Thomas Murray - CSD regulation – a new entrant’s perspective

CSD regulation – a new entrant’s perspective

Until fairly recently, Central Securities Depositories were uncompetitive, national monopolies that operated in a risk averse framework to service the settlement needs of their local market(s). Changes have been, and are being, implemented into this environment that are changing the ways in which CSDs operate. Their core service offerings as systemically important financial market infrastructures remain the same, but it is the way in which they operate that is evolving.

It is not just changes in the CSD space itself that are having an impact – rules around central clearing and depositary banking are also affecting CSDs. One of the responses to this has been the introduction of new players to the CSD space. As we explored from its perspective earlier, BNY Mellon has made the decision to establish a CSD in Belgium -

As a new CSD, BNY Mellon has been able to incorporate the regulatory changes that have occurred into its model. Whereas submissions such as CSDR and the CPSS-IOSCO Principles for Financial Market Infrastructures require remodelling of certain areas by some existing CSDs, BNY Mellon was able to incorporate those from the off.

The issue of new regulations in the CSD space is something that we explored with ECSDA at the end of 2013 -

Does BNY Mellon see all of the regulation as being necessary, especially as there is no precedent for CSD failure? “CSDR was very useful in defining what the regulators see as the core business of a CSD,” says Chris Prior-Willeard, CEO of BNY Mellon CSD. “In April 2012 the final CPSS-IOSCO Principles for Financial Market Infrastructures was published, which coincided with our application for authorisation as a CSD. We followed the CPSS-IOSCO framework in our application to the National Bank of Belgium. All of the aspects and principles have been applied to our application and our CSD. Had we done this a couple of years previously, we wouldn’t have had this rigour, which we found very helpful; it afforded us pure objectivity as to what constitutes a CSD.

“Of the 24 CPSS-IOSCO principles, 21 apply to us and they run through our core. It hasn’t been easy as there is a lot to take on. A lot of the key considerations in the principles are not closed, either; they are very open. But now that we have that structure, it is very beneficial.”

With new regulation, however, come new challenges that need to be incorporated into the framework of a CSD. “The challenge for us is that we just hit CSDR as it was being conceived,” explains Chris. “The basic premise was that CSDR would arrive in October 2012 and there would be a two year ‘grandfathering’ period for pre-existing CSDs. So our strategic target was to be a pre-existing CSD in time for CSDR because it does change life for a CSD quite significantly.

“So this was actually helpful as regards setting our timeline. To a certain extent, working with NBB we achieved that timeline. CSDR slipped a bit and on 18 December 2012 we got our Royal Decrees and that was fantastic. There is within CSDR, Article 52. This addresses the separation between banking and settlement. We took the view, along with our regulator, quite early that the separation was about reducing risk from a settlement function and it was pretty clear that there would be this division. So what we did was to set up a separate legal entity, a non-bank CSD in Belgium. With regulatory satisfaction, we now operate on a linked basis. We buy services from our European bank in Brussels and we have a separate legal entity for our CSD.

“There is still, however, a great deal of discussion between this separation of settlement and banking. Because that is so fundamental, this lack of clarity certainly falls under the definition of a regulatory challenge. We are just asking for clarity on this issue. We are actually hedged and don’t mind which way it goes. If there is a forced separation of banking and settlement, then fine. If there isn’t, then fine. This is a key element of regulating CSDs in Europe and the lack of clarity is unfortunate at this stage.”

The uncertainty is created by a number of regulations and initiatives pulling in opposite directions. AIFMD places limited liability upon depositaries at CSD level, where UCITS aims to close this loop-hole by putting liability back in at the CSD level. Then T2S is pushing European CSDs into a competitive environment where CSDR then defines a CSD in limited terms against this backdrop and leaves the CSDs little room for manoeuvre in response to competition.

As Chris points out, BNY Mellon has hedged and is well prepared for either outcome. “Our aim is to give clients a choice,” he continues. “This is a huge business and you cannot flip it overnight. We will be able to offer both commercial bank money as well as central bank money settlement. If the client wants a choice, we can provide that choice.”

