CSDR – Don’t Fail to Prepare or Prepare to Pay the Failure Penalty!

Devised at an EU level, the Central Security Depository Regulation (CSDR) will force European CSDs to take measures to prevent settlement fails and processes required when such fails took place. These include penalty schemes, as well as forced buy-in and sell-out procedures which require trading parties to deliver either cash, or financial instruments in the event of non-delivery. This can be used to avoid the potential liquidity risks that can occur due to failed settlement instructions. CSDs will apply financial fines for failing to complete transactions on the intended settlement date. The rule, enforced on 1 February 2021, means that there will now be a legal obligation for one side of the trade to pay a hefty fine. There are multiple facets to this most complex of rules. Let me highlight  two of the most immediate concerns:

1. reporting of failed settlements and calculation of cash penalties
2. mandatory buy-in process

The main challenge that the industry is struggling with is to access the granularity of information needed to assess the financial instruments that could fail to settle under CSDR. While they may be able to get cash amounts from CSDs, custodians can’t easily get hold of the reference and price data being used to work out exactly how the penalties were calculated. This includes highly important insights such as how to determine the market valuation of any given instrument, not to mention the closing price of the most relevant market within the EU.

So, what does a custodian do for price information? Normally, the price information would be based on final trade of the day. However, some trading venues do not even provide this information. And without it, it is practically impossible to arrive at an accurate turnover figure. Certainly not in time to compare the turnover figure with another venue where the same instrument is also listed or traded. 

And here lies the Pandora’s box of problems that could open up not just for custodians, but also for anyone involved in a trade chain for an  instrument under CSDR. Trade fails and resulting penalties are, of course, less likely for say liquid equities or equity style instruments like ETFs or warrants. But for the more illiquid instruments, it is a different story. Take trying to identify the market value on the closing price of a credit bond as a prime case in point. It could be weeks, or even months, before the bond is even traded. The trouble is, with no accurate liquidity level for the instrument, it becomes almost impossible to assign the correct penalty rate. 

So, what can the financial sector as a whole do to ensure they do not fall foul of CSDR when it comes into full effect in February next year? Nine months will go by in a flash – which means the industry really needs to be gathering the information needed to test the impact of trading in a “CSDR-compliant” regulatory environment. 

• CSDs will need the most up to date high quality reference and pricing data in order to calculate extra compensations or cash penalties. 
• Custodians and any other market participants potentially involved in a CSDR sensitive trade, will need to ask CSDs for detailed analysis about the likely instruments “in-scope” under CSDR. 

So much work to do and so little time. It may just force the industry to accelerate its preparations. After all, no EU financial institution wants to face the inevitable consequences because of lack of preparation.