IMPACT OF CSDR REGULATIONS

Transcription

1 IMPACT OF CSDR REGULATIONS Sumit Ghosal & Neeraj Sinha This paper looks at the impact of shortening the settlement cycle from T+3 to T+2 as per the CSDR Regulations in Europe. It analyzes the impact on the market intermediaries and the changes required in the new regime.

2 INTRODUCTION To have an efficient trade life cycle, the risks associated with post trade processes needs to be minimized. With increased cross border trades, the post trade environment continues to be a complex one, especially with the lack of harmonization in market practices across different regions. This lack of harmonization has created inefficiencies in the post trade processes leading to frequent trade and settlement failure. After the 2008 financial crisis, market regulators have taken multiple steps to increase operational efficiencies and reduce the credit and counterparty risks of the market participants. One of them is to shorten the securities settlement cycle. In Europe, CSDR has mandated that all countries should move to T+2 ahead of its plan to harmonize the settlement cycle through Target2Securities. A political agreement was approved on 26 th February 2014 and the legislation came into effect in April The date established across Europe for implementing the move to T+2 is the second quarter of The US markets are looking to implement T+2 cycle in the third quarter of , the Singapore markets are looking to implement T+2 settlement cycles in while the Australian markets are also looking to implement the same by March The mandate is applicable for all transactions in transferable securities including equities and fixed income securities, exchange traded funds and warrants, that are executed in trading venues and are settled in international or domestic CSDs. Non listed investment fund shares, OTC trades and primary market transactions are not covered under this requirement. Trades that are executed off order book but in accordance with the rules of the Exchange and subsequently reported to the exchange will implement T+2 as the standard settlement cycle. It will still be possible to report off order book trades to the Exchange with non-standard settlement 5. However, for the above to be successful, it is necessary to have a robust operational system which is synchronized across various regions. CURRENT SCENARIO Most major markets currently complete the settlement on the third date from which the trade is done. This settlement cycle is commonly known as Trade date plus three days or T+3. Day T Activity The post trade clearance and settlement cycle begins on the date the trade is executed. Trade details are electronically transmitted by participants to the Clearing House or Clearing Corporation for processing. T+1 Clearing House/Corporation guarantees settlement on principle of novation. Clearing Corporation assumes the role of central counterparty, taking on the buyer s credit risk and seller s delivery risk. T+2 Summary reports issued by clearing corporation to brokers/dealers giving summaries of cleared trades, including net positions of cash and securities due to be delivered or received to the clearing corporation. T+3 Actual settlement occurs on this day with delivery of securities to buyers and delivery of cash to sellers.

3 The US markets and the European markets (with the exception of Germany and Slovenia which follows the T+2 cycle) follow the T+3 cycles. In Asia, with the exception of India, Hong Kong and Taiwan (which already follow the T+2 cycle), all other countries follow the T+3 cycles. 9 As a result there is a disparity in the settlement cycles for cross border trades in the European regions and Asian regions. While the US markets and its dealers do not face this disparity in the settlement cycle for domestic trades, it has to deal with multiple settlement cycles with European and Asian regions for trades done in these regions. Harmonization of the settlement cycle periods would enable a uniform practice across countries to enable smooth cross border transactions. There are other inherent disadvantages for a longer settlement cycle as listed below: Systematic risk faced by the clients or dealers from potential losses for open trades for a longer period especially in a volatile market. Clearing corporations charge mark to market margins and other margins as collaterals to guarantee settlement and reduce counterparty risk through the principal of novation. A longer settlement cycle means a longer lock in period for the collaterals used for the purpose of margins. Greater counterparty risk in the case of a longer settlement cycle, especially in a highly volatile market. PROPOSED CHANGES IN MARKET INFRASTRUCTURE TO IMPLEMENT T+2 Of all the markets migrating to a common T+2 settlement cycle, the European Union has defined the necessary changes required in the most structured manner. The changes required in implementing T+2 cycles in the European Union are defined in the Central Securities Depositories Regulation Act (CSDRA) and are as below: T+2 Settlement 6 It will be mandatory for all market intermediaries to settle their trades after two business days. In the European Union, the cutoff date to implement this is the second quarter of While this rule is applicable to listed securities, it has been recommended by the T2S (Target To Securities) Steering Committee that the T+2 rule be applicable to OTC trades as well. The recommendation for OTC trades to be settled on a T+2 basis will not be applicable for all asset classes and is a recommendation from T2S Steering Committee and is not part of CSDR. Dematerialization or Immobilization of Securities 6 The CSDR states that all securities listed on a trading venue or trading platform has to be settled in a dematerialized or immobilized form through accounting entries. While the vast majority of securities are already in dematerialized/immobilized form, there still exists trading volumes of around 3000 trades per day in physical certificate form in UK and Ireland combined as investors in these two countries still have the option of holding their securities in certificate form. As per CSD Regulation, a settlement model has to be implemented by 2025 for all existing certificate holders to convert their securities to electronic form.

