Why ‘CSDR’ may spell ‘Chaotic Settlement Discipline Re-papering’ for the Financial Industry

We know that the Central Securities Depositories Regulation is causing chaos and confusion within financial services, so we asked Regulatory Lawyer, Barrie Ingman, for his take on contending with the lack of clarity for CSDR.

Setting the scene for CSDR

The Central Securities Depositories Regulation (‘CSDR’) arguably sits within one of the more obscure areas of the regulatory landscape. As such, for many it helps to first put it in context before exploring it in detail. In this regard, it is worth revisiting the five pillars of financial regulation again, which are:

All financial professionals are familiar with the first of these three pillars, and few will have escaped the recent wall-to-wall coverage of the fifth. However, the fourth pillar governing financial market infrastructures (FMIs) typically receives much less attention than the others, and it is within this pillar that the CSDR sits.

The broad scope of CSDR

The Association for Financial Markets in Europe’s (AFME) Post Trade whitepaper, which provides an overview of the various types of FMI, notes that CSDs typically provide SSS services to the industry and that, in the EU, SSSs and CSDs are governed by the CSDR. However, the CSDR is much broader than this, establishing:

1. A regulatory framework for CSDs including SSSs.
2. The maximum EU trading venue settlement date of T+2.
3. A Settlement Discipline Regime.

Underlying the apparent simplicity of the settlement discipline regime lies significant complexity and uncertainty, which, together, have left the industry in a bit of a panic given that the rules are due to enter into force on 1 February 2022.

It is this complexity and uncertainty that this article explores.

Complexity of CSDR rules

In terms of complexity, the application of each rule is dependent on several factors that have a significant impact on the scope of the regime. Specifically, the Article 6 rules impose obligations that apply between EU investment firms (and presumably EU credit institutions) and their professional clients (including eligible counterparties per ESMA’s Article 6 Guidelines), whereas the cash penalty rules principally apply to CSD participants (which are generally large financial institutions providing custodial services, many of which are domiciled outside of the EU), and the buy-in rules apply to trading counterparties, trading venue members or CCPs depending on the nature of the trade.

Moreover, Article 6 rules apply to settlement failures of transactions in instruments specified in Article 5, CSDR, whereas cash penalty and buy-in rules apply to transactions in these instruments but only where they are ‘admitted to trading or [are] traded on a trading venue or cleared by a CCP’ – which has generally been taken to mean instruments in ESMA’s FIRDS database, excluding those in ESMA’s Short Selling Exemption List.   

The cash penalty rules are further complicated by the fact that CCPs levy and distribute cash penalties on cleared trades to their clearing members. Whereas, for uncleared trades, penalties pass from the CSD to its participants. There is no requirement to pass the penalties on to the clients ultimately responsible for the settlement failure and relevant firms may decide to absorb these penalties, so long as the model adopted does not violate antitrust laws or MIFID II inducement rules.

The buy-in rules are also accompanied by additional complicating factors, notably the fact that application depends on the nature of the transaction. CCPs are responsible for executing buy-ins for cleared trades, trading venues responsible for imposing buy-in rules on their members for uncleared on-venue trades. CSDs are responsible for imposing the buy-in rules on their participants for uncleared OTC trades, which must contractually be extended to participants’ clients.

This last requirement is further supplemented by Article 25 of the CSDR Settlement Discipline Regulatory Technical Standards (RTS), which require CSD participants to modify their custodial contracts, and trading parties to modify their counterparty contracts, so that both ensure that the buy-in regime applies across the ‘settlement chain’ and across jurisdictions, in a manner explicitly designed to give rise to extraterritorial effect.

Unanswered questions for CSDR

Even more disconcerting than these complexities, however, is the lack of clarity around the scope of the regime, with the industry still unsure as to whether it applies to primary markets, open repos, ETF redemptions and creations, derivative collateral and margin transfers, and a host of other transaction types.

In addition to these worries over scope and application, several other questions remain unresolved such as how the regime can operate given only one buy-in agent has emerged, and how firms should approach the inconsistent reconciliation of asymmetric pricing the regime introduces when the buy-in price differs from the original price.

Equally, as seemingly contemplated in Recitals to the regulation and the RTS, but omitted from the substantive articles, the industry is also eager to know whether a buy-in pass-on mechanism is permissible, which would avoid multiple buy-ins occurring across a settlement chain by excising all but the end parties. The absence of such a mechanism is likely to give rise to the unintended consequences of price distortion and compromised liquidity, undermining the very principles the regime is designed to achieve – namely market confidence and efficiency.

These and a litany of other outstanding issues are listed in ESMA’s Questions Received (but largely unanswered) spreadsheet, several of which are referenced in the Commission’s July 2021 Interim CSDR Report, which concludes that given these outstanding matters it is ‘appropriate…to consider’ amending the settlement discipline regime.  

Unfortunately, the Interim Report does not specify any timing or the substance of any such amendments, which has prompted 16 trade associations to publish a joint Open Letter to the Commission beseeching them for clarity ‘on an urgent basis’ on timing and the content of any proposed amendments, and requesting a postponement of the buy-in rules until such rules are enacted.

These requests are deemed necessary so as to avoid firms undertaking sizable yet potentially redundant technological and operational business changes, and to prevent a duplication of the monolithic global contractual repapering exercise mandated by the regime, which is of a scale that would typically take the best part of a year to execute for large firms, but which is having to be undertake in half that time, as firms wait to see if the Commission follows up on its conclusions in its Interim Report, by initiating changes to the regime.

To re-paper, or not to re-paper?

At the time of writing, impacted firms are gearing up for a very costly re-papering exercise that may never happen, which involves (amongst various other considerations) future proofing terms against the FMI rulebook changes mandated by the regime and figuring out how to ensure the enforceability of extraterritorial contractual changes on clients who do not necessarily wish to be re-papered, including those from the UK who are no longer subject to the regime following the UK’s decision not to onshore the CSDR settlement discipline rules.

Financial institutions presently have a finger hovering over a re-papering button, knowing that if they push it too early, they may have to unwind the process almost immediately at significant cost and disruption, but equally knowing that if they press it too late, they may end up non-compliant come deadline day. It’s an anxious time for all and even if the buy-in rules are modified or delayed as the Commission suggests, the industry will still need to grapple with how and whether to re-paper for the detritus that remains of the regime following any such amendments.