[MUSIC]

Alex Dockx:

Hello! And welcome to our second audio discussion on the CSD Regulation or CSDR.

Alex Dockx:

My name is Alex Dockx and I lead the J.P. Morgan Global Custody Industry Development. I'm joined today by my colleague, Emma Johnson, who has been playing a leading role in CSDR discussions with European trade bodies and regulators. In this episode, we will be discussing the CSDR Refit, the mandatory buy-in and the implication for the industry.

Emma, to help set the scene, please can you provide a brief overview of the European Commission's review of CSDR?

Emma Johnson:

Yes, of course. In October, 2020, the European Commission instigated a review of CSDR, to appraise the effectiveness of the regime, which included a public consultation open to industry and market participants which sought feedback on all aspects of the regulation, including the Settlement Discipline Regime or SDR, as we sometimes refer to it as, despite the fact that it had not yet entered into force.

Emma Johnson:

The inclusion of the SDR provided an opportunity for J.P. Morgan to advocate on behalf of our clients and the firm, on targeted amendments to the regime, and to provide suggestions to resolve the many open questions raised by the industry. Needless to say, the mandatory buy-in dominated the responses for public consultation and subsequent discussions.

Emma Johnson:

So, we welcomed the European Commission's interim report, published in July 2021, which seemed to acknowledge the mounting concerns the industry had on this topic. In addition, there were also proposals in the Refit covering the provision of banking services and a simplification of the requirements for cross-border services by CSDs, which we won't cover in this audio discussion.

Emma Johnson:

In March 2022, the European Commission published its legislative proposal, for what would be a Refit, which is the term used for the European Commission's ‘better regulation’ fitness and performance agenda, which aims to make EU law simpler, more targeted, and easier to comply with.

Emma Johnson:

The Refit proposal outlined targeted changes to the regime, including the proposed introduction of what is referred to as the two-step approach to tackle settlement fails, which could see the mandatory buy-in introduced if cash penalties did not improve settlement fails in the European Economic Area.

Emma Johnson:

This is the start of the formal negotiation process between the European parliament, council, and commission. And once agreed by all three institutions, will lead to the final revised CSDR legislation. This is a standard process for any regulation in Europe, and it also means there'll be additional revisions to the EC proposal.

Alex Dockx:

So, the mandatory buy-in regime appears to be retained in the European Commission proposal. Can you explain what this means exactly and when or indeed if, mandatory buy-ins could be introduced?

Emma Johnson:

Yes. I believe the rationale for the European Commission retaining the buy-in, is as the ultimate vehicle to address settlement fails. Seems to stem from their concern that the volume of fails in the region is high, compared to third country markets. In particular, the US market seems to be the main point of comparison, despite the marked differences in the US market, compared to the EEA. In terms of when and how buy-ins may be introduced, based on a Refit proposal as currently drafted, the EC may decide to adopt mandatory buy-ins to certain financial instruments, or categories of transactions, based on the following.

·         If the application of a cash penalty has not resulted in a long term, continuous reduction of settlement fails in the union;

·         If settlement efficiency have not reached appropriate levels, considering the situation in third country capital markets that are comparable;

·         And the level of settlement fails in the union has always likely to have a negative effect on financial stability.

Emma Johnson:

In terms of the draft itself, there appears to be some flexibility of when the MBI can be introduced, although we do welcome more detail. This is not to suggest that J.P. Morgan is supportive of retaining MBIs in CSDR. We believe that, historically, the challenge and the implementation of the regulation has been the incorporation of a trading related measure in the post-trade regulation, pitched at the level of the CSD participant, rather than the actual party to the trade. We're concerned that the MBI could impact the jurisdiction's securities markets, as buy-ins impact trading liquidity and come at a heavy cost to all parties. Even if the MBI is to be introduced for limited asset classes, it could still threaten the competitiveness and attractiveness of the EU's capital markets. In addition, it's important to note that settlement fails can be the result of a number of factors, such as market structure, and the mandatory buy-ins will not address these root causes.

Alex Dockx:

So to add to that, Emma, in August this year, European Central Bank published similar concerns. They recommend that Mandatory Buy-in regime should be removed, stating it would cause a ‘significant interference in the execution of securities transactions and the functioning of securities markets.’ The ECB also recommend that should the MBI be retained, that securities financing transactions or SFTs be excluded from the scope of the MBI. They also highlighted the operational cost and complexity and negative impact MBIs could have on market liquidity. While the ECB doesn't have the final say, it indicates that ours and the wider industry concerns seem to be shared by the ECB.

