Following the latest financial crisis, the Central Securities Depository Regulation (CSDR) (n° 909/2014) has been applied on July 23rd, 2014 by several financial institutions in the European Union (EU) with the proposal of the ESMA and came into effect on February 1st, 2022. This regulation emphasizes one of the main aspects of the finance industry that was underestimated preceding the crisis: operational risk. CSDR regards the European Union investors operating in the financial markets and aims to limit the operational risk by improving the securities settlement. Several financial instrument types are involved: bonds, equities, and ETF mainly. Specifically, ETFs were one of the major subjects following the application of this regulation. Before going further on the implications of the CSDR, we will focus on its objectives in terms of limiting operational risks.
What is the CSDR regulation