The Central Securities Depositories Regulation, or CSDR, was first published into the official journal by ESMA in August 2014, aimed at improving securities trade settlement in the European Union on EU central securities depositories. Although some predict further delay in implementation, it is scheduled to come into force in September 2020, more than six years since it was first tabled.
In the interim, there has been intense debate by various market and industry participants around its content and the underlying intention and much speculation as to whether some of the consequences are unintended or not. Most industry unease relates to elements of Article 7 of the regulation, which involves a new mandatory buy-in regime for failed securities trades that settle on an EU CSD or involve an EU-based party.
These concerns refer to potential impacts on both market liquidity and bid-offer spreads in light of the more challenging liquidity environment since the financial crisis and post-MiFID II, with particular attention on secondary corporate, high-yield and emerging bond markets.
Amongst many, there are two main elements that seem to be causing most consternation. The first is the mandatory nature of the buy-in process. Whereas in the past there has been reticence to initiate these proceedings by either party to a transaction, CSDR would trigger a regulatory requirement on the part of the security recipient to do so.
The second is the exterritorial nature of the regulation, which means that when a party transacts with an EU counterparty or settles a trade in an EU CSD, the buy-in regime included in Article 7 applies.
The likely effects will be felt market-wide: buy side, sell side and an array of third parties, including execution venues and various technology vendors.
Sell-side impacts are likely in three areas: trading desks sourcing of inventory from Securities Finance functions, algorithmic/automated pricing engines and manual market-making.
Trading desks’ willingness to offer risk prices implies an enhanced communication and decision-making paradigm with Securities Finance functions with predictive confidence tools before supplying balance sheet to address client queries. Instead of inventory sourcing happening post-trade, there will likely be a requirement to integrate inventory sourcing pricing and location probability dynamically into the price formation process of the market-maker pre-trade in order to accurately price the risk of failure to locate.
Algorithmic pricing engines, a relatively recent development, will likely require tools to parameterise pricing either to pass or adjust bid-offer spreads to incorporate CSDR risk (the so-called “CSDR put”). Without new tools, automated pricing models could lead to higher failure rates and asymmetric settlement breaks that investment bank management and risk departments will be keen to avoid, as well as the related spectre of regulatory scrutiny on market participants which don’t act to offset for the new paradigm.
For risk pricing performed by market-makers, the same requirements exist for pricing to integrate these factors in real-time for the same set of reasons as above. Indeed, as there is a greater likelihood that less liquid securities with lower probability of inventory borrow rates makes it disproportionately important for this activity to incorporate the regulation into price formation of risk pricing.
All aspects of price formation as described above for the sell-side would also benefit from a deeper understanding of the size of distribution and dispersion of individual bond issues to determine the likelihood of being able to source liquidity.
In parallel, the dynamic applies to non-bank liquidity providers, crossing platforms and other third parties, not least as in certain circumstances they can be called upon to execute the buy-in function.