4 Settlement Discipline The CSDR stipulates that clients has to necessarily honor their obligations on the specified settlement date and failure to do so authorizes the market intermediaries to take necessary preventive measures to prevent settlement failures. o Settlement Fines 6 - CSD s currently have a penalty mechanism in place for settlement fails, which acts as an effective deterrent. But as per the CSD Regulation guidelines, the penalties are to cover a far broader range of securities across all European markets than is covered currently. CSDR also encourages the fines collected from the defaulter to be credited to the non failing client as compensation. o Buy In Process 6 The CSDR imposes a mandatory buy in process on any financial instrument which has not been delivered within four business days of the original settlement date. This period can be extended to a maximum of four working days in the case of illiquid securities. As per the CSDR, CSD s will not execute the buy ins themselves but will only monitor the execution of the buy in process. While the above have been specified by CSDR, the guidelines for other markets are also on similar lines. Like the CSDR, DTCC is also looking to implement increased penalties for failed settlements and dematerialize existing physical securities. In addition to similar guidelines as above, other major changes which have been specified by the US Markets are (and will be applicable to all securities markets) would be: Institutional trades to be matched latest by noon on T+1, preferably on T+0 as a best practice. Mandated matching at depository end for purpose of settlement. Improve accuracy of standard settlement instructions Make the securities holding pattern completely dematerialized. Make Straight Through Processing (STP) between clients, brokerage firms, trading venues, custodians, clearing houses and CSD s more efficient to eliminate exceptions. CHANGES TO MARKET INTERMEDIARIES TO IMPLEMENT T+2 CYCLES Various market intermediaries will be affected in different ways for implementing T+2 settlement period. The major changes and risks faced by various intermediaries can be listed as below. Market Intermediary Clearing Corporations Functionality T+2 Related Change Challenges (if any) Trade Matching Clearing Trade Settlement Timely and automated confirmation to be done on same day Clearing and net positions have to be determined on same day of trade Receive settlement instructions and affect settlement as per Poor static data will cause delays/failures in confirmations More efficient networks with banks and depositories Messaging and connectivity with market intermediaries to be

5 Investment Manager Custodians Trade Notification Collateral Management Exception Handling Trade Capture Trade Confirmations Trade Allocation Trade Confirmations Trade Clearing shortened settlement cycle Final trade notifications to be sent as soon as possible to ensure smooth settlement, especially in the case of cross border trades Valuation of collaterals to be done on trade date T and T+1 date and margin calls sent out accordingly. Client reporting to be made near real time. New regulations will bring more stringent fines and Buy In processes. Trade capture and reconciliation with front office systems to be streamlined to avoid any failed trades in shortened cycle Response to any confirmations/affirmations should be automated and on same day of trade to prevent settlement failures Trade allocation needs to be done on the trade date Trade affirmation and confirmation have to be on same date to ensure smooth clearing and settlement For off market trades, custodians need to generate net positions on same day of trade and inform the client or broker of the obligations. more efficient to avoid exceptions Messaging systems to be as per latest ISO standards Data management is a challenge as pricing of collaterals to be done on trade date T. Ability to move collateral across regions for cross border trades in Europe within a condensed time frame is another challenge Poor Static data for all clients and instruments can create invalid trades leading to settlement failures Poor static data related to counterparties can cause confirmation/affirmation failures Static data challenges can lead to failures. Messaging systems need to deliver seamless straight through processing

