Understanding CSDR in detail
29 March 2016
The settlement discipline regime of CSDR, as proposed, might actually make failure an option, according to Matthew Johnson of DTCC
Image: Shutterstock
The industry has now had the time to familiarise itself with the final level two regulatory technical standards tackling settlement discipline under the Central 色花堂Depositories Regulation (CSDR). The European 色花堂and Markets Authority (ESMA) published the final text on 2 February without much fanfare, even though this piece of the regulation is possibly the most far reaching of all, as it spans from trade capture all the way through to trade settlement, encompassing the entire trade lifecycle.
Measures to prevent trade fails include standardised information to be captured in trade confirmations, endorsement (but not mandating) of electronic mechanisms to dispatch confirmations and allocations, as well as to provide this entire detail in a written format. These are commendable efforts, even if monitoring the industry鈥檚 adherence to the mandated rules might prove somewhat challenging.
Arguably, one of the most interesting aspects of the regulation is the introduction of penalties for transactions that fail to settle on the intended settlement date. CSDR will penalise those market participants that are unable to deliver securities or cash within the T+2 timeframe. Each failed trade will incur a daily charge on the notional value of the transaction for each day the trade fails, up until the mandatory buy-in period鈥攁lthough the buy-in inclusion is another conversation all on its own.
This sounds punitive, as many European markets currently do not have standard trade failure penalties. This could make trade failure a costly business鈥攐r does it? The vast majority of market participants support harmonised trade failure penalties as they believe it will lead to an improvement in performance, including enhanced focus on straight-through processing (STP), and the electronification of trade confirmation and settlement.
But when we take a closer look at the size of these penalties, they may not have the desired effect, which might explain why so many market participants were in strong support of them.
For example, if an institution fails to settle an equity transaction for whatever reason, the fail will incur a 1 basis point (bps) charge on the notional value of the transaction. If we put this into figures, an equity transaction worth 鈧�100,000 will incur a 鈧�10 penalty for each day that it fails, so not a very steep penalty.
That said, however, ESMA鈥檚 decision to keep the penalty costs low was factored into the cost of borrowing. If an institution is short to deliver they can borrow to cover the position. And of course, borrowing comes at a cost. Many larger institutions have auto-borrow processes in place, even if it is more expensive than manual borrowing.
So, with these economics in mind, will the settlement discipline regime work in practice? Failed trade costs, as well as borrowing costs, all affect the bottom line of a dealer鈥檚 trading book for which heads of dealing are ultimately responsible.
As a head of dealing, you may give approval to the operations team to setup auto-borrow agreements with as many custodians as possible. For example, the cost of auto-borrowing may be 50 bps鈥攖his means that settling trades on time costs 50 bps while the price of letting them fail under ESMA鈥檚 proposals is only 1 bps. Potentially, one could save 49 bps by letting the trades fail. As the rules currently stand, there is a serious risk that this may happen. If so, it will be a stark example of the unintended consequences of regulation.
As a result, the settlement discipline regime of CSDR could actually drive-up failed trade rates rather than decrease them, therefore defeating the very purpose it has set out to achieve.
Measures to prevent trade fails include standardised information to be captured in trade confirmations, endorsement (but not mandating) of electronic mechanisms to dispatch confirmations and allocations, as well as to provide this entire detail in a written format. These are commendable efforts, even if monitoring the industry鈥檚 adherence to the mandated rules might prove somewhat challenging.
Arguably, one of the most interesting aspects of the regulation is the introduction of penalties for transactions that fail to settle on the intended settlement date. CSDR will penalise those market participants that are unable to deliver securities or cash within the T+2 timeframe. Each failed trade will incur a daily charge on the notional value of the transaction for each day the trade fails, up until the mandatory buy-in period鈥攁lthough the buy-in inclusion is another conversation all on its own.
This sounds punitive, as many European markets currently do not have standard trade failure penalties. This could make trade failure a costly business鈥攐r does it? The vast majority of market participants support harmonised trade failure penalties as they believe it will lead to an improvement in performance, including enhanced focus on straight-through processing (STP), and the electronification of trade confirmation and settlement.
But when we take a closer look at the size of these penalties, they may not have the desired effect, which might explain why so many market participants were in strong support of them.
For example, if an institution fails to settle an equity transaction for whatever reason, the fail will incur a 1 basis point (bps) charge on the notional value of the transaction. If we put this into figures, an equity transaction worth 鈧�100,000 will incur a 鈧�10 penalty for each day that it fails, so not a very steep penalty.
That said, however, ESMA鈥檚 decision to keep the penalty costs low was factored into the cost of borrowing. If an institution is short to deliver they can borrow to cover the position. And of course, borrowing comes at a cost. Many larger institutions have auto-borrow processes in place, even if it is more expensive than manual borrowing.
So, with these economics in mind, will the settlement discipline regime work in practice? Failed trade costs, as well as borrowing costs, all affect the bottom line of a dealer鈥檚 trading book for which heads of dealing are ultimately responsible.
As a head of dealing, you may give approval to the operations team to setup auto-borrow agreements with as many custodians as possible. For example, the cost of auto-borrowing may be 50 bps鈥攖his means that settling trades on time costs 50 bps while the price of letting them fail under ESMA鈥檚 proposals is only 1 bps. Potentially, one could save 49 bps by letting the trades fail. As the rules currently stand, there is a serious risk that this may happen. If so, it will be a stark example of the unintended consequences of regulation.
As a result, the settlement discipline regime of CSDR could actually drive-up failed trade rates rather than decrease them, therefore defeating the very purpose it has set out to achieve.
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