The Central Securities Depositories Regulation (the "CSDR") came into effect on 17 September 2014 and will complete the EU regulatory framework for financial market infrastructure. Amongst other things, the CSDR provides a regulatory framework for the safe, efficient and smooth settlement of transactions in financial instruments carried out in the EU, including by requiring trading venues and investment firms established in the EU to implement measures to prevent and address failures in settlement processes. These measures apply from 13 September 2020.
This alert considers the impact of the new framework governing settlement fails on investment firms and their counterparties and clients. The impact of the CSDR extends beyond the cash securities markets and applies to securities financing transactions (i.e. repo and stock lending) as well as certain types of derivative contracts. The imposition of a one-way payment mechanism for compensation in respect of a buy-in has proved to be a controversial topic for all of these markets.
Implementation under the CSDR will require investment firms and their counterparties to build systems and processes and adapt their trading documentation by 13 September 2020. Firms should consider preparing for compliance now.
Settlement fails under the CSDR
A settlement fail includes both the non-occurrence of settlement on the intended settlement date due to a lack of securities or cash and a partial settlement of the transaction through the transfer of insufficient securities or cash.
A settlement fail is deemed to occur irrespective of the underlying cause. The CSDR measures apply regardless of any other default procedure that may be applicable in respect of the underlying transaction and do not depend on the outcome of any associated litigation.
Measures to prevent settlement fails
Under the CSDR, in an attempt to ensure prompt settlement and to prevent a settlement fail, investment firms executing client orders are required to collect certain information concerning clients' transactions. This includes an allocation by the client of securities to the transaction, confirmation of that allocation and confirmation of the acceptance or rejection of the terms of the transaction before the intended settlement date.
This requirement applies to any transaction settled in a CSD if that transaction concerns transferable securities, money-market instruments, units in collective investment undertakings or emission allowances. This requirement does not apply in respect of other transactions including, for instance, derivative contracts.
The firm's clients (although not market counterparties) must then provide certain prescribed information to the investment firm executing their order as well as the client's written confirmation of acceptance of the terms of the underlying transaction.
Measures to address settlement fails
Where a settlement fail does occur, CSDs must impose the following measures:
- Penalties on failing participants, including cash penalties calculated in respect of every business day on which the transaction has not been settled after the intended settlement date.
- A buy-in process under which, if the failing participant does not deliver securities to the receiving participant within four business days (in most cases) after the intended settlement date, those securities will be purchased in the market and made available for settlement and delivered to the receiving participant (the "Buy-in Process").
These measures are mandatory and are one-way. Although they will typically apply at the CCP or CSD account holder level the costs will, of course, be passed on to the underlying clients of the broker/custodian.
The entity that is responsible for executing the buy-in under the Buy-in Process depends on whether the transaction is cleared, executed on a trading venue or executed on an OTC basis and not subject to clearing.
Where a transaction is cleared, the central counterparty ("CCP") will be responsible for executing the buy-in. Where a transaction is executed on a trading venue but not cleared, the relevant participant in that venue must execute the buy-in. Where a transaction is executed on an OTC basis and is not cleared, the relevant CSD participant will be required to execute the buy-in.
- Buy-in Process for transactions cleared by a CCP
Where the CCP determines that a buy-in is possible, it is required to launch an auction or appoint an agent to execute the buy-in on behalf of the clearing member which failed to make the delivery. That clearing member must put any outstanding settlement instruction in respect of the settlement fail on hold. The buy-in agent or the clearing member will then deliver financial instruments that have been bought in to cover the settlement fail to the CCP. Where a buy-in is not possible, cash compensation is payable by the clearing member to cover non-delivery of the relevant securities.
- Buy-in Process for transactions executed on a trading venue but not cleared by a CCP
Where the party entitled to delivery of securities determines that a buy-in is possible, it will appoint a buy-in agent to purchase the securities subject to the settlement fail. That party must put the settlement instruction in respect of the settlement fail on hold. The buy-in agent will transfer the bought-in securities to the party entitled to delivery. That party will notify the party which failed to make delivery of the buy-in, including the price and quantity of securities purchased. Following this notification, it is required to pay any cash compensation required to cover a difference between the buy-in price and the settlement price in respect of the settlement fail. Where buy-in is not possible, cash compensation is payable by the failing participant.
- Buy-in Process for transactions not executed on a trading venue and not cleared by a CCP
The process for a buy-in between parties trading on an OTC basis is identical to that for a buy-in executed in respect of an uncleared transaction executed on a trading venue. The buy-in agent is appointed by the party expecting delivery.
Impact on trading documentation
Investment firms and their clients must reflect the processes for each of these types of transaction in their contractual documentation by 13 September 2020. This includes amending contracts to incorporate provisions necessary to execute the buy-in, pay buy-in costs to the buy-in agent, reflect any price difference between the trade price and the buy-in price and pay cash compensation that may be due under CSDR in respect of the Buy-in Process.
Investment firms must also ensure that these contractual terms are enforceable in each of their jurisdictions, which may require parties to obtain legal opinions to this effect.
This will mean changes to terms of business, master agreements for repo and stock lending, certain derivative contracts as well as prime brokerage and custody and clearing documentation. As yet no industry standard wording or implementation protocols are available but we expect that standardised wording will start to appear before long.
Fieldfisher's award-winning Condor alternative legal solutions platform is ideally placed to assist you to implement the changes to contract terms which are required under the CSDR. Condor provides a cost-effective documentation solution, working with your in-house team to repaper clients in accordance with the requirements of the CSDR. Our Fieldfisher lawyers can advise on the impact of the changes and carry out the enforceability assessment required under CSDR, providing clients with a total solution.
Impact of hard Brexit
We ought to mention that in the event of a 'hard Brexit', those provisions of CSDR that are 'in-flight' (i.e., not applicable law on before the day of exit – including those considered in this alert) will not automatically be adopted into UK law upon exit. A hard Brexit could therefore result in a divergence between the UK and the EU implementation of these obligations.