Where there is a challenge, however, there is usually an opportunity. “Under AIFMD there is still uncertainty over what exactly is meant by ‘depositary delegation,’” continues Chris. “Until that becomes clear, you don’t know to what extent holding an AIFM’s assets at a CSD gives that relief of liability. Again, we need clarity. Again, however, we’ve hedged. We have a fully regulated and authorised CSD that has that ability to hold those assets. We feel as though we’ve got most options covered and that we’re in a strong position.”

BNY Mellon, as a new entrant, has been able to adopt a thoughtful approach to the establishment of its CSD. It is well placed to react to the regulatory challenges that lie ahead, something that has, in itself, become an opportunity to its CSD. It has also been able to incorporate and be prepared for future regulatory and CSD initiatives in Europe such as the move to a T+2 settlement cycle, anticipated to be completed across Europe in October 2014, and the go-live date of T2S, expected in 2015, by which time it will have been nine years in the making.

The move to T+2 is part of CSDR and its successful implementation is crucial to the success or otherwise of T2S. “I remember the days of GSTPA (Global Straight Through Processing Association) when the industry was experimenting with T+1… we all know what happened there!” says Chris. “Equally, I remember the move from account settlement to rolling settlement. We’re still very much in a people industry, although the move to electronic settlements from certificates was absolutely the right thing – settlement on certificate basis is not even T+3. Our direction is completely dematerialised; we have made no allowance for certificates at all. Also, the way in which our systems are designed, we can handle anything down to T+0, so we’re pretty relaxed about this move.”

The implementation of T2S has proven to be a more contentious issue. Designed, initially, to reduce the cost of cross-border settlements, it will no longer be able to deliver that goal. It has both its supporters and detractors. Indeed, one panellist at the recent Global Custody Forum commented that “T2S will cost in excess of €1 billion to save €50-100m.”

Chris, however, is a supporter of T2S. “Yes, I believe it is a good thing. I have followed the concept of a single European market closely and believe that standardisation and harmonisation are good things,” he says. “When a project as ambitious as T2S comes along, there has to be some regulation that paves the way to achieve these goals. When you get to the actual system itself, it has to be the right thing for the European market. Of course, when trying to implement a project such as T2S, there is always going to be local opposition because of the imposition of a standardised approach.

“What impresses me about T2S is the very clear political support for it. That’s what gives it greater momentum. With anything like this, there are always headwinds, but from our point of view, when we cast our first strategy, being a CSD on T2S was very important.”

One result of T2S will be increased competition amongst European CSDs. Naturally, as a new competitor in the space, Chris views this as a positive development. “Look at what MiFID did for exchanges,” he suggests. “In my opinion, T2S intentionally brings about competition because of the desire to have an efficient European single market that can be competitive with any other trading bloc worldwide. If you cannot mandate certain levels of efficiency, the only other way is to make them compete.

“Our own emergence as a CSD is because of T2S. We are unashamedly a different type of CSD that is entering the market and the encouragement we have received is because our arrival as a CSD is a direct consequence of the new regulations and of T2S.”

Where there is competition there is usually consolidation. Will this be any different for CSDs? “MiFID had this result for exchanges, so it is safe to assume that the same approach will have the same effect for CSDs,” predicts Chris.

It is clear that BNY Mellon has carefully considered all of the regulatory challenges and opportunities presented by the rapidly evolving European CSD space. The hedging of positions on certain outcomes of the regulatory overhaul means that the company is not keeping its fingers crossed on certain outcomes. There are clearly certain scenarios, certainly around AIFMD and UCITS, that would be beneficial to BNY Mellon in terms of its existing business framework and the new CSD, but it is not dependent upon those falling in its favour for a successful CSD – it has been set up with a clear path in mind, something that its longer established competitors have not had the advantage of being able to do. It has been able to be proactive with the regulation, not reactionary.

“We’re doing the sensible thing; we’re starting small and we’re learning,” concluded Chris. “Ours is an evolving story. Our strategy is very clear and I think it’s exciting. We’re working with prospective clients and will be able to announce our first clients very soon. We know exactly what we want to do and we are not bound by precedent. This has been very carefully structured and implemented. There is nothing knee-jerk about what we have established. Whether we see that from others in the market remains to be seen, but this is a pioneering move and we have set the precedent for others.”