Regulations in the CSD space – are they all necessary?

There is a lot of change taking place in the CSD space right now. As a knock-on effect of the post-2007 financial crises, CSDs have been nominated as systemically important market infrastructures that have been subjected to new rules, regulations and principles that are aimed at improving the safety framework of such entities. As well as T2S, the move to a T+2 settlement cycle, the CPSS-IOSCO Principles for Financial Market Infrastructures and new rules coming around AIFMD and UCITS V that will have knock-on effects in the CSD space, there is the designated CSD Regulation that is changing the way in which CSDs operate.

CSDs, like CCPs, came out of the financial crisis well. They stood up to the test of severe market conditions and, as such, increasing importance has been placed upon them in the regulatory push to improve safety, efficiency and transparency in the markets. The two infrastructures operate in very different ways, though. It is not appropriate, or sensible, to apply the same standards and risk frameworks and operational principles to both.

Unlike CCPs, there is no precedent for a CSD failure. Their settlement systems have evolved over time with the improvement in technology and they are now vastly more sophisticated entities than they were in the days of book settlement where all records were kept on paper. They have also, in Europe at least, been natural monopolies. Every market has access to at least one CSD that services its settlement needs. Given that everything has run smoothly for CSDs, even in times of crisis, is all of the regulation that is being placed upon them and all of the changes that are occurring as a result, a good thing?

“At European level there are a number of upcoming initiatives, but there is primarily one that has a direct impact on CSDs and that is the CSD Regulation (CSDR),” says Soraya Belghazi, secretary general of ECSDA, the European CSD Association. “As an association at ECSDA, we are very much focused on this piece of regulation because it is very comprehensive and it is the first time, really, that we are going to have binding regulation at a European level that will introduce the same rules for all of the CSDs in Europe

“Is it necessary? I would say that yes, it is necessary. There are a number of benefits that we expect to arise out of CSDR and from the beginning ECSDA has been supportive of this initiative. It is different from other European regulations such as EMIR that are a direct result of the post 2007 financial crises, so in a way it has been less urgent. There is already a European framework in place for exchanges, trading venues and CCPs to have harmonised roles in the capital markets space. With the upcoming T2S initiative, it is important to have a more harmonised regulatory environment for CSDs as well.

“So I would certainly say that the regulation is a good thing as in some areas it will bring important benefits and harmonise the roles of CSDs and make it easier for them to compete. In order to have fair competition you need to have harmonisation to create a level playing field, so in that sense it is very important.”

The emphasis of the regulatory movement globally is on making safer and more efficient markets. Given how well CSDs have performed in the past, it could be argued that they are already pretty risk averse, therefore safer, entities. “It is absolutely fair that CSDs should come under the regulatory microscope, too. We agree with this,” says Soraya. “The question then becomes, how far should the regulations go? You clearly can’t use the same tools to regulate a CSD as you use to regulate a CCP, this would be very inappropriate. The issue is not so much the number of regulations impacting CSDs, but it’s rather a question of finding the right balance and scope for regulation. Principles around the failure of a CSD and its safety framework are welcome and necessary, but you need a proportionate framework, with more flexibility than for CCPs, given CSDs’ lower risk profile.”

Lowering risk is an obvious goal at the moment, planning for worst case scenarios and extreme market conditions. Planning for the failure of a CSD is difficult, though. What would the consequences be? “It is very difficult to envisage what would happen if a CSD failed because there is no precedent for it,” says Soraya. “There are examples of CCPs failing, but not of CSDs. Beyond hoping that won’t happen, of course, you need a very, very strong safety framework that means that you can always reach a stage of recovery and ensure the continuity of critical services, without having to reach the stage of resolution. We recognise that CSDs are systemic market infrastructures and this is a big part of the CPSS-IOSCO Principles, in recognising that, even in the smaller markets, CSDs do perform a central role. So work has been undertaken to think the unthinkable and work out what needs to be put in place if a CSD did fail.

“Our focus at ECSDA is very much on recovery. We never want to have to end up in resolution mode, there needs to be every chance of a recovery occurring. A big factor is the point that most CSDs are not exposed to counterparty credit risk, they are only exposed to the recovery of payment fees from a failed participant, so this really isn’t an issue to be factored in. What could go wrong in the case of a CSD is a major operational problem, for example, not the failure of a major participant like in the case of CCPs. The failure of large market participants should not affect the CSDs, at least not directly, and should not lead to insolvency.”

It is clear that there are still areas to be resolved in the CSD regulatory space. Whilst you can never make financial market infrastructures too safe, you can take the regulatory interference too far. As Soraya points out, the principles used to govern CCPs cannot be applied verbatim to CSDs. One pattern that has become established across Europe is that of increased competition.

Next time, we’ll look at the effects of CSDR and T2S upon competition amongst European CSDs. This is a new element to the CSD space, so it is being taken into the unknown to a certain extent. Now that the regulations are almost finalised, what will be the effect of competition upon CSDs?