“Not my problem gov” has long been the response from the major investment managers when it comes to settling transactions. In fairness, why should a BlackRock or Fidelity really care? After all, most of the time their brokers are responsible for telling a custodian bank about the specific settlement date. Also, the vast majority of securities, including standard stocks and corporate bonds, are settled using the date of the transaction plus two days (T+2). There is, however, a problem on the horizon in the form of the Central Security Depository Regulation, more commonly referred to as CSDR.
Far from being another way for politicians to squeeze more tax revenue out of the market, this rule has been introduced to incentivise “on time” settlement. The problem is there are no direct beneficiaries from this legislation. Those who don’t, or choose not to, settle on time are definite losers. In simple terms, CSDR will require impacted European Central Security Depositories (CSDs) to apply financial fines for failing to complete transactions on a contracted settlement date, and award these penalties to the other side of the transaction. Instead of having a formal agreement between the buyer and seller, there will now be a legal obligation for one side to pay a penalty fee. Conversely, the other side receives cash if the trade is not settled on time where they are settling through a CSD.
So, what does this mean for asset managers? Well, until now, if a broker decided to charge a fund manager interest for continually failing to deliver securities on time, then the client would just go elsewhere. Yet under CSDR, interest charges will be mandatory. It is a bit like dealing with a credit card – if you do not pay your bill on time you get charged 4% APR. With 3.65% charge penalty whacked onto a late settlement – CSDR is not dissimilar. Therefore, unless asset managers start delivering securities in a timelier fashion, they could face some hefty fines. This is a particular issue for larger houses, most of whom have direct relationships with custodian banks these days.
But penalties are not the only issue. “Mandatory Buy ins” are also being introduced, whereby the buyer of securities will be obliged to buy-in their counterpart according to rules. Instead of going through CSD’s, this is a direct obligation between the trading counterparts. As such, any situation where an asset manager can’t, for whatever reason, deliver what it has promised opens up a pandora’s box full of problems. For example, a fund manager often sells a security in the hope that the price would fall in order to make profit. However, what happens if the price starts to move sharply, say 15% to 20% in the other direction? The fund manager in question may get caught on a short squeeze under the CSDR mandatory buy-ins. This is a process where shares are forced to be repurchased if the seller does not deliver the securities in a timely manner. Although short-selling is by no means the only predicament.
Also, under buy-ins, what is deemed a liquid security is due to be settled after four days, while an illiquid asset needs to be settled after seven. The trouble is, how does a firm determine what’s liquid and illiquid? While there is discussion around a central source of data for this, it is very likely to be 100% and there is likely to be a range of different views from across the market. Instead of the trade being valued at the price on which the deal was struck, firms have to revalue the security everyday that the price changes. This heightens the importance of an asset manager, as well as their custodian bank, doing one calculation based on a joint market view. There is just one sticking point, such services do not exist yet. As you can see there are a plethora of issues and associated impacts that are heading in your direction. Between now and the enforcement of CSDR in 2020, asset managers need to address their processes and plans and establish how they will handle the inevitable settlement fails issues above. Until this happens, it won’t just be the custodian banks will find that this particular law costs them more than they initially thought.
Daniel Carpenter is head of Regulation at Meritsoft