(What remains of) Settlement Discipline begins today

1 February 2022 marks the coming into force of the CSDR’s Settlement Discipline Regime (SDR). As originally envisaged the SDR aims to harmonise the authorisation and supervision of CSDs across the EEA, mandating rules for CSD organisation and conduct.  and uniform settlement requirements. The seemingly bland intention to promote safe and efficient settlement proved controversial at best, unworkable at worst. Already subject to a series of technical and COVID-related delays, on 24 November 2021, the EU signalled its agreement to postpone the mandatory buy-in element of its timely settlement incentives.  While buy-ins will be reconsidered under the forthcoming 2024 CSDR Refit/Revision, it became evident that their unilateral application would act to drive business away from the EU, even if what remained were settled slightly quicker. The postponement of mandatory buy-in is accordingly likely to be permanent. While this was broadly welcomed by CSDs and their clients, elements of the SDR remain and are now in force. This note will briefly examine what they are and their potential implications.

CSDR Scope

The CSDR in all its three phases is of broad application. It applies to all EEA CSDs, their clients and resulting trades settling in the EEA. It therefore comprises CSDs in all EU member states, as well as those located/or settling trades in Liechtenstein, Iceland, Norway and Switzerland. In an early indication of post-Brexit demarcation, the UK indicated that it will not implement the SDR. However, given the CSDR applies to all trades settled with an EEA CSD, it has extensive, practical extraterritorial effect. As well as EU CSD direct participants, the SDR will bite on EU investment firms via provisions including allocation confirmations and will have effect outside the EEA according to their degree of connection with in-scope CSDs. There is at least a strong possibility that the broader market will seek to avoid a two/multi-track settlement process, with the SDR provisions becoming standard market practice that at least incorporates the UK.

How will SDR Penalties operate?

Aside from the raft of measures aimed at harmonising CSDs themselves, the SDR’s penalties regime is of greater import to the wider market. Unsurprisingly, the CSDR operates exclusively via CSDs. CSDs are required to report on a daily basis cash penalties for trades that fail to settle under the T+2 timeframe. The directly affected participant must be provided with the account details for each failed settlement, facilitating the transfer of the cash penalty to the next participant in the settlement chain, where applicable in terms of fault. The CSD is required on at least a monthly basis, to collect the net amount of cash penalties from each failing participant must be charged and collected on at least a monthly basis and to re-distribute these amounts to those adversely affected. Specific penalty amounts depend on the underlying market liquidity of instrument involved in the fail. Penalties will range from .5 – 1bp, charged daily on the market value or the affected instrument in the case of failure to deliver, or on the cash amount in respect of failure to pay. More liquid instruments will tend to towards the higher end of the penalty scale in recognition that they should be easier to find/transact, therefore less subject to settlement failure.

Passing the penalty on

The CSDR aims to achieve a +99% same day match rate. Numbers vary, but across the EU same day match agreement is currently estimated to be approx. 93%, settlement fails therefore continue to be a relatively common event. As above, daily penalties will be imposed by CSDs on their direct clients. However, settlement chains may be extensive and actual responsibility for failure may reside at any link in the chain. The mechanism to pass penalties further up the settlement chain is not addressed in the SDR and there is no Central Bank guidance to date.

Absent such guidance, fund management companies who are both directly and indirectly affected by the new penalty regime must consider a number of factors. Firstly, AIFMD and UCITS legislation forbids any fund from passing on “undue costs” to any funds’ end-investors. Any onward allocation of cash penalties must conform to ESMA’s 2020 supervisory briefing on the supervision of costs in UCITS and AIFS, including evidence to the board of an externally-managed fund and applicable Regulators that the matter has been appropriately assessed.

Under both the UCITS and AIFMD frameworks, fund management companies are under a legislative obligation to ensure that no “undue costs” are borne by investors in any fund under management. In circumstances where the cash penalties may be borne by the fund, the fund management company in question should be able to justify this position to the board of directors of the externally managed fund and provide to its competent authority documentary evidence (in the form of board minutes or otherwise) that it has considered the matter and is satisfied that this does not constitute an “undue cost” taking into account the considerations outlined by ESMA in its published in 2020. Constitutive documents and the fund’s prospectus should be reviewed to ensure risk disclosures refer to the potential for penalty costs.  Governance structures may require revision to allow for the onward allocation of cash penalties and where applicable, service-level and other contractual agreements may need at least a re-visit.

If funds are not already a long way along this process, as a matter of some urgency, both EU and UK firms they should take the following practical steps:

• Assess the extent to which cash penalty regime is likely to impact their operations
• Assess the extent to which penalties and/or credits can be passed onto funds and the degree of extra communications/disclosures/notices will be required to effect this change
• Maximise utilisation of STP technologies/processes to minimise settlement fails

Details will include, but not be limited to, decisions such as:

• Agreement that clients will agree allocation confirmations;
• Overall responsibility for cash penalties/credits;
• Agreements as to retention/transfer of cash penalties/credits
• Minimum transfer amounts for cash penalties/credits; and,
• The degree to which partial settlement may mitigate penalties.

In terms of potential operational and financial impact, the removal of the complex mandatory buy-in regime has greatly simplified the SDR. However, it would be a mistake to assume that the “beast” has been slain, the operational, legal and potentially commercial impacts of the regime remain consequential. It is to be hoped that affected firms/funds are already fully prepared; however, the lack of official guidance to date combined with competition for internal resources renders uniform, perfect preparation overwhelmingly unlikely. If you are affected even minimally by the SDR and haven’t acted so far, now is the time.

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