Insights from ESMA's CSDR Refit Consultations

Focus on Review of Cash Penalties and Mandatory Buy-Ins for Settlement Fails

On July 09, 2024, the European Securities and Markets Authority (ESMA) initiated three consultations on the Central Securities Depositories Regulation (CSDR) Refit. One of the key papers addressed settlement discipline, focusing on settlement fails not attributable to transaction participants and the contexts in which operations are not considered trading.

ESMA emphasized that the settlement discipline regime should not automatically penalize all settlement fails without considering these circumstances.

Information Requirements for CSDs

The other two papers covered information requirements for European CSDs to national authorities and notifications from third country CSDs. ESMA invited feedback from relevant stakeholders by September 09, 2024, with plans to finalize proposals for the European Commission by Q1 2025.

Industry Concerns and ESMA's Response

In previous consultations, industry associations - the International Capital Market Association (ICMA), the International Securities Lending Association (ISLA), and the Association of Global Custodians (AGC) had expressed concerns over proposed cash penalties for settlement fails, arguing against progressive penalties due to a lack of supporting data and the potential for increased complexity and costs.

ESMA acknowledged that there are exceptional situations where the settlement discipline measures, including cash penalties and mandatory buy-ins, should not be applied. These include:

1. ISIN suspension due to reconciliation issues
2. ISIN suspension from trading
3. Cash settlements outside the CSD operated system when relevant payment system is closed
4. Technical failures at the CSD level (e.g. cyber-attacks, infrastructure failures, network issues)

ESMA has also suggested considering further scenarios where settlement is delayed or cannot occur for reasons outside participants' control. These are:

5. Securities under sanctions or anti-money laundering proceedings
6. Settlement instructions on hold due to court orders or similar authorities

CSDs are required to report all the above cases to their competent authorities, who may request the application of cash penalties if they deem the non-application of penalty unjustified.

Proposed Exemptions from Cash Penalties and Mandatory Buy-Ins

ESMA has mentioned that the following circumstances should not be classified as trading regarding cash penalties and the mandatory buy-in regime:

1. Free-of-payment (FoP) securities transfers for collateral (de)mobilization
2. Market claims and corporate actions, such as distributions and reorganizations e.g. cash/ stock dividends, bonus issues, redemption, tender offers, stock splits, conversions
3. Technical creation of securities, involving transfers from the CSD’s issuance account to the issuer’s account
4. Creation and redemption of fund units on the primary market (excluding ETFs)
5. Realignment operations

However, ESMA has also clarified that failed deliveries due to delays in instrument issuance or restrictions during corporate actions are not excluded from cash penalties and the buy-in regime.

Clarification on Insolvent Participants

On ‘insolvent participants’, ESMA has stated that once insolvency proceedings are initiated against a participant, Article 7(2) no longer applies to settlement fails caused by that participant. Consequently, this means:

6. Cash penalties for settlement fails caused by the insolvent participant cease
7. Previously calculated cash penalties must be managed separately
8. Cash penalties do not apply to the liquidation-related settlement instructions for the insolvent participant

Preparing for Regulatory Changes

With the December 31, 2024 deadline approaching for the technical advice from ESMA regarding the CSDR review, financial institutions should prepare for potential regulatory adjustments that may impact their operational frameworks. The clarification of settlement discipline exemptions could lead to changes in compliance strategies and risk management practices. Additionally, the financial institutions may need to enhance their reporting mechanisms to align with ESMA's expectations for transparency. By proactively addressing these areas, the financial institutions can better position themselves for the upcoming regulatory changes.