Emma Johnson:

This feels like an important development, as the ECB's opinion will be influential. And even though we know the ECB are not part of the triologue process, they are a powerful ally, and their public statement will be of interest to the Member States and MePs. Notwithstanding the merits of retaining the mandatory buy-in or not, on a positive note, the Refit proposal does attempt to improve the drafting and operation of the mandatory buy-ins and cash penalties, which we very much welcome, although we would caution that there are still areas of concern with the proposal as currently drafted.

Alex Dockx:

Okay. So, putting the merits or not of the MBI aside, could you please briefly summarize the other proposed changes to the settlement discipline regime?

Emma Johnson:

Of course, and at a high level, there are some attempts to resolve some of the industry's main challenges, such as

·         amendment to transactions scope, exempting settlement fails ‘not attributable to the participants and not including two trading parties’;

·         There's a pass-on mechanism;

·         symmetrical payments for the buy-in differential; and

·         a temporary suspension of the regime, for example, in the event of market turmoil, which is also proposed, which in principle, we support.

However, who should be subjected to the MBI obligations remains a key issue, as a Refit does not address the language and terminology, which places the obligations on CSD participants, rather than the actual parties to the trade.

Emma Johnson:

In practice, this will mean that the contractual enforcement of the MBI will still fall to the CSDs, who are required to impose a regulation on their participants, through the CSD's rule books, which then requires legal repapering through the trade custody chain, which will be a costly global effort.

Emma Johnson:

This is perhaps, better known as RTS Article 25. It is therefore vital that the Refit makes the distinction between trade and settlement, and revises the language and definitions used in the level one and delegated regulation.

In addition, we would like further clarity on the sequencing, and mechanics by which MBIs may enter into force. A substantial lead time will be required, to prepare for implementation, including the repapering of the relevant contracts I mentioned, plus operational and technology readiness, which typically require a lengthy lead time and budgetary planning across the industry. In this time, fails may have improved, which would result in unnecessary costs which is obviously an issue. And lastly, not to forget cash penalties. An exemption for settlement fails caused by factors not attributable to participants to the transaction, is positive. However, excluding operations that do not involve two trading parties, could prove too broad. As the most appropriate measure to address settlement fails, cash penalties should really apply to as many transaction types and settlement instructions originating from the CSD participants or their clients as possible.

Emma Johnson:

Scaling back too far can only limit the regime's effect and could result in economic loss for the participants who have a chain of instructions involving different transaction types.

Alex Dockx:

So, based on your response to an earlier question on when MBI can be introduced, it does seem that this dependency on metrics and data. Ultimately, this will require clarification then ? as there is no ‘baseline’ measurement of settlement fails. An assessment of the extent of, and reasons for settlement fails parameters, was not conducted prior to the introduction of cash penalties in February.

Emma Johnson:

Exactly. In addition, mandatory buy-ins only address settlement fails still outstanding after four or seven business days. So it's crucial that any policy decision is based on data relating to settlement fails still outstanding after four to seven business days and not settlement fails measured on intended settlement dates. The lack of a comprehensive fails analysis aligning to the CSDs reporting parameters under the SDR, also means then, that it's tricky to be able to truly decipher the success cash penalties are having, since as you say, Alex, there is no comparable baseline.

Now, Alex, if I could turn to you, is there anything in your opinion, the Refit proposal has overlooked?

Alex Dockx:

Well, in my personal opinion, there's still is quite a lot of excessive detail in the level one, I give a few examples:

·         Extension period should be in the level two text, and should be applied to the instrument level;

·         Cash compensation remains unchanged and should be symmetrical, rather than asymmetric as currently drafted;

·         Public disclosure of CSD participants should either be removed or applied to accounts designated as client accounts, so as not to be penalize intermediaries who cannot influence a trading pattern's operational practices of their clients;

·         And you already mentioned that legal repapering which will have a global impact.

Alex Dockx:

On a similar note, with regards to extraterritoriality, only shares have a third country exemption when “the principal venue of the trading of shares is located in a third country”. There is no similar exemption for any fixed income instruments, which creates an uneven application of the scope and may create additional complexity on cross border  fail chains in third country instruments, which could unduly penalize investors with transacting across jurisdictions. This could become particularly pertinent when more markets start to move to a T+1 settlement cycle.

Alex Dockx:

I would also stress that we believe that only professional regulated entities should be required to initiate and manage the buy-in, and take an upstream approach towards a trading party or CCP member who caused the settlement fail, and not downstream towards the investor. We believe that this requires much more thought, and will be an important consideration for our global custody clients. Despite typically being a buyer, and therefore the impacted party, they're the ones who have to bear with the operation and cost burden of the regime. So we continue to stand by, ready to assist, and defend our clients' interests here.

