EC propose reform to harmonising security settlements and regulate CSDs
The European Commission is proposing to harmonise the securities settlement period in the European Union (EU), as part of a package of reforms to strengthen the post-trading process and regulate Central Securities Depositories (CSDs). The Commission believes that the settlement period should be ‘as short as possible’ with T+2 the likely goal.
The Commission believes that further legislation is required to reduce settlement fails -- which could be a source of systemic risk. Rules relating to measures taken before the event to guard against settlement fails are particularly important. The Commission has several suggestions:
- encouraging CSDs to incentivise early settlement by participants through an appropriate tariff structure
- requiring the use of pre-matching procedures and early matching by participants
- introducing harmonised operating/cut-off times and requiring the use of straight-through-processing (STP) technology which allows the entire trade process to be conducted electronically without the need for manual intervention.
These changes will be far-reaching; coming at a time when firms are already struggling to prepare for other imminent market infrastructure regulations. However, tightening, and harmonising, key post-trading standards makes sense and these proposals will address a key remaining deficiency in the current post-trade infrastructure.
The introduction of the Euro has been a catalyst for cross-border investment in securities and the smooth functioning of cross-border investment is predicated on common standards across the Union. A high degree of settlement discipline reduces counterparty risk, or more specifically liquidity risk and replacement risk. More importantly, it promotes investor protection; helping to ensure that transactions between buyers and sellers of securities are settled in a safe and timely manner. As well as being a source of regulatory arbitrage, the Commission believes that heterogeneous rules and practices reduces efficiency as it increases the risk of operational failure, impedes operating in multiple jurisdictions, results in higher back office costs, and requires costly custom-made solutions.
Targeting the supporting infrastructure around securities settlements should raise standards across the board. Once the Regulation on over-the-counter (OTC) derivatives, central counterparties and trade repositories (or EMIR) come into force (by the end of this year), most essential market infrastructures will be regulated at the European level. Key trading venues are covered by the original Markets in Financial Instruments Directive, with MiFID II looking at the balance, while central counterparties and trade repositories will come under the scope of EMIR.
To date, Central Securities Depositories (CSDs) have been an exception with different settlement practices co-existing across Europe. To address comprehensively systemic risk following the crisis and to anticipate the expected impact of the Target2Securities initiative, the Commission is now tackling the final piece of the post-trade puzzle.
Under the current proposals, CSDs should be subject to an authorisation and supervision regime to ensure they conform to high prudential standards when performing their activities.
Authorised CSDs are to be granted a ‘passport’ under the new regime to provide their services in other EU member states -- which will help remove existing barriers to access. Similarly, a third country CSD may be granted access to the EU if it is recognised by the European Securities and Markets Authority (ESMA).
Under proposals, issuers would be given the right to record their securities in any CSD authorised in the EU. Moreover, CSDs would be the given the right to provide services for securities that have been constituted under the law of another member state, and to become a participant in a securities settlement system of another CSD. A CSD would also have the right to receive transactional information from other market infrastructures such as central counterparties and trading venues.
Unsurprisingly, the Commission are suggesting that CSDs should be required to adopt a low-risk business model, rationalising their activities. The Commission’s legislative proposals identify three ‘core’ activities for CSDs:
- operating a securities settlement system
- providing a notary service
- providing central maintenance services.
They also provide a list of possible ancillary services which a CSD should be able to perform in addition to those services, such as both non-banking and banking-type services facilitating securities settlement including securities lending, processing corporate actions, etc.
A key facet of the Commission’s proposals is to force the dematerialisation of tradeable securities which will be a significant challenge for EU countries which have not yet gone through this process widely. A transition period of several years (up to 2020) is envisaged for this process.
Another notable element is attention to preventing conflicts of interest. The Commission foresees the possibility for CSDs to offer commercial bank settlement to its participants where central bank settlement is impossible (the Commission recognises that it is not in a position to dictate what central banks settle). In these instances, the Commission determines that the CSD needs to appoint a separate settlement agent to provide any associated banking-type services to those system participants. This settlement agent may be part of the same group as the CSD, however, in this case, the bank providing those banking services will have to limit its banking services to those ancillary to securities settlement.
In line with other recent proposals, the Commission is also looking to introduce common sanctioning standards across the EU.
CSDs are systemically important institutions for the financial markets. They enable the settlement of virtually all securities transactions -- which are worth over 900 trillion Euros per year. The Commission’s proposals with respect to these institutions are therefore important and should be examined carefully by all firms which participate in securities markets.
The proposals now pass to the European Parliament and the Council of the EU (the Council) for negotiation and adoption which should take about a year, or perhaps longer, given the heavy workload that European institutions face in dealing with the eurozone crisis, and other major pieces of legislation already in negotiation such as CRD IV and MiFID II.
EBA and ESAs discuss capital and collateral requirements under EMIR
Two further discussion papers were published on the regulatory technical standards (RTS) associated with EMIR on 6 March, as the regulators continue fleshing-out the various technical aspects of the new clearing regime, whilst also ensuring that stakeholders may respond as the Regulation takes shape.
Both discussion papers are based on the text of the political agreement reached by the European Parliament and the Council, and the European Commission on 9 February 2012 (the final text has not yet been published in the Official Journal of the EU).
