The European Union is expected to pass a CSD Regulation (CSDR) into law later this year. For the first time, there will be a standard definition of a CSD across all EU member states and a common set of standards to be met.
The key points of the legislation are as follows.
- It mandates T+2 settlement for all transactions executed on trading venues. In other words, the requirement does not apply to off-exchange transactions, though the industry is proposing that T+2 should be the default settlement period for OTC trades as well, unless the two parties agree otherwise. Most European markets have decided to move to T+2 settlement from 6 October this year.
- It requires CSDs to implement measures to prevent, address and penalise settlement failures – these are discussed further below.
- It sets requirements for the governance of CSDs.
- It requires CSDs to have fair, public standards for admitting participants and to publish their prices.
- An interesting provision is the requirement that an issuer has the right to choose the CSD in which its securities are settled. This has the potential to make CSDs compete for issuers, although differences in company law may limit their freedom of choice in practice.
- It requires CSDs to provide non-discriminatory access to each other for establishing links and for non-discriminatory access between CSDs, CCPs and trading venues.
- It requires cash settlement to take place in central bank money wherever possible. It tightens the rules for CSDs providing banking services themselves or through other companies within the same corporate group.
The legislation requires the European Securities and Markets Authority (ESMA) to prepare technical standards implementing the legislation and ESMA has just issued a Discussion Paper on the proposed regulations.
Preventing settlement failures
Ensuring that transactions settle on the due date is critical in all securities markets. In most developing markets there are requirements that cash and securities must be in position and blocked before a trade is executed. This ensures that settlement will take place on the due date.
However, this model is not practical in European or most developed markets. When order execution times are measured in microseconds, the delay necessary to exchange messages with the CSD to block securities would not be acceptable. When it is possible to trade the same security on multiple different trading platforms and millions of orders are being placed and cancelled before execution each day, the number of messages between trading platforms and CSDs to block and release positions would overwhelm the system. The approach therefore is not to carry out checks before trading takes place but to place responsibility on the trading parties to ensure settlement takes place on the due date.
ESMA proposes a multi-tool approach.
- Matching of transactions will be compulsory and ESMA will mandate standard matching fields.
- CSDs should create incentives for early input and matching of settlement instructions. There should be penalties for settlement instructions not received two days before settlement date. When settlement is on T+2, this means all settlement instructions should be received on trade date!
- CSDs should provide hold/release functionality and multiple-batch (or real-time) processing to enable participants to manage their settlement.
- CSDR requires that there should be buying-in procedures where securities are not settled within four business days of intended settlement date (which may be extended to seven days) or within 15 days in the case of an SME growth market. There are difficulties with this approach, however. The first is that buying-in may not be possible: if the seller cannot find the securities to deliver, that may mean they are simply not available. Second, buying-in is generally the responsibility of trading venues or CCPs, rather than CSDs, which are not necessarily equipped to buy securities in the market.
- Finally, CSDR also requires CSDs to establish a system of cash penalties (known as “settlement discipline”) for transactions not settled on the due date. Detailed requirements have not yet been published.