Emma Johnson:

Now, Alex, you've had a long involvement in CSDR, on both J.P. Morgan's and the wider industry's behalf. Do you see the Refit proposal as a positive development?

Alex Dockx:

Well, going back to 2012 to start the original CSDR proposal by the European Commission, and its adoption by the co-legislators in 2014, with the number of requirements such as mandatory buy-ins, but also with some good developments, such as the roll out of T+2 and consistent CSD regime, it's probably fair to say that CSDR took a long time to implement and has not been a complete success on all fronts. It took a long time and lots of detailed conversations with regulators to establish where the problems stemmed from, and how to address them. To their credit, the authorities were receptive to the industry's concerns, but the major issue was that a lot of the principals were anchored in the level one regulation itself. To address them required re-opening CSDR, which is what the Refit proposal is exactly trying to address and as you alluded to earlier, Emma.

Alex Dockx:

So, in that respect, it is definitely a positive development, as it allow those issues to be addressed at the root. Where a bit more work is required is on some of the detailed proposals like you explained before. Overall, my personal experience has been positive, in terms of working with European Commission, ESMA, and the national authorities. In terms of their openness to listen to the industry and making necessary adjustments, after listening to our views, also challenge us where required.

Emma Johnson:

Alex, just to close up the dialogue on the CSDR Refit, what are the next steps and key dates?

Alex Dockx:

It’s possibly a bit early to tell, however, we believe that the European Council meetings have already begun and expect that the Council reach its conclusions by the end of 2022. The European Parliament are also forming their opinion. We estimate that the entire process of discussions between the Council, Parliament, and Commission will reach conclusion in early to mid 2023 but, of course, we await further information from the European legislators.

Alex Dockx:

So Emma, it looks like the ball is now a bit in the industry's court. So what do we need to do?

Emma Johnson:

It's such a good question. The MBI is still proposed in regulation and we must take it very seriously. There is a clear call for action now. The entire industry needs to collaborate and quickly gain clarity of what causes settlement fails and work through what they can resolve. For example, taking action to resolve SSI issues and ensure that securities are in the correct depot on ISD. And ensure that the CSD's functionality adequately optimizes settlement. It also need to identify what is structural, i.e. what are the issues in the jurisdictions' complex market structure that impede timely settlement? And what may require new or amendment to existing regulation.

Emma Johnson:

The rhetoric now needs to move from defense to being able to articulate and demonstrate the issues, to educate the authorities, and to suggest solutions.

Emma Johnson:

J.P. Morgan are actively engaged in the industries' efforts to improve settlements efficiency through co-chairing AFME and ICMA task-forces.

Emma Johnson:

The retention of the MBI must be taken seriously. However, we have discussed some of the challenges with the Refit and the retained requirements in the regulation. What should be the next steps for J.P. Morgan, our clients, and the wider industry with regard to regulation?

Alex Dockx:

Emma, in my opinion, the delegated regulation would require full revision. And the industry should be prepared to help shape those requirements. It will be essential for the industry to align on what is required to make the mandatory buy-in regime operable without imposing the operational and regulatory burden on the investor.

Alex Dockx:

As an example, it will be essential to the buy and the sell-side to work through the pass-on mechanism and cash compensation which were both being proposed in the Refit and to find a workable solution. This is a strong area of focus for our division to protect our clients. In addition, there's work to do on basic housekeeping, which we also covered in our last audio discussion on CSDR penalties. The industry will need to be more diligent and precise in the formatting of settlement instructions and use the correct transaction codes.

Alex Dockx:

This is not just important for CSDs to be able to identify which should be penalized or not. It's also fundamental for the CSD's reporting of fails to their national competent authorities. More granular, accurate fails reporting is the need of the hour, which serves a means to draw a conclusions for where the issues exactly lie. That could be, for example, at the trading party level, at the market level or certain fail reasons, which would each warrant further assessment.

Alex Dockx:

Remember, European Commission are also considering finance stability. And if market participants instruct all settlement instructions as cash trades then that could suggest there's actually a bigger issue that there in reality is. Meanwhile, I agree on your point about collaboration. On the whole I would say that there needs to be greater transparency in collaboration across the industry and across market infrastructures as well. That includes more partnership with regulators. We all have a shared interest in ensure European Economic Area is an attractive place to invest.

Emma Johnson :

Alex, it's been a pleasure discussing this CSDR Refit and the consequences for the industry. It is such an important topic that we both feel strongly about, and we will provide a future update for the Refit’s lifecycle.

Alex Dockx:

We would like to thank you for listening. Please look out for our next issue in the coming months, where we will focus on the Refit’s progress through the European Council and Parliament. And follow up on cash penalties as the regime matures.

This discussion was recorded on October 5, 2022.

[END]