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WorldMarch 20 2015

EU settlement discipline could push bond markets over the edge

Proposals for the mandatory buy-in of securities if trades fail to settle could drive market-makers out of the market.
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What is it?

In July 2014, the European Council of member states adopted the central securities depositories regulation (CSDR). The European Securities and Markets Authority (ESMA) published first draft technical standards in December 2014, followed by a public hearing a month later. The consultation period closed in February 2015, and more than 50 responses were received. Among other elements, CSDR contains settlement discipline rules designed to cut down on the number of trades where one party fails to deliver securities.

What is changing?

If one counterparty fails to deliver securities under a securities lending transaction such as a repurchase (repo) trade, the current International Capital Market Association (ICMA) rules allow a discretionary buy-in of securities by the failed-to party to replace those assets that were not delivered. This is usually applied on the final leg of the trade – in other words, if the party borrowing the securities fails to return them to the lender when the repo matures. But it is not generally used on the initial leg of the trade if the lender fails to deliver.

“On average, firms face about three to four buy-ins per quarter. It is usually seen as a rather aggressive step that can damage the relationship between the counterparties. If the trade involves a long collateral chain that needs unblocking somewhere or an illiquid instrument such as a frontier market bond, it is well understood that the trade may take a little longer than expected to settle,” says Andy Hill, director of market practice and regulatory policy at ICMA.

Moreover, a buy-in may not suit the failed-to party on the initial leg of the trade. By definition, if they are borrowing a security, it is likely to be because they did not want to buy the instrument outright.

The CSDR, however, has proposed a mandatory buy-in if a trade does not settle within four days for liquid securities, or seven days for illiquid securities, as well as a cash penalty on the party that fails to deliver.

What do the depositories say?

The European Central Securities Depositories Association (ECSDA) estimates that mandatory buy-in could trigger 1.8 million buy-ins per year, totalling €2500bn in bought-in securities. Fines would total €2.2bn. Moreover, the CSDs themselves have been designated by ESMA to enforce these rules, which has provoked deep concern from ECSDA.

“ESMA suggests giving CSDs an unprecedented role, requiring them to perform new tasks which are not entrusted to them today. Some of these tasks might not be practically possible for CSDs to perform and are likely to increase CSDs’ risk profile by creating new liabilities. An alternative approach is needed whereby buy-ins are handled at trading level, not at the settlement level,” ECSDA said in a response to the CSDR consultation.

Unintended consequences?

ICMA conducted a survey among sell-side participants in January 2015 to estimate the wider market implications of these measures. Respondents estimated that they would have to double bid/offer spreads on sovereign bonds to take account of the increased buy-in risk, and more than double the spread on liquid corporate bonds.

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More than a quarter of participants said they would stop offering to sell illiquid sovereign bonds unless already positioned, while more than 40% would stop offering illiquid corporates. ICMA estimates that the changes will cost investors €1.365bn for every €1000bn of bonds traded, and a minimum of €3bn in total costs to the repo market. Mr Hill says even these figures do not capture the full potential cost of lost market-making and securities lending capacity.

What’s the alternative?

The difficulty is that mandatory buy-in is set out in the level-one text of CSDR. This would require backing from the European Parliament, the European Commission and the European Council of member states to amend.

“We would hope that policy-makers are concerned enough about the unintended implications for market liquidity to do that. There is talk of amending unhelpful regulations as part of the capital markets union, but that could mean waiting until 2019 – we need a response before then,” says Godfried de Vidts, director of European affairs at inter-dealer broker ICAP and chairman of the European Repo Council.

In the meantime, the industry is pushing ESMA to delay implementation. The current plan is to bring CSDR into force in early 2016, with an 18-month phase-in period. ECSDA has asked for a 24-month phase-in, while Mr de Vidts believes ESMA should wait and see the effects of other measures before enforcing mandatory buy-in.

“The EU is still rolling out [the] Target2-Securities [pan-European settlement system] that should remove some of the fails we currently have. We are also working on industry initiatives such as harmonising national CSD cut-off times. We would ask ESMA to at least wait until these changes are implemented to know if this mandatory buy-in is a solution looking for a problem,” says Mr de Vidts.

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