CSDR increases pressure on authorised participants in fragmented European ETF market

European Commission proposed changes to CSDR in March

Tom Eckett


Authorised participants (APs) are feeling the brunt of the Central Securities Depositary Regime (CSDR) since it came into effect at the start of February as European regulators signal no plans to remove the cash penalties being implemented for settlement failures.

In March, the European Commission proposed a number of changes to CSDR including confirmation it would not implement mandatory buy-ins, however, that it would proceed with reporting requirements for settlement fails and the cash penalties regime.

Although the European Commission admitted mandatory buy-ins could lead to increased costs, reduced liquidity across asset classes and financial stability risks, it has the option to re-introduce buy-ins “if the rate of settlement failures does not improve”.

In reaction to the European Commission’s changes, Pete Tomlinson, director of post trade at the Association for Financial Markets in Europe (AFME), expressed concern about the lack of clarity over what will cause the European Commission to re-introduce mandatory buy-ins.

“AFME does not believe mandatory buy-ins are appropriate for any asset class or transaction type and will have disproportionate negative consequences on market liquidity and efficiency that could undermine the attractiveness and competitiveness of EU capital markets,” he added.

Federico Cupelli, deputy director for regulatory policy at the European Fund & Asset Management (EFAMA), added: “The earlier buy-in rules were viewed negatively by APs in terms of reduced operational efficiency, leading to higher costs for investors and affecting the ability of the ETP to protect itself from counterparty risks.”

While market participants are in the clear of the mandatory buy-in regime, for now, cash penalties have started being issued to liquidity providers by central security depositories (CSDs) for any settlement failures.

According to an industry source, cash penalties for one issuer’s suite of ETFs could total up to €2m this year, a hefty chunk for liquidity providers pricing the range.

Cash penalties are a particular issue for ETFs which tend to have high settlement failures versus the underlying securities they track.

As Adrian Whelan, global head of regulatory intelligence at Brown Brothers Harriman, explained: “ETFs are likely to be heavily affected. The impact to ETFs is expected to be especially noticeable since ETFs typically have a high rate of settlement failure in relation to share creation and redemption combined with delivery of underlying securities.

“While the ETF shares may settle in two days (T+2), the securities underlying the ETF shares may require five or more days for delivery (T+5). Increased costs to ETFs for failures could be passed on to investors.”

Failures can happen for a number of reasons including operational issues or a lack of liquidity in the market and the European Commission has even noted “the scope of cash penalties…should be clarified”.

“Such exclusions should cover transactions that failed for reasons not attributable to the participants and transactions that do not involve two trading parties, for which the application of cash penalties or mandatory buy-ins would not be practicable or could lead to detrimental consequences for the market, such as certain transactions from the primary market,” the European Commission added.

Market makers often do not own the full basket of securities when pricing ETFs meaning there is always a risk they will not be able to deliver on time and subsequently incur a fine. This issue is especially prevalent in Europe where the market is highly fragmented across 30 exchanges in 25 countries.

“The cash penalty regime still remains in place and could still potentially affect secondary market trading in ETP shares,” Cupelli warned.

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