Custodians to EU Regulator: Ease Up on New Settlement Rules

Uniform standards for how European securities depositories handle trades that fail to settle on time might sound like good thing — particularly since more than 30 of their markets have moved to a two-day settlement cycle and the phased launch of the new centralized settlement platform, Target2-Securities, is around the corner.

But that’s not how the world’s largest custodian banks view the proposed new rules issued by the European Securities and Markets Authority (ESMA). They see themselves being dumped with lot of extra work, risk and cost in the event trades fail to settle on time.

As the pan-European regulatory body, ESMA is responsible for coming up with the nitty-gritty details of the broad-ranging Central  Securities Depository Regulation (CSDR) which creates a consistent “settlement regime” as part of standardized operating procedures. The Level One or high level language on the CSDR was issued by the European Commission last September. The Level Two — the proposed technical specifications — was issued by ESMA in December 2014 with comments due by February 19. The goal is to implement the regulation in 2017 when the final round of European securities depositories outsources their settlement functions to the ECB’s T2S system.

Although the depositories are first in line to feel the heat from the proposed new regulations, as the largest settlement agents custodians are close behind. The banks believe their fund management clients will also be hurt, having to post more collateral to accommodate custodians who will be on the hook for failed settlement transactions. Requiring such collateral will, in turn, reduce the supply of collateral and the supply of securities positions which could be borrowed.

Not Buying into Buy-in

Based on their comment letters to the ESMA about the CSDR, custodians are the most worried about the buy-in provisions. The new regulations make custodians responsible for executing the buy-in for the injured party in case a trade fails to settle on time. That burden would be in addition to penalties imposed by European securities depositories on their participants for failing to settle trades on time. The CSDR would require those local settlement infrastructures to have the same methodologies for calculating the fines and procedures for implementing them.

The buy-in provisions, which ESMA wants custodian banks to handle in their role as members of depositories, are focused on only one category of securities trades — those which are either not processed through a clearinghouse or not executed on a recognized trading venue, both of which are already responsible for the buy-ins. Depending on the liquidity of the security — likely a bond — the buy-in would take place either four days, seven days or fifteen days after the intended settlement date, or on the same day the trade didn’t settle on time. Currently, clearinghouses and trading venues handle buy-ins for trades passing through their books.

ESMA has spared the depositories from executing buy-ins, but they do have to report in detail on the buy-ins, and even notify custodians whose clients are affected by the buy-ins. Therein lies the rub. “We might have to provide information about the underlying client of the custodian, which we might not have, and more importantly ensure that we send the buy-in notification to the right custodian,” says Robert Fair, senior business manager for Euroclear UK & Ireland in London, speaking on behalf of the family of depositories under the Euroclear umbrella. “We presume we will be able to get the correct data from the custodian, but have some concerns about the level of detail required in the notification process.”

Operationally, each of Euroclear’s depositories would have to set up the correct procedures for transmitting the buy-in notifications, and so far there are no industry standards for either the content of the message or the format. A depository could also be called to the carpet by a custodian it wrongly notified.

Not Risk Takers

For custodians, the buy-in procedures are even more of an anathema. Setting aside the additional administrative work involved with buy-ins, custodians say they aren’t risk-takers or clearing agents for a purchaser of securities. “Although the Level One provisions do give a limited responsibility for the buy-in process to depositories, ESMA now says that members of the depositories should have the responsibility for executing buy-ins. This means that we as custodians will be absorbing risk we shouldn’t,” says James Cunningham, senior advisor on regulatory affairs for BNY Mellon, the world’s largest custodian and one of over a dozen firms whose comment letters appeared on the ESMA’s website.

BNY Mellon offered its two cents on both a standalone basis and as part of the European “Focus Committee of the Association of Global Custodians,” whose members include Brown Brothers Harriman, Citibank, Deutsche Bank, HSBC Securities Services, JP Morgan, Northern Trust, RBC Investor & Treasury Services, Skandinaviska Enskilda Banken, Standard Chartered and State Street.

Under the ESMA’s proposed regulation, the custodian would turn into a defacto clearing agent in having to buy the securities to deliver to its client firm which didn’t receive them before the settlement deadline. If the price of that security is to be higher or even lower than on the day the trade took place, the custodian bank would settle the difference with the custodian bank of the firm that didn’t deliver the securities. Hopefully they will know where to go to collect their money. Chances are they won’t know. “It is important to note that the CSD participant does not have any direct contractual relationship with any of the other participants of the same CSD or others and indeed may not even know their identity or contact details,” says the European Focus Group of the AGC.

Financial risk aside, there is also legal risk. What happens if either trading counterparty doesn’t agree to the buy-in because it doesn’t agree on who is at fault? Or if one of the two counterparties is located outside the European Union? Just what authority does the custodian have to collect its money? Apparently, none so far, because the contractual agreements between counterparties don’t call for the custodian of either party to execute any buy-in and it is unclear whether ESMA’s rules could even be enforced on non-EU counterparties.

Scrambling for Data

If custodians think that handling buy-ins will be a problem, collecting and forwarding all of the information ESMA wants about internalized settlement will be just as bad. The reason: the custodian might not have all the necessary details. The custodian may know the value of the trades, but it will only know the identity of its fund manager client and not the underlying fund for which the trade was executed. The ESMA is unclear about who it wants identified, argue BNY Mellon and its peers.

And what about the type of trade? Custodians argue they won’t know whether the internalized trade is a repurchase transaction, a securities lending transaction or even a portfolio transfer — a trade for a client who will move onto another custodian. Custodians may also not know which  regulatory body should receive the report. Case in point: if a custodian has branches in more than one market in the European Union it could have to report to the securities watchdog of the parent company or multiple regulators for branch offices. Even if ESMA were to require that only the aggregate volume and value of the transactions be reported — a more reasonable scenario — the same figures could be filed by both sides of the transaction creating disorted reporting, say custodians.

What is the better alternative? In the case of trades not processed through a clearinghouse, how about putting the buy-in responsibility on the actual trading counterparty who didn’t receive its securities on time and let the counterparties work it out. Custodians should execute buy-ins for trades which belong to them, and not those conducted by a client.

When it comes to reporting requirements, custodians acting as settlement internalizers don’t think they should have any. ESMA’s purpose in asking for the information is to ensure that the settlement risk of trades that settle on the books of a custodian isn’t higher than trades settling on the books of a European securities depository. ESMA doesn’t know because custodians don’t report on internalized trades, but they insist the settlement risk is the same regardless of where the trade settled. When cash is not paid to the settlement internalizer, securities are simply not delivered. When securities aren’t delivered, the cash also isn’t transferred to the seller.

What will custodians settle for at the very least? They are hoping ESMA will be willing to limit or at least clarify which securities, types of transactions and counterparties are affected by its buy-in requirements and reporting requirements. Even so, custodians want as much lead time as possible to prepare. ESMA has suggested an 18-month delay from the publication of the final Level 2 rules, but custodians say that’s not good enough because that timeframe coincides with the last migration wave of European securities depositories to the new T2S platform. Custodians want another six months to get over that hump before setting up policies and operations for new messaging standards and reporting systems, not to mention renegotiating their contracts with fund managers to match the regulation.