Outreach Blog

Thursday, December 30, 2021

Digitized Finance Testing Approved by European Union

Buy-in Agreement clears the way for DLT Settlement Pilot


Author: David Schwartz J.D. CPA

 

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)

 

 

 

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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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