In one paper, the European Banking Association (EBA) is seeking stakeholders' views on capital requirements for central counterparties (CCP) under EMIR. The EBA's view is that a CCP's capital should be at all times at least equal to the higher of the following two amounts:
- the CCP's operational expenses during an appropriate time span for winding-down or restructuring its activities
- the capital requirements for those risks that, according to EMIR, must be covered by appropriate capital.
The EBA believes that risk exposures and capital requirements should be calculated using approaches analogous to those applied to banks under the Capital Requirements Directive. Capital held under international risk-based capital standards should be included in order to avoid double regulation. Whatever approach is adopted under the RTS, the EBA expects capital requirements will be at least equal to those resulting from the principles published in 2011 by the Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions (IOSCO).
The other discussion paper, released jointly by all three European Securities Authorities: EBA, the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA), focuses on draft regulatory technical standards on risk mitigation techniques -- essentially the use of collateral and (additional) capital requirements for OTC derivatives which are not cleared by a CCP. The paper addresses the following issues:
- Collateral (margin) requirements: The discussion paper looks at the use of initial margin (to protect against default) and variation margin (to guard against market fluctuations), the frequency with which they should be posted/collected, and by whom.
- Capital requirements: The ESAs believe that no additional capital requirements will be imposed on financial counterparties already subject to a prudential regime, such as credit institutions, investment banks, and insurance companies (dubbed PRFCs) as current requirements are deemed sufficient to cover the associated risks. Prudential requirements currently imposed on Collective Investments in Transferable Securities (UCITS) and Alternative Investment Fund Managers (AIFM) are not sufficient but the ESAs do not feel able -- absent the relevant legislation in the Level 1 text of the UCITS and AIFM Directives -- to impose additional capital requirements in RTS. Collateral alone must therefore be sufficient to cover the associated risks. Consequently, the paper considers a flexible approach to the use of the initial margin, suggesting different options to its collection/posting for consideration by stakeholders. One option would be to require only PRFCs to collect initial margin, perhaps only above a given threshold. Each option will impact all market participants, but UCITS and AIFMD particularly need to focus on the ramifications. The ESAs realise that each option will come at a cost and request that stakeholders provide as much empirical evidence as possible to support arguments for or against any of the options.
- Transactions with third country counterparties: The ESAs believe it is essential that collateral posted outside the EU is adequately protected.
- Risk management procedures: The ESA’s are considering setting a cap on the minimum transfer amount below which no collateral needs to be transferred in order to reduce operational risk. The ESAs believe that the minimum transfer amount should be left to the agreement of the counterparties, but should not exceed a cap to be set out in the draft RTS.
- Intra-group exemptions: The paper does not provide much detail on this issue, as it was a ‘late entry’ in the trialogue negotiations. However, the ESAs will develop draft RTS specifying the procedure competent authorities should follow to apply an intra-group exemption to the exchange of collateral. In particular, they will consider what constitutes a practical or legal impediment to the prompt transfer of own funds or repayment of liabilities between counterparties.
The ESAs all noted their intention to take into account in finalising their proposals developments at an international level and in the United States. In early March, the Bank for International Settlements (BIS) published its working paper no. 373: ‘Collateral requirements for mandatory central clearing of over-the-counter derivatives’, looking at current practices. BIS research shows that major dealers already have sufficient unencumbered assets to meet initial margin requirements, although some may need to increase their cash holdings to meet variation margin calls. The paper also indicated that a default fund worth only a small fraction of dealers' equity appears to be sufficient to protect CCPs against almost all potential losses that could arise on default of one or more dealers.
The consultation period on both the EBA and ESAs’ discussion papers closes on 2 April 2012. It is expected that a similar process to that indicated for the ESMA discussion paper on RTS under EMIR (published 16 February) will be adopted, in that following input from stakeholders to the issues raised in the discussions papers, a second consultation on the draft text will follow in the summer--prior to submission to the Commission by the end of September. However, this is dependent to some extent on when the final text of EMIR is published in the Official Journal.
FSB update on LEI progress
One of the positive developments from the G20 summit in Cannes last year was the agreement that a Legal Entity Identifier (LEI) was both necessary and should be developed at a global level to help firms develop a consistent and integrated view of their counterparty risk exposures. A unique, and single, LEI would also be beneficial to regulators, greatly facilitating the aggregation and sharing of information in order to effectively monitor risk concentrations.
The Financial Stability Board (FSB) was tasked with pushing forward the development of an identification system for financial counterparties. Their recent update report suggests that ‘significant’ strides have been made in identifying the key issues and developing framework solutions. However, before the work on its five streams (governance; operational model; scope, confidentiality and access; funding; and implementation and phasing) is completed, the LEI Expert Group has decided to publish its thinking on two technical points to give early clarity and guidance to industry, and to help with forthcoming proof-of-concepts.
First, the Expert Group has agreed that a 20-character alphanumeric code is a good basis for the global LEI code. Second, the Expert Group has agreed the following 6 data elements will all form part of the minimum set of reference data required:
- name of the legal entity
- address of the headquarters of the legal entity
- address of legal formation
- date of the first LEI assignment
- date of last update of the LEI
- date of expiry, if applicable.
It should be noted that this limited minimum set of the reference data is the product of the first round of regulatory discussions. This early guidance is also subject to final confirmation as the Expert Group completes its work.