Umberto Menconi, head of Digital Markets Structures, Market Hub, Banca IMI, Intesa Sanpaolo Group
Since the financial crisis waves of new regulation and the need to meet these changes with innovative technology has presented our industry with many challenges – from labour transformation to processing to organisational changes and their concomitant costs – and so it continues. The agenda for 2020 is already very busy. For example:
- 31st January: Brexit is approved, with the full effect from 1st January 2021 after an eleven-month transition period.
- 11th April: the go-live date for the Securities Finance Transaction Regulation (SFTR) which aims to enhance the transparency and regulatory oversight of the securities financing market.
- 20th April: the last date to answer to the “Public consultation on the Review of the MiFID II/MiFIR regulatory framework” launched by the European Commission (EC), and little more than two years after MiFID II’s introduction in January 2018.
- By 1st June: the expected submission by the EC of a legislative proposal on how to turn the reporting obligation into a binding capital requirement for banks under the Fundamental Review of the Trading Book (FRTB).
Amidst this hectic timetable, a little bit of breathing space came on February 4th with the publication by the European Securities and Markets Authority (ESMA) of the “Final Report – CSDR RTS on Settlement Discipline – postponed entry into force”1, which postpones until 1st February 2021 the coming into force of The Commission Delegated Regulation (EU) 2018/1229 of 25 May 2018, supplementing Regulation (EU) No 909/2014 of the European Parliament and of the Council with regard to regulatory technical standards on settlement discipline (‘RTS on settlement discipline’). The aim of this delay is to meet the additional time needed for the go-live date of the penalty mechanism jointly established by the central securities depositories (CSDs), that use a common settlement infrastructure, and to give time to manage IT system changes, the development of ISO messages, market testing and adjustments to legal arrangements between the parties concerned.
CSDR Buy-in mechanism effects
The concept of mandatory buy-ins in the over the counter (OTC) bond markets, which are not centrally cleared, has been an emotive topic since it was first proposed in the lead up to CSD Regulation (CSDR) in 2014, because of its strong impact not only in terms of profitability and cost, but also in terms of market liquidity and client relationship.
There is not always the same reason for a security fail: a trade may not settle due to wrong or delayed instructions or because the seller is short of securities, or may not have enough of the security to fulfil the full delivery obligation and hence fail to deliver the full amount (unless a partial settlement is agreed). The fragmentation in European CSDs is another factor which needs to be considered, in particular after Brexit comes into force in 2021. Any losses derived from differences between the price of the original transaction and the buy-in price are paid by the failing counterparty in addition to penalties occurred in the extension period. While buy-ins are typically discretionary, as they can create unpredictable costs and are used for market participants to manage settlement risk in the case of failed trades, the obligation to initiate a buy-in procedure against a failing counterparty, with limited flexibility on timing to complete the process, may impact the financial markets ecosystem.
While they continue to support the rules to drive greater settlement efficiency and improved operational processes, for the ultimate benefit of the end investor, many market participants and associations are questioning whether this new market regulation might really improve settlement efficiency and are proposing a phased-in approach as well as changes to the actual regulatory framework of mandatory buy-ins to mitigate the risk of unintended consequences, all of which seem to run counter to the intended goals of the regulation.
An interesting study from the International Capital Markets Association (ICMA), entitled ‘Mandatory buy-ins under CSDR and the European bond markets – Impact Study’, in November 2019 revealed the majority of asset managers and pension funds surveyed expect a negative impact on bond market efficiency, pricing and market liquidity as a result of the rules. In turn, removing incentives to lend securities in the securities lending and repo markets, and reduce financing access to smaller corporate clients, all in conflict with Capital Market Union (CMU) objectives. Market makers could decide not to quote illiquid securities if there is a possibility of not finding it on market, or they could decide to increase bid/offer spread.
The impact is different depending on the type and on the liquidity of instrument transacted: equities, government bonds, corporate bonds, SME securities, and emerging market bonds.
Italian domestic markets
It would be very difficult to evaluate the total number of buy-ins that will be activated after the mandatory buy-in rules come into force across Europe, because market environment and trading behaviours are changing and technological innovation such as blockchain and distributed ledger technology are reshaping settlement and payment operating models.
Italian domestic markets still have a relevant retail component in terms of investors and order size. And equity, equity-like and fixed income instruments are mainly traded on regulated markets and multi-lateral trading facilities (MTFs), often supported by the central counterparty (CCP) trading model and less in a bilateral OTC space. In this scenario, on one side the actual CCP model rules partially reduce the impact of the new mandatory buy-in mechanism rules, whose impact is more restricted to illiquid bonds, traded in a bilateral OTC space. On the other hand, the small order size and low extension of the partial settlement agreement might magnify the negative impact of growing illiquidity in European markets.
How to prepare for mandatory buy-in going into force
The general awareness and preparedness of firms, both from an operational and trading strategy perspective, is still limited, and the industry welcomed the delay to 2021 proposed by ESMA. This was because it could allow further market impact analysis and changes to be proposed to the new regulatory framework, with the aim of better achieving the regulators goal of increased settlement and process efficiency.
In this environment, market participants need to take advantage of the delay, by undertaking a medium-term plan, both internally and externally, and in partnership with their clients, to adapt strategic trading business, risk management, repo-lending procedures, internal reporting and monitoring and operative settlement processes to reduce fails exposure and be able to fully meet the new regulations coming into force.
The author would like to thank Chiara Rocchi who helped in the research and preparation of this article.
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