified European Settlement System Hits Home Stretch

The need for a consistent regulatory approach to settlement systems and settlement processes arose after the financial crisis of 2008-2009. Although CSDs did not show any signs of failure at the time, they were not consistently regulated across the 28 countries, an irregularity that the European Union, pressed by the Group of 20, decided to eradicate. 

Following the advent of the Eurosystem's Target2-Securities (T2S) project, the CSDR came as an extra piece of regulation that would provide a standardized settlement discipline to cut cross-border costs, harmonize settlement cycles to two days, and introduce penalties for settlement fails.

The regulation is still in the process of being implemented, with Esma expected to deliver its draft technical standards to the European Commission by June and implementation towards the end of this year.

The single market for securities settlement already took a big turn last October with the move to T+2, which went smoothly, but a number of controversial points still need to be addressed regarding settlement discipline in terms of both parameters and consequences.

According to James Cunningham, director of external and regulatory affairs at BNY Mellon, particular concerns around settlement discipline include the mandatory buy-in procedures, the phase-in period for the implementation of the settlement discipline regime, and fines for late settlement.

"The biggest fundamental problem in Level II remains in the mandatory buy-in as there are issues that become unsolvable if trading activities occur with participants outside the EU," says Cunningham.

Buy-In
The mechanism for executing mandatory buy-in against failing transactions in financial securities is believed to impair liquidity across all asset classes considerably by increasing the risks and costs of trading European securities markets for both market-makers and investors, according to the International Capital Markets Association (ICMA). In some instances, it could even prevent CSDs from dealing with clients outside of the EU altogether, says Cunningham.

"The biggest fundamental problem in Level II remains in the mandatory buy-in, as there are issues that become unsolvable if trading activities occur with participants outside the EU," he says. "What we need to achieve is that the buy-in process takes place at the trading level and not at the settlement level. The current Esma proposal can work if the trading party is also a CSD participant, so trading and settlement are affected by the same entity. But the day you get trading parties that are not CSD participants is when you'll start getting theoretical problems that get considerably aggravated and become unsolvable if those participants are outside the EU." 

Penalty Regime and Failed Trades
Another topic the industry reacted to is the penalty regime, which seemed quite modest compared to what some markets outside Europe have been implementing.

According to Omgeo's Tony Freeman, who heads up industry relations for the Depository Trust and Clearing Corporation-owned company, a £10,000 equity transaction will cost £1 per day in failed-to-trade penalties, as opposed to $500 (£330) for every failed trade imposed by the financial authority in New Zealand.

For him, there is a correlation between very high settlement efficiency and the level of penalties paid as New Zealand achieves 99.83 percent market efficiency, compared to 96 to 97 percent in Europe.

"The point of the discussion around the late settlement fine is related to calibration," explains Cunningham. "The question of the size of the fines is critical both from the operational perspective of the intermediaries that have to process these penalties, but it is also important for the overall market impact."

He explains that some market makers in certain securities could end up being hit both by the buy-in obligations and by the late settlement fines, which would have a cumulative impact on their businesses.

Defining the Scope
For Freeman, fines are meant to be a disincentive, not a punishment.

"They could implement a flexible penalty regime which can be calibrated to drive behavioral change. If you want to change behavior, then you need to be able to adjust it according to market conditions," he says.

However, CSDs have neither agreed on a standard definition of a failed trade, nor resolved if they want to be able to build the operational mechanisms to report the failed trade to their regulators.

"What we need to get out of the process is a clear understanding of what activities are in scope and what activities are out of scope and for that, we need good definitions to guide on how to apply these obligations," says Cunningham.

The Bottom Line:

• The industry is concerned by the requirements around settlement discipline and in particular the mandatory buy-in procedures, the phase-in period for the implementation of the settlement discipline regime, and fines for late settlement.

• Buy-in mechanisms could prevent CSDs from dealing with clients outside of the EU if the buy-in process continues to take place at the settlement level rather than the trading level.