a. the securities depository
b. the custodian of the injured counterparty
c. the injured trading counterparty
d. all of the above
The European Securities and Markets Authority, the pan-European regulatory agency, recently decided that the answer should be switched from b to c when it comes to how the new Central Securities Depository Regulation (CSDR) should be implemented. Nonetheless, custodian banks and broker-dealers, who lobbied against the initial provisions, tell FinOps Report that they aren’t completely satisfied. Custodians remain concerned about their additional operational and reporting responsibilities while broker dealers say that the mandatory buy-in process might unfairly penalize sellers of securities.
At its core, the CSDR requires European securities depositories to all follow the same operating rules and procedures so that they could adapt to the European Central Bank-operated Target2 Securities platform, a centralized settlement system, and a uniform two-day settlement cycle. The rules include the methodology for charging participants who do not deliver securities or cash on time to meet their settlement commitments during the shortened time-frame, adopted in October 2014. Buy-ins represent an additional element of the new”settlement regime,” aimed at deterring settlement fails, and the question of just who is responsible for executing a buy-in for some trades had been among the most contentious aspects of the legislation.
In the case of trades which are processed through a clearinghouse or an accepted trade venue, no one disputes ESMA’s decision that the clearinghouse or trade venue should be responsible for the buy-in. That’s not the case when it came to uncleared or over-the-counter trades. There are no official estimates for just what percentage of trades those constitute, but broker-dealers expect fixed-income securities to be the most affected.
In its initial version of the technical specifications for the CSDR published in December 2014, ESMA revealed that custodian banks would execute buy-ins for the injured client. In its new version of the rules released in February 2016, the pan-European regulatory agency agreed with custodians and others that it should place the responsibility for the buy-in on the harmed counterparty — the one that didn’t receive securities on time. Other positive news: ESMA extended the timetable for implementation of the entire settlement regime to June 2018, and eliminated most securities finance transactions — repurchase agreements and securities lending deals — from the required buy-in rules. The buy-ins also don’t have to be executed until about a week after the trade failed to be settled on time — three days more than ESMA initially envisioned.
More to Do
Custodians are relieved, but still not entirely off the hook. “The ESMA has decided that the custodian bank must still execute the buy-in if its client cannot,” explains Marc Tibi, head of network management for BNP Paribas Securities Services in London.”Even if a client does the buy-in, we still need to collect all the information about the trade and forward it to whoever is designated by the regulatory agency. European securities depositories contacted by FinOps declined to comment on the new rules, which could also present them with some additional reporting requirements.
The administrative work related to reporting buy-ins is just the tip of the iceberg for custodians. They must also correctly allocate any settlement fines charged by European depositories to their appropriate clients and verify that the fines are correct. Tibi cautions that the extra reconciliation work will require changes to custodian back-office systems to calculate the same fines using the same methodology. Last, but not least, custodians will undoubtedly need to clarify the new math to their fund manager customers who will have to explain it to their underlying fund clients. Although European depositories have always implemented settlement fines, each relied on a different formula. Therefore, historic calculations might not be a good barometer for new charges.
Even executing a handful of buy-ins will be stressful for custodians. If price of the buy-in is higher or lower than originally executed price, the custodian bank executing the buy-in will have to settle up with the custodian bank of the counterparty. Custodians are also concerned they may face legal liability if they execute a buy-in incorrectly — either without the consent of its client or for the wrong client. It may be difficult to determine just who is the “original” injured party, because it may be part of a chain of interrrelated transactions which failed to settle on time. Count on a lot of negotiations, contractual changes, and hand-holding warn legal experts.
Broker-dealers who will likely execute some of the buy-ins say that ESMA’s revised rules don’t always follow market practice. If the buy-in price is the same as the executed price, neither the buyer nor the seller loses any money so no one needs to be compensated. No harm, no foul. If the price of the asset during the buy-in is higher than the price of the original deal, the seller of the asset will compensate the buyer the difference between the price of the asset at the time of the original deal and the buy-in price. Therefore, the buyer hasn’t been harmed. Still, good news.
But what happens if the price of the asset at the time of the buy-in is lower than the price of the original deal? Therein, lies what Andy Hill, senior director for the London-based fixed-income traders group International Capital Market Association (ICMA) calls an asymetry. “In a standard buy-in process the payment of the differential between the executing price and the buy-in price can go in either direction between the seller and the buyer depending on whether the buy-in price is higher or lower than the original price,” explains Hill. “This ensures an equitable outcome for both seller and buyer.”
However, the buy-in process prescribed by ESMA, he argues, does not allow the buyer to compensate the seller in the event the buy-in price is lower than the original trade price. So what’s wrong with the seller absorbing an economic loss? Hill insists it creates undue economic gains and losses for other financial intermediaries involved in a related series of transactions through no fault of their own. Clearinghouses and trading venues which must execute buy-ins for trades processed through a clearinghouse or executed on a trading venue will also be forced to follow the same buy-in rules, which will affect their member firms.
“ICMA doesn’t believe that this was the original intent of the regulation and once implemented the asymetry is likely to create economic anomalies,” says Hill. “It is not unusual for buy-in prices to be below the original trade price and in fixed-income markets interconnected transaction are quite common,” ICMA has lobbied the EC to change the language of the buy-in compensation rules to the CSDR before they must be finally implemented.
How are fund managers affected? As the underlying investors, the ECMA’s “new settlement regime” will undoubtedly spell additional reporting requirements and costs. They will have to notify their custodian banks of any buy-ins they execute and accept additional charges from custodian banks executing buy-ins. Those charges will be added to any settlement fines passed on by the participants of the depositories. Of course, fund management shops also have their own administrative expenses to investigate just why the trade failed to settle on time and communicate with custodians and counterparties. “We’re counting on spending a lot of time with our custodians understanding the methodology and rationale for extra charges,” the operations manager of a European fund management shop tells FinOps. “We’re also worried about how much each fail will actually cost. The pricetag will likely be exponentially higher than was previously the case.
Bottom line: While ESMA may have eased some of its more stringent initial buy-in requirements, but for buy and sell-side firms, there will be plenty of operational costs and grief to go around. Failing to settle a trade on time isn’t exactly a crime, but it still won’t pay. Fortunately, everyone will still have some time to prepare for the inevitable.