CSDR – fail to prepare, and prepare to pay the failure penalty!

CSDR – fail to prepare, and prepare to pay the failure penalty!

By Heiko Stuber, Senior Product Manager at SIX

“The clock is ticking” – an infamous catchphrase now synonymous with seemingly every Brexit update from Michel Barnier. As applicable as this line is to every twist and turn of this political psychodrama, the countdown to October 31st is by no means the only deadline front of mind for European financial institutions right now.

Devised at an EU level, the Central Security Depository Regulation (CSDR) will force European CSD’s to take measures to prevent settlement fails. These include penalty schemes, as well as forced buy-in and sell-out procedures which require trading parties to deliver either cash, or financial instruments in the event of non-delivery. This can be used to avoid the potential liquidity risks that can occur due to failed settlement instructions. CSDs will apply financial fines for failing to complete transactions on the Intended Settlement Date. The rule, enforced on September 14 2020, means that there will now be a legal obligation for one side of the trade to pay a hefty fine. There are multiple facets to this most complex of rules. But two of most immediate concerns include the reporting and calculation of cash penalties, and the settlement of transfer orders on behalf of clients on a bank’s own account, rather than through a CSD. The latter, referend to as internalised settlement reporting, is of particular concern to custodian banks right now.

The main challenge is that custodians are struggling to access the granularity of information needed to assess the financial instruments that could fail to settle under CSDR. While they may be able to get cash amounts from CSDs, a custodian can’t easily get hold of the reference and price data being used to work out exactly how the penalties were calculated. This includes really important insights such as how to determine the market valuation of any given instrument, not to mention the closing price of the Most Relevant Market within the EU.

An issue is that not all trading venues provide closing prices. So, what does a custodian do for price information? Normally the price information would be based on final trade of the day. However, some trading venues do not even provide this information. If this wasn’t enough, how does a firm arrive at an accurate turnover figure? As such, in order to be compliant, there needs to be a way to get all of the trade information summing up the volume and multiplying by the price in order to get the turnover figure. All this before then needing to compare the turnover figure with another venue where the same instrument is also listed or traded

And here lies the pandora’s box of problems that could open up not just for custodians, but also for anyone involved in a trade chain for a CSDR instrument. Trade fails and resulting penalties are, of course, less likely for say liquid equities or equity style instruments like ETFs or warrants. But for the more illiquid instruments, it is a different story. Take trying to identify the market value on the closing price of a credit bond as a prime case in point. It could be weeks, or even months, before the bond is even traded. The trouble is, with no accurate liquidity level for the instrument because it trades so infrequently, it becomes almost impossible to assign the correct penalty rate.

So, what can the financial sector as a whole do to ensure they do not fall foul of CSDR when it comes into full effect in September next year? 12 months will go by in a flash – which means the industry really needs to be gathering the information needed to test of the impact of trading in a “CSDR-like” regulatory environment. For CSDs, they will need the most up to date reference and pricing data in order calculate extra compensations or cash penalties. As for custodians and the any other market participants potentially involved in a CSDR sensitive trade, the focus has to be asking CSDs for detailed analysis about the likely instruments “in-scope” under CSDR. So much work to do and so little time – perhaps this should be ESMA’s Barnier-style catchphrase for CSDR. It may just force the industry to accelerate its perpetrations. After all, no EU financial institution wants to face the inevitable consequences from a lack of preparation.

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