The European Commission has reached agreement with legislators and financial trade groups on a digitized infrastructure to reshape the EU and, by extension, the global securities markets. The resolution affects all transactions involving EU securities, including securities loans, by (1) green-lighting the Distributed Ledger Pilot Regime, an effort to foster fintech innovation in the EU, and (2) delaying mandatory buy-ins, a highly contentious aspect of the ongoing sweeping reforms to the EU's securities settlement system.
Green-lighting the Pilot Regime for Distributed Ledger Technologies
The political agreement clears the way for a large-scale proof of concept for market infrastructures based on distributed ledger technology (DLT). The pilot is part of the European Commission's Digital Finance Strategy, a program intended "to make Europe's financial services more digital-friendly and to stimulate responsible innovation and competition among financial service providers in the EU." The DLT Pilot Regime will enable regulated institutions to develop DLT-based infrastructure for the trading, custody, and settlement of securities. It is also intended to ensure that "the EU financial services regulatory framework is innovation-friendly and does not pose obstacles to the application of new technologies."
Mairead McGuinness, EU Commissioner for Financial Services, Financial Stability, and Capital Markets Union, said:
“I warmly welcome the political agreement between the European Parliament and Council and would like to thank the negotiators for both the speed and effectiveness of their work on the DLT pilot regime proposal. This agreement is important as it allows Europe to move forward in supporting innovation while safeguarding investor protection, market integrity, and financial stability.”
The DLT Pilot has far-reaching effects because it permits market participants to run "multilateral trading facilities" or "securities settlement systems" using DLT in a sandbox setting. This will allow market participants to innovate and test DLT platforms and services while highlighting regulations that may need to be revised in light of new technologies and identifying regulations that may be insufficiently innovation-friendly. The ultimate goal of the pilot is "to ensure that the EU embraces the digital revolution and drives it with innovative European firms in the lead, making the benefits of digital finance available to European consumers and businesses."
Delaying Mandatory Buy-ins for Failures-to-Deliver Financial Instruments
Along with the political green light to the DLT Pilot Regime, the European Commission also reached a political compromise to defer the implementation of the mandatory buy-in provisions of the Central Securities Depositories Regulation (CSDR).[1] The European Commission agreed to delay the European Securities Markets Authority (ESMA) and securities industry groups to delay CSDR's mandatory buy-in provisions on the grounds that market participants were not going to be ready by the implementation date, significant questions about the provisions remained unanswered, and that the buy-in regulations were not sufficiently clear.
In a public statement dated December 17, 2021, ESMA asked the European Commission to delay the application of the CSDR buy-in provisions referencing the DLT Pilot Regime and noting that the deferral of CSDR's buy-in provisions would allow for the decoupling of the "the date of application of the provisions dealing with the buy-in regime from the provisions dealing with penalties and reporting."[2] ESMA also noted that the legislation necessary to effect the new compromise on the DLT Pilot Regime would not be adopted before the CSDR buy-in rules are to become effective. Therefore, they were requesting a deferral to take into account "potential additional costs linked to any additional later change of the systems and processes of market participants implementing these measures."
Industry Consultation Succeeds in Allowing Testing for DLT-based Settlement Pilots
In association with several trade groups, the International Securities Lending Association, in a December 22, 2021 letter to ESMA, threw the weight of their members' support behind the delay in implementation of CSDR's mandatory buy-ins. The provisions scheduled to have taken effect on February 1, 2022, would have made market participants liable to pay daily penalties against each transaction failing to settle under the T+2 timeframe. Aimed at enforcing settlement discipline, the regulation would have made automatic buy-ins mandatory when a counterparty failed to deliver financial instruments to the receiving party within four to seven trading days, depending on liquidity of the issue.[3]
The International Capital Markets Group (ICMA) characterized the CSDR buy-in rules as structurally flawed and "not fit for purpose." Consequently, ICMA said the implementation of the mandatory buy-in rules would "undermine the integrity of Europe's capital markets and have significant detrimental impacts on secondary bond market liquidity and pricing."
The detrimental impact of the buy-in rules will particularly affect trading in less liquid corporate bonds, according to ICMA, with implications for the attractiveness of Europe as a centre for both capital raising and investment.[4] ICMA has long regarded the CSDR buy-in regime as "ill-conceived," and offered market-led initiatives to improve settlement efficiency. Those alternative regimes might include a system of disincentives, said ICMA, to include cash penalties.
ICMA has pointed out that contractual, discretionary buy-in frameworks, such as the ICMA Buy-in Rules, have been used successfully in OTC markets for more than four decades. Notably, those rules provide for a discretionary interval between the buy-in notice and its execution.
[1] Regulation (EU) No 909/2014 of the European Parliament and of the Council of July 23 2014 on improving securities settlement in the European Union and on central securities depositories and amending Directives 98/26/EC and 2014/65/EU and Regulation (EU) No 236/2012 Text with EEA relevance (CSD Regulation)
The primary goal of the European Union's Central Securities Depositories Regulation (CSDR) is to increase the safety and efficiency of securities settlements throughout the EU. It does this by creating a single EU-wide regulatory framework for financial market infrastructures. Because CSDR covers the dematerialization and/or immobilization of securities, the settlement period for securities trades, and imposes a novel settlement discipline on markets, it affects not just central securities depositories, but also represents a big change for market participants as well.
CSDR has two main components:
- A passport system authorizing CSDs to provide their services across the EU, and
- A settlement discipline regime that includes cash penalties and mandatory buy-ins for failing transactions.
[2] In a September 23, 2021 letter to the European Commission, ESMA asked for a delay in the application of CSDR mandatory buy-in provisions, requesting, "urgent action to provide a signal that a modification of the current implementation deadline is considered, postponing the mandatory buy-in framework as soon as possible and, ideally, at the latest by October of 2021."
ESMA heard from many in the industry opposing the timeline for buy-in implementation. ESMA characterized those objections in their September 23, 2021 letter to the European Commission asking for a delay to the buy-in rules:
"On the buy-in regime, as relayed by a number of trade associations, the challenges are twofold: the absence of clarity regarding some open questions necessary for the implementation of the buy-in requirements, and the uncertainty as to whether the European Commission’s legislative proposal will include amendments to the mandatory buy-in rules and the extent of any potential amendments. These challenges directly impact market participants’ ability to implement the regime and might involve potential additional costs linked to any additional later change of their systems and processes. Having regard to these challenges, ESMA supports a delay of the buy-in regime."
[3] Per paragraph (17) of the CSD Regulation:
"In most cases, a buy-in process should be initiated where the financial instruments are not delivered within four business days of the intended settlement date. However, for illiquid financial instruments, it is appropriate that the period before initiating the buy-in process should be increased to a maximum of seven business days. The basis for determining when financial instruments are deemed to be illiquid should be established through regulatory technical standards, taking account of the assessments already made in Regulation (EU) No 600/2014. Where such a determination is made the extension of the deadline for initiating the buy-in process should be up to seven business days."
See also, CSD Regulation, CHAPTER III Settlement Discipline, Article 7, "Measures to address settlement fails."
[4] The urgent need to suspend and revise the CSDR Mandatory Buy-in Framework, An ICMA briefing note, July 2021 (updated)