Industry associations have told European regulators that there is no basis for increasing penalties for settlement fails beyond their current form and have warned of the unintended consequences of doing so.
The European Securities and Markets Authority (ESMA) published a consultation paper in December 2023 on the CSDR penalty regime seeking input on amendments which may include cash penalties that increase with the length of the settlement fail.
Cash penalties for settlement fails were introduced in February 2022, however rates were not immediately impacted and continue to be a concern for regulators. Still, many associations believe it is too soon to take stock and that there isn’t enough data and evidence to support increased penalties, while the drawbacks are many.
Among those to have responded have been the International Capital Market Association (ICMA), International Securities Lending Association (ISLA) and the Association of Global Custodians (AGC).
ISLA wrote that “there has not been sufficient time since the implementation of the regime in 2022 to be able to accurately determine its effectiveness on reducing settlement fails”.
ICMA pushed hard on the fact that there is no “logical or economic basis” for progressive penalties pointing to an “absence of any data or cost-benefit analysis to support” the proposal.
“Progressive penalties would introduce an unnecessary level of complexity, with the associated cost and resource drain, not only for implementing CSDs, CCPs, and custodians, but also market participants who need to reconcile penalty credits and debits, as well as pass these on to clients. Furthermore, this would put additional stress on an already dysfunctional claims process that has been born out of the EU’s CSDR penalty mechanism,” the association said.
Unintended consequences
AGC also believes the proposal would be a significant and costly undertaking not only for CSDs but also for the wider industry, including custodians. The association also believed some of ESMA’s options were not progressive but represent “major increases in overall penalty rates and significant increases in the complexity and operational costs of running the penalty regime for all intermediaries in the custody chain.”
Complexity, costs and liquidity issues came up repeatedly, along with the lack of justification for progressive penalties. ICMA commented that progressive penalties introduces unnecessary stress to a market that is most likely already facing liquidity challenges.
“Accordingly, progressive penalty rates would not provide an additional motivation to settling trades, but rather an incentive to avoiding trades, thereby becoming counterproductive,” the trade body added. “Increasing the cost of failing will not make an illiquid security any less illiquid…this will only make illiquid securities more illiquid.”
In addition, the move was put into the context of a possible shift to T+1 in Europe, along with the Capital Markets Union. On the latter, some associations felt the proposal would make Europe a less attractive market.
On T+1, introducing more complexity into the penalty regime coupled with such a significant undertaking means that the proposal needs the most careful of consideration.
ISLA noted: “It should be noted that an overhaul to the penalty regime would take considerable resource away from a focus on T+1, although it is acknowledged by the industry that in order to be successful in accelerating the settlement cycle, there must also be high settlement rates across the EU.”
ESMA said the feedback it receives will feed into its technical advice, which is expected to be sent to the European Commission by the end of September 2024.
Background to the proposal
The regulator’s latest consultation appeared to be looking at removing the economic incentives to letting the trade fail but adding in the progressive fines. ESMA said the penalties need to be “unequivocally more expensive than remedial action, like borrowing the securities or funding the cash” and “certain in terms of calculation and forecasting, to facilitate cost/benefit calculations in terms of remedial investments”.
Another reason the fines may not be as impactful is due to the sell-side absorbing the costs rather than passing them onto the buy-side.
“The proposed amendments to the structure and severity of the mechanism should effectively discourage settlement fails, incentivise their rapid resolution and improve settlement efficiency,” the report said.
Cash penalties for settlement fails were introduced in February 2022, however rates were not immediately impacted and continue to be a concern for regulators.
According to data from ESMA, fails peaked at around 12% of total settlement instructions in May/June 2021, and again spiked following the introduction of CSDR’s Settlement Discipline Regime in February 2022, which introduced penalties for late or failed trades.
The number of fails saw a steady increase until the end of Q2 2022, accounting for around 10% of total trade values. However, since then, efficiency in the market has steadily improved, with the latest figures (April 2023) placing the share of failed instructions at around the 5% mark.
The latest data in February showed equities settlement fails across CSDs within the European Union fell to a monthly average of below 6% during the second half of 2022, a vast improvement on rates witnessed over the past two years.
On social media however, some experts questioned the consistency of the data. Pete Tomlinson, director, head of post-trade at the Association for Financial Markets in Europe (AFME) commented on a post about the data saying: “Frustratingly, this bears little resemblance to the last TRV report (in which EQ fail rates for 2022 were always below 10%). how can the industry track progress without consistent data?”
Much like their response to the notion of mandatory buy-ins under CSDR, the industry is firmly against the use of progressive penalties in any form.
Mandatory buy-ins are still looming over the industry – they were not removed entirely in the CSDR refit proposal – but ESMA has reiterated that the aim should be to build a cash penalty mechanism that reduces the need for more drastic measures, rather than turn to the contentious buy-in regime.