CMI in Focus - CSDR and its Implications for Third-Country CSDs

The Central Securities Depository Regulation (CSDR), the European Union’s legislation on central securities depositories, came into force in September of this year, although its application is awaiting the publication and implementation of the Level 2 technical standards. The new regulation is the latest in a wave stemming from the political backlash following the collapse of Lehman Brothers in 2008 and the ensuing Global Financial Crisis.

Despite all post-trade infrastructure continuing to operate in a secure and stable manner throughout the crisis, recognition of the central position of CSDs and CCPs to the orderly and efficient running of markets has led to increased requirements for their oversight. For the first time through the CSDR, a definition of a CSD and what core services it should provide has been made. Furthermore, CSDR will harmonise settlement rules in an attempt to impose a single settlement discipline in the market. One of the most important factors is the introduction of a two-day settlement cycle for all CSDs in the EU. Most CSDs in EU Member States are planning to migrate to a T+2 cycle during October 2014.

CSDR will also attempt to eliminate cross-border barriers within the EU in a safe and efficient manner so issuers, investors and CSDs themselves can have easier access to other depositories. Lastly, CSDR seeks to enhance overall market transparency and to facilitate the movement of capital.

In order to enforce the new regulation, CSDR created a common structure to grant authorisation and to monitor compliance. These procedures are embedded in a multi-layered framework which consists of five components: (i) Level 1 Regulation (77 articles documented in CSDR), (ii) Level 2 Standards (also known as technical standards), (iii) European Securities Market Authority (ESMA) guidelines, (iv) annual monitoring reports by ESMA and (v) EU Commission review in five years’ time. This approach implies that national regulators will need to cooperate closely with relevant authorities (e.g. ESMA) and peers in other member states.

At first glance, CSDR seems to make sense. Like many EU directives and regulations, however, the difficulties come with the implementation, often against unrealistic deadlines. ESMA has not issued the technical standards yet which will provide the detail of what CSDs will have to implement in order to comply and where CSDs will face the most significant challenges that will emerge from this regulation.

The draft Level 2 Standards will be made public in June 2015 and will enter into force in November 2015. CSDs will need to be compliant with those standards by November 2016. That means depositories will have 12 months to make all the necessary adjustments to their operations in order to fully comply with CSDR.

The technical standards will indicate what CSDs are expected to achieve in terms of risk management framework, business continuity, recovery plan, transparency arrangements, record keeping, price transparency, fails reporting and account segregation. One of the most contentious issues still open is the so-called ‘Settlement discipline’ issue whereby CSDs seem to be charged with guaranteeing all transactions not covered by a CCP. Also, there will be additional safeguards for CSD banking services, including a capital surcharge.

This last item is particularly important as all CSDs are being encouraged to move up the value chain in reaction to Target 2-Securities (T2S). Any banking services provided as part of, for example, an Investor CSD’s custody service, will attract the same kind of capital and liquidity provisions as those embedded in Basel III. While the likes of the ICSDs already have these regulatory requirements in hand, it would pose a significant barrier for entry of new CSDs into these service areas. Atypical models to circumvent this (e.g. using a third-party liquidity provider) may be deemed sub-optimal and put these new entrants at a significant disadvantage.

So, CSDR is a European issue created by European authorities for European CSDs, right? Wrong!

Whilst it is true that CSDR is a European legislation aimed at European depositories, there are two articles in the text that make CSDR relevant for non-European CSDs. Articles 25 and 48 define the conditions that third-country depositories need to meet if they wish to operate in the EU. The former is aimed at regulating non-EU depositories that provide services in Europe through a branch, while the latter governs the links that EU CSDs hold with third-country CSDs.

Article 25 indicates that any CSD from a non-EU member state wishing to branch into Europe must have full ESMA recognition. This implies that the requesting CSD must be subject to effective supervision and oversight, equivalent to that applicable to European depositories.

The competent authorities in the member state in which the third-country CSD intends to provide its service must assess that the applicant is in a position to comply. This would be a direct parallel to the registration requirement under EMIR for clearing houses in third-countries with EU-based clearing members. Against this background, CSDR will impose additional burdens to those depositories that currently do business with European partners.

The silver lining is that if the non-European CSD has already undertaken an assessment of the CPSS-IOSCO principles for financial market infrastructures (PFMIs) and is deemed as ‘observing’ the PFMIs; then it is likely that the third-country depository will obtain the ESMA recognition.

In the case of Article 48, the same logic will apply to third-country CSDs operating links with European depositories. The key points in this article relate to the extent of risk involved in the CSD-CSD link with higher risk profiles requiring extra scrutiny from ESMA. The two main criteria for assessing this is whether the links are DVP (delivery versus payment) or not and whether direct or indirect, with non-DVP and/or indirect being subject to a higher degree of scrutiny.

So what?

CSDR is bringing significant changes to the European capital market infrastructure. Depositories in the region will need to change the way they operate. With a harmonised plain level field, issuers and investors will be able to select any CSD they want in the region. This enhanced competition across core services means depositories will only be able to differentiate themselves via tariffs, ancillary (possibly banking) services and links to third-country CSDs. It is likely that small and/or inefficient CSDs will be absorbed by larger, more competitive entities, the very rationale behind the twin pillars of CSDR and T2S.

Whilst competition could be beneficial for investors and issuers, the investment costs CSDs will bear in the short-term to transform their businesses will likely be passed on to customers and end investors. These costs could be relatively high, especially as CSDs will have a relatively narrow window to make all the changes to their systems from the moment the Level 2 Standards are published. Failing to meet these standards means the CSDs will not be able operate in their own markets.

Add to this the major distraction and uncertainty that the re-authorisation process will bring to CSDs and the leap of faith CSDs will be making as they on-board to T2S and it is easy to see that the post-trade industry in Europe is in for a rough ride over the next few years. For third-country CSDs, opportunities exist to branch into Europe and it is likely we will see more than one of the major players do so. For the rest, it is essential that they are cognisant of the requirements of CSDR in relation to links to EU CSDs and that they are ready with their CPSS-IOSCO PFMI self-assessments and legal and regulatory equivalency studies.

For further information contact:

Luis Carlos Nino

Luis Carlos Nino
Senior Risk Analyst
Thomas Murray Data Services
+44 (0) 20 8600 2346

Jim Micklethwaite

Jim Micklethwaite
Director, Capital Markets
Thomas Murray Data Services
+44 (0) 20 8600 2309

Tags: RegulationCSDRCSDICSDT+2T2SSettlementEuropean UnionEU