Harmonizing European Depositories May Be a Bumpy Ride

In trying to harmonize the operations of European securities depositories, regulators may well be creating unintended operational and financial burdens for the settlement houses and their members in dealing with trades which fail to settle on time.

“The shorter timetable for settlement and the fines for late settlement will be far more difficult to implement [than capital requirements] as they will impact all market participants, not just securities depositories,” explains Soraya Belghazi, secretariat of the Brussels-headquartered European Central Securities Depository Association (ECSDA), the trade group for national and international securities depositories.

The new rules, agreed upon by the European Commission, European Parliament, and Council of Ministers on December 18, call for European securities depositories to follow the same prudential requirements, settlement discipline and settlement deadlines — two days after the trade is executed instead of the current common practice of three days or T+3. Known as the CSD-R, the measures will also incorporate risk mitigation and governance standards in defining for the first time the role of securities depositories operating the post-trade plumbing system on the continent.

The nitty-gritty details of just how the complex set of rules should be implemented will likely not be published by the European securities watchdog European Securities Market Authority (ESMA) until at least March, but the current draft provides some inkling of what’s in store for the 30 affected European securities depositories. At a minimum, all must hold at least six months of operating capital whether or not they have banking licenses. Those European securities depositories operating with a banking license — Euroclear Bank in Brussels, rival Clearstream in Luxembourg, Clearstream in Frankfurt, Hungary’s KELER and Austria’s OeKB — will be faced with additional prudential requirements including capital reserve charges. Those charges will supplement, not replace, capital requirements imposed by the Basel II Accord.

European securities depositories say they won’t have a hard time meeting the new financial challenge and for the handful of those with banking licenses, the new guidelines are a welcome relief. That is because the EC had initially considered a more onerous requirement — ring-fencing banking from depository units.

“It is only fair that there will be prudential requirements reflective of the financial risk undertaken,” says Belghazi. Likewise, according to Ilse Peeters, director of public affairs for the Euroclear family of depositories, the seven depositories already follow some pretty stringent financial requirements. “We adhere to the Basel II rules, so meeting the EC’s additional requirements will not be too hard and should not impact our member firms,” she says. Case in point: international securities depository Euroclear Bank boasts a capital ratio of 45 percent — far higher than the ten to 12 percent followed by most large global banks.

Speeding Up Affirmations

Although European securities depositories can easily settle trades within a two-day timetable, that’s not necessarily the case for fund managers and their custodians and broker-dealers. At issue is whether buy-side firms and their service providers can acknowledge their trade details far more quickly — on the same day the trade is executed — instead of the current practice of the next day or even later. Mandating a so-called same-day affirmation timetable is beyond the reach of European securities depositories which can only influence their direct member banks and broker-dealers. Those financial firms will need to understand the change in settlement discipline so they can pass on additional fees for late settlement to their end-clients.

“The timing of both measures — the move from T+3 to T+2 settlement and the introduction of tougher penalties for transactions that do not settle on the intended date — will need to be considered carefully,” says Belghazi. “What we want to avoid is imposing new penalties shortly after the market has had to adapt to T+2 since the shortening of the settlement cycle is likely to create a temporary increase in fails.”

Although less than one percent of European trades fail to settle on time, by some industry estimates, that’s still plenty for the European securities depositories and their members to deal with considering the multi millions which must be settled each year. Any increase in fails will only add to the administrative time and costs — not to mention fines — involved with cleaning up the trades.

In mandating a T+2 settlement cycle as of January 2015, regulators are requiring a buy-in of securities four days after the two-day settlement timetable isn’t met — a process which will likely be imposed by clearinghouses. Although most European securities depositories do fine member firms who don’t settle their transactions on time, they could face costly operational challenges in changing their policies depending on just how far astray the EC’s new rules fall from current practice. Bank and broker-dealer members of depositories will also need to operationally brace themselves, as will their ultimate fund manager and asset owner clients which could be the ultimate payees of the extra expense.

Tower of Babel

A report on the settlement discipline of European securities depositories issued by the ECSDA in 2011 shows just how divergent policies really are. For example, Euroclear UK& Ireland; Euroclear France and Euroclear Sweden triple whammy their members by charging extra fees for recycling settlement instructions; additional fees for trades which don’t settle on time; and extra fees for settlement instructions received after the designated deadline. In contrast, OEKB in Austria; SIX SIS in Switzerland; Iberclear in Spain; and Depozitarul Central in Romania only charge penalties to member firms for trades which don’t settle on time. Denmark’s VP charges extra fees to recycle settlement instructions and extra fees for trades that don’t settle by the correct deadline. If such discrepancies aren’t mindboggling enough, there are disparate methodologies for how fees should be calculated and who should pay them.

The EC’s arrangement for levying new penalties for settlement fails appear confusing — if not downright unfair — as over two dozen European national securities depositories won’t be settling trades for much longer. They have signed an agreement with the European Central Bank to outsource their settlement functions to a new platform called Target2 Securities (T2S), shifting operations in phases from 2015 through 2017. Therefore, it would seem logical that the ECB, rather than the depositories would be responsible for levying the penalties. But apparently, the ECB intends depositories to shoulder the burden as they are the ones owning the bank and brokerage relationships.

“The timing of the implementation of fines could be troublesome, depending on when they must be imposed,” explains Euroclear’s Peeters. “If they become effective when we — the Euroclear group of national depositories — are migrating to T2S we may face programming changes.” At issue is the depositories having to manage two large resource-consuming projects in parallel, requiring massive planning and potential expense.

Without final details of how the settlement fines will work, depositories are forced to play an uncomfortable waiting game. In the meantime, some are already taking action to reduce the settlement timeframe ahead of the regulatory requirement. About ten European securities depositories, including all those in the Euroclear family of depositories, say they will impose a two-day settlement timetable in October 2014.

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