6 Trade Settlement Corporate Actions Exception Handling Settlement instructions need to be generated on T+1 day to effect settlement on T+2 Corporate actions will be need to be handled in a tighter cycle as the ex date for corporate actions will be one day instead of two days. Fails management for all post trade processes needs to be automated as the reaction time is lower in the shortened cycle Payment Banks Messaging Messaging standards to be standardized across all markets to ensure timely settlement of funds Clearing Establish network amongst other clearing banks for more efficient clearing and transfer of funds Static data related to client details and instrument details needs to be accurate BENEFITS OF MOVING TO T+2 SETTLEMENT PERIOD Shortening the settlement cycle will mitigate systematic risk by reducing exposure between the party and the counterparty of the trade, between counterparties and the clearing house and for the clearing house itself. For individual investors, shortening of the settlement cycle will provide a greater confidence in the safety of the markets and will allow quicker access to funds following trade execution as well as reduce exposure risk between client and the broker. For US markets, according to a BCG study done for DTCC, when the settlement cycle is reduced from T+3 to T+2, the broker-dealer s risk of default falls from $300 million to $190 million, a 35% decline under stress scenario and from $2,600 million to $1,600 million, a 40% decline under major failure scenario. This is the potential loss a buy side carries if the broker dealer defaults in settlement 7. To guarantee settlement, clearing houses collects margins to cover potential losses in casse of a default by a broker on his portfolio. By reducing the settlement cycle, it is estimated that the clearing house would be able to reduce the average collateral contributed by the member by around 15% to 24%. In the case of US markets, a study indicated that a movement from T+3 to T+2 will lead to a decline of nearly $600 million from $4 billion in periods of average volatility 8.

7 Having a uniform settlement cycle across different regions helps global investment managers and global custodians to manage their cash flows and collateral better, improving liquidity and simplifying logistics. In the case of the European market only, a T+2 settlement cycle will help in implementing the T2S program to simplify settlements across Europe. COSTS AND RISKS ASSOCIATED IN MOVING TO T+2 SETTLEMENT PERIOD As per the BCG study, incremental industry investment required to move to T+2 would be approximately $550 million for DTCC. On a per firm basis, for a large institutional inter broker dealer, the investment would be $4.5 million driven by system/platform enhancements and end to end testing and analysis. Average custodian investment is estimated at $4 million around enhancement of interfaces and standardization of data formats. The investment for a large buy side firm is estimated at $1 million 7. For the European market, the European Central Securities Depositaries Association (ECSDA) estimates that the cost of implementing CSDR across Europe would be around 67 million Euros. A high degree of sophistication is required for smooth processing of back office operations in the absence of which the below risks can be encountered With reduced settlement periods, there is a narrower window between confirmation of trades and settlement of trades. Any problems in the post trade processes could lead to a settlement failure with financial implications for the clearing house as well as the broker. A clear automated audit trail needs to be maintained to track any exceptions. The compression of post trade activity to a narrower window will intensify pressure on inventory and collateral management of banks. List of Abbreviations Abbreviation CSDR Act T CSD OTC trades T2S DTCC ISO BCG Full Form Central Securities Depositaries Regulation Act Trade Date. T+2 refers to Trade Date plus two working days Central Securities Depository Over The Counter trades Target To Securities, an European securities settlement engine Depository Trust & Clearing Corporation International Organization for Standardization Boston Consulting Group References 1. ESMA Regulation dated January 5, Shortening the Settlement Cycle: The Move to T+2 by Price Water House and Coopers

8 3. Singapore moves to shorten Settlement Cycle by James Rundle in Waters Technology 4. T+2 Settlement Frequently Asked Questions by ASX (February 2015) 5. Q&A Implementation of T+2 standard settlement cycle on Swiss market SIX 6. The CSD Regulation-a guide for clients by Euroclear 7. Cost benefit analysis of shortening the settlement cycle BCG 8. DTCC recommends shortening the US trade settlement cycle April Shortening Securities Cash Settlement Authors Sumit Ghosal is a capital markets specialist and has rich experience in all aspects of investment banking, especially in post trade processes. He had worked for regulatory and self-regulatory bodies before moving to the IT industry as a functional consultant. He can be contacted at Sumit.Ghosal@hcl.com. Neeraj Sinha heads the capital markets practices and has vast experience in investment banking, product engineering and wealth management. He can be contacted at Neeraj.Sinha@hcl.com.