Once the CSDR standards are published in the EU’s official journal, firms will have two years to prepare before measures come into play. What would you advise for custodians?
We need to focus on understanding what it is that the regulatory authority is trying to achieve and how it affects the role of a custodian. A review of the infrastructure to see how to incorporate settlement discipline fines into their service is also necessary. From our perspective, it’s very much around how we are going to receive and process information and how we are going to interpret those rules and guidelines into proper practical implementations that we can use to improve our business model as a service provider. We are looking at increased demand for securities borrowing—there could be an opportunity for custodians to identify a borrowing capability to assist clients from limiting, or avoiding, a mandatory buy-in.
A key question for custodians is whether they would ever absorb charges on behalf of their client. The industry is venturing into unchartered territory with respect to a new settlement discipline and a new way of servicing clients. This in itself will be complex, taking into consideration the levels of reconciliation required to de-mark each category of instrument, by the client, and by the respective classification of liquidity. There is no universal process for this today, so in the medium term, I would expect a huge amount of development across all market participants to achieve automated processes and procedures.
What implications does CSDR have for custodians?
One of the key implications of CSDR is data in the form of volume and processing power to manage new conventions and the importance of having solid and robust static data. The obligation to offer segregated accounts is an interesting operational challenge from a capacity and data management angle. It could also lead to increased settlement inefficiency. What strikes me is that by offering segregated accounts, you are putting more settlements through a system: segregated accounts create more and more buckets that represent the client or sub-client holdings.
If one needs to transact more individual transactions in order to make an overall movement of the securities, then that’s creating the need for additional operational bandwidth at any custodian house. This highlights the need to have robust and accurate static data records, as well as solid trade analytics to identify known areas of current settlement inefficiencies to help maximise any potential to maximise straight-through processing (STP) in time for 2020. So, while segregation is great for transparency, it will create additional settlement flow, which will have an impact on the middle office to maintain requisite levels of settlement efficiency.
Internalised settlement can be one such way to overcome some of this friction, but that in itself will require development to ensure the appropriate reporting standards are met.
Equally, the inclusion of securities lending services will aid in the smooth process of timely settlement, but not without its own careful considerations toward introducing additional settlements to the process and thus compounding the potential exposure settlement inefficiency.
If cash penalties are handed to custodians, are you expecting the custodian to absorb the cost or pass them back to the client?
It will be purely a commercial choice. In the event that charges are passed on, there are multiple routes to charging, on a netted basis either by the client or by the counterpart. In the event that systems and data reconciliation prove too complex and onerous to pass charges on, then we may well see charges absorbed.
There is already evidence coming out of the second Markets in Financial Instruments Directive’s (MiFID II) unbundling of research and execution commissions that have paved a way for a simplified process to pass on charges, perhaps a more generalised charging mechanism will emerge to address this issue.
Are there any opportunities for custodians that you see with SFTR?
For our clients, it’s all about securities borrowing. There’s a huge opportunity for more securities financing. However, this also exposes the potential for those would be-securities lenders to be exposed to CSDR fines themselves.
If you’re lending a security to a borrower to avoid a CSDR-related fine, that could be acceptable because it’s outside of the Securities Financing Transactions Regulation (SFTR). But the moment that instrument then needs to be recalled and delivered on, the reversal of that loan back into mainstream availability may actually create exposure as a CSDR incident.
There are also specific rules to benefiting from a buy-in exception, which applies to transactions that have a second or closing leg set within 30 days from the first leg. Any transaction with a term longer than 30 days, or indeed without a closing leg, will still be exposed to the settlement discipline regime.
Balancing the opportunity to increase revenues and relevance by offering this enhanced service with the potential exposure to SFTR and CSDR fines will be tricky.
This is going to be an interesting way of looking at how greater efficiency can be provided, how this can be cost-beneficial and revenue-rewarding to the buyer and the custodian, and how it can also limit the downstream impact of potential fines.
How does CSDR differ from other regulations that the industry has been preparing for in recent years?
It does more to harmonise settlement decisions, settlement efficiency and settlement transparency across European geography so that in practice it will look more akin to the US market. In the sphere of everything that’s happened in the regulatory world of Europe (or indeed globally), where everything is driving toward transparency—CSDR is just another example of this trend with the added benefit that efficiency is increased, risk is reduced and a focused attempt to achieve finality of settlement is shared across all financial market participants.
In the transition from T+3 to T+2, the market lost a third of its processing window. The markets had time to get to grips with that tranche of CSDR, and now the settlement discipline function will really ramp up the need to get transactions settled on-time, removing risks from the system and creating transparency at the same time. This is another way of reducing exposure and ultimately reducing cost because the cost will only really come out of inefficiency.
Looking at the next 12 months, what trends are you currently seeing in the custody space, and what are your predictions for the year ahead?
With regulatory and political will put to one side, as an industry there is a benefit in making the best market conditions irrespective of geopolitical uncertainty. Financial markets are global. I suspect there will be continued collaboration for the good of market efficiency, global client coverage and a will to minimise geopolitical barriers.
From a business perspective, the focus remains on preparedness for the regulatory environment and the execution of it—this has become an ongoing priority now for all financial institutions. So, I think business as usual for financial institutions is very much going to continue to be: “get on with implementing the changing regulation and get on with your own plans to make sure there’s proper efficiency in the system”.
I would also expect that the ever-growing fintech conversation space is going to continue to have a very strong voice, especially when it comes to the collection, monitoring and reporting of data, as well as the ability to analyse it.
There will be a focus on trend analysis and predictive analysis in terms of what activities we are failing on and what information we can gather on that failed activity in order to improve it.
