What is the CSD Regulation?
The CSD Regulation1 (CSDR) is an EU/EEA regulation which introduces measures for the authorisation and regulation of EU/EEA central securities depositories (CSDs). While much of the regulation focuses on the prudential, organisational, and business standards of CSDs, some of its requirements directly affect trading level entities that settle trades on EU/EEA CSDs. These include measures to address settlement fails. Chapter III of the Regulation deals with Settlement Discipline. Article 7 provides for measures to address settlement fails, which include cash penalties for settlement fails and mandatory buy-ins.
Who is affected by CSDR settlement discipline provisions?
Settlement Discipline will apply to all transactions intended to settle on an EU/EEA CSD2 in transferable securities, moneymarket instruments, units in collective investment undertakings, and emissions allowances,3 which are admitted to trading or traded on a trading venue or cleared by a CCP.4 This will apply to all trading level entities, regardless of their domicile, that enter into such transactions that settle on an EU/ EEA CSD, whether directly as CSD participants, or indirectly via a settlement or clearing agent (who is a CSD participant). It is important to note that initiating the CSDR buy-in process is a regulatory requirement and not a right.
What is a buy-in?
Essentially, in the event of a settlement fail, conventional, noncentrally-cleared bond market buy-in mechanisms provide a buyer of securities the contractual right to source the securities elsewhere (usually for guaranteed delivery), cancel the original trade, and settle between the two original counterparties any differences arising from the net costs of the original transaction and the buy-in transaction.
A key feature of conventional, non-cleared bond market buy-in mechanism, such as those provided under the ICMA Buy-in Rules, is that the economics of the original transaction are preserved, and that neither party is inadvertently disadvantaged or advantaged as a result of the buy-in. It has to be remembered that standard buy-ins are not a ‘penalty mechanism’, they are a contractual remedy to provide for physical settlement of a trade. They are also executed at the discretion of the failed-to entity, as a right and not an obligation.
Additionally, conventional buy-in mechanisms are usually mirrored by sell-out mechanisms which provide the seller of securities with a conventional buy-in mechanisms are usually mirrored by sell-out mechanisms which provide the seller of securities with a contractual remedy if settlement fails through the fault of the buyer.
What are the timeframes of the mandatory buy-in requirements?
The buy-in provisions are outlined in Sections 3 and 4 of the Regulatory Technical Standards5 (RTS) on Settlement Discipline. The regulation requires that in the event of a settlement fail, a buy-in process is initiated as follows:
- four business days after the intended settlement date (ISD) for liquid6 shares, and
- seven business days after ISD for bonds and all other instruments. This is referred to as “the extension period”.
Who executes the buy-in process?
With the exception of trades cleared by a CCP, where the CCP will be responsible for initiating the buy-in process, the failed-to trading entity is responsible for initiating the buy-in process. The failed-to trading entity is required to appoint a buy-in agent to execute the buy-in against the failing trading entity.
The buy-in is required to be completed (executed and settled) within 4 business days for liquid shares and 7 business days for all other instruments. Any costs arising from the buy-in, as well as the price differential between the buy-in execution price and the original transaction price, are paid by the failing trading entity to the failed-to trading entity.
What happens if the buy-in is unsuccessful?
If the buy-in is unsuccessful, the process will be settled by means of cash compensation. This will require the original trade being cancelled and a payment being made by the failing trading entity to the failed-to trading entity based on the difference between the current market price7 and the original transaction price. Before going to cash compensation, the failed-to party has the option of attempting the buy-in one more time using the same buy-in timelines (known as the deferral period).