The CSDR solution
05 Sep 2018
Kerril Burke, CEO of Meritsoft, discusses the company’s CSDR solution and the mandatory buy-in process associated with CSD
Image: Shutterstock
Will the mandatory buy-in process happen entirely without the intervention of the CSD?
Our understanding (at Meritsoft) is yes. The buy-in will not go through Central Securities Depository (CSD), but instead be direct obligations between the two trading counterparts. On occasion, the CSD may be involved indirectly in settling new instructions, but will not know or need to know they relate to a buy-in.
Therefore, any situation where a firm can’t deliver what it has promised starts to unravel the inherent complexity of CSD Regulation (CSDR). For example, firms often sell a security in the hope that the price would fall in order to make profit.
However, what happens if the price moves in the other direction, and the firm gets caught on the wrong side of the trade?
If the price starts to move sharply, say 15 percent to 20 percent in the other direction, the firm may get caught on a short squeeze under the CSDR mandatory buy-ins.
This is a process where shares are forced to be repurchased if the seller does not deliver the securities in a timely manner.
Under CSDR buy-ins, what is deemed a liquid security is due to be settled after four days, while an illiquid asset needs to be settled after seven.
The trouble is, how does a firm determine what’s liquid and illiquid?
In the non-exchange markets, there is likely to be a range of different judgements based on market consensus.
Who will then enforce the regulation and make sure buy-ins are executed if it’s completely bilateral?
We are not sure who will enforce the regulation yet. However, I imagine it will be a process that would be subject to compliance review.
CSDR has been constructed in a way that means one side gains, and the other loses on a “fault” basis.
The problem is that there could be any number of factors as to why a trade fails to settle.
It may be something fairly straightforward such as one side failing to instruct an order to be placed at a certain time.
It could be something far more disconcerting, such as the buyer of the security not having enough cash.
Conversely, and this is the major headache facing banks, the seller may not actually have the security to sell.
Or, more likely, may not have enough of the security to fulfil the full delivery obligation and hence fail to deliver the full amount unless a partial settlement is agreed.
Would it be accurate to say that Meritsoft has built a CSDR solution that allows firms to calculate the cost of penalties so they can compare it to CSDs’ calculations?
Yes, exactly. In basic terms, CSDR will require impacted European CSD’s and International Central Securities Depository (ICSD) to apply financial fines for failing to complete transactions on the contractual settlement date and award these penalties to the other side of the transaction.
Instead of having a formal agreement between the buyer and seller, there will now be a legal obligation for one side to pay a penalty fee, while the other side receives cash if the trade is not settled on time where they are settling through an impacted CSD or ICSD.
These penalties are dependent on the type of instrument transacted, with different rates applying to equities than to corporate bonds, government bonds etc.
As you say, our product allows firms to calculate the cost of these penalties so they can compare their calculations to the CSD’s calculations.
However, we also aim to facilitate our customers in managing the credits and charges and where appropriate allocating them to their underlying clients and then facilitating the onward collection of penalties.
We are also facilitating customers in managing any ‘buy-in’ exposure as a failing transaction approached the mandatory buy in dates for liquid and illiquid securities.
Finally, we plan to facilitate the calculation, central management, exchange and settlement of penalties via a central utility/hub.
Is Meritsoft’s CSDR solution directed at custodians?
The solution is directed at custodian’s, investment banks, brokers, fund managers and CSD’s. But it is important to remember that one firm’s penalty will be different to another firm’s credit.
Until now, there has been no standard market practice for dealing with this issue, which is why market participants are trying and figure out a way to share information around buy-ins and penalties.
Our solution generates potential buy-in notifications and validations, which helps investment and custodian banks to overcome this issue.
Our understanding (at Meritsoft) is yes. The buy-in will not go through Central Securities Depository (CSD), but instead be direct obligations between the two trading counterparts. On occasion, the CSD may be involved indirectly in settling new instructions, but will not know or need to know they relate to a buy-in.
Therefore, any situation where a firm can’t deliver what it has promised starts to unravel the inherent complexity of CSD Regulation (CSDR). For example, firms often sell a security in the hope that the price would fall in order to make profit.
However, what happens if the price moves in the other direction, and the firm gets caught on the wrong side of the trade?
If the price starts to move sharply, say 15 percent to 20 percent in the other direction, the firm may get caught on a short squeeze under the CSDR mandatory buy-ins.
This is a process where shares are forced to be repurchased if the seller does not deliver the securities in a timely manner.
Under CSDR buy-ins, what is deemed a liquid security is due to be settled after four days, while an illiquid asset needs to be settled after seven.
The trouble is, how does a firm determine what’s liquid and illiquid?
In the non-exchange markets, there is likely to be a range of different judgements based on market consensus.
Who will then enforce the regulation and make sure buy-ins are executed if it’s completely bilateral?
We are not sure who will enforce the regulation yet. However, I imagine it will be a process that would be subject to compliance review.
CSDR has been constructed in a way that means one side gains, and the other loses on a “fault” basis.
The problem is that there could be any number of factors as to why a trade fails to settle.
It may be something fairly straightforward such as one side failing to instruct an order to be placed at a certain time.
It could be something far more disconcerting, such as the buyer of the security not having enough cash.
Conversely, and this is the major headache facing banks, the seller may not actually have the security to sell.
Or, more likely, may not have enough of the security to fulfil the full delivery obligation and hence fail to deliver the full amount unless a partial settlement is agreed.
Would it be accurate to say that Meritsoft has built a CSDR solution that allows firms to calculate the cost of penalties so they can compare it to CSDs’ calculations?
Yes, exactly. In basic terms, CSDR will require impacted European CSD’s and International Central Securities Depository (ICSD) to apply financial fines for failing to complete transactions on the contractual settlement date and award these penalties to the other side of the transaction.
Instead of having a formal agreement between the buyer and seller, there will now be a legal obligation for one side to pay a penalty fee, while the other side receives cash if the trade is not settled on time where they are settling through an impacted CSD or ICSD.
These penalties are dependent on the type of instrument transacted, with different rates applying to equities than to corporate bonds, government bonds etc.
As you say, our product allows firms to calculate the cost of these penalties so they can compare their calculations to the CSD’s calculations.
However, we also aim to facilitate our customers in managing the credits and charges and where appropriate allocating them to their underlying clients and then facilitating the onward collection of penalties.
We are also facilitating customers in managing any ‘buy-in’ exposure as a failing transaction approached the mandatory buy in dates for liquid and illiquid securities.
Finally, we plan to facilitate the calculation, central management, exchange and settlement of penalties via a central utility/hub.
Is Meritsoft’s CSDR solution directed at custodians?
The solution is directed at custodian’s, investment banks, brokers, fund managers and CSD’s. But it is important to remember that one firm’s penalty will be different to another firm’s credit.
Until now, there has been no standard market practice for dealing with this issue, which is why market participants are trying and figure out a way to share information around buy-ins and penalties.
Our solution generates potential buy-in notifications and validations, which helps investment and custodian banks to overcome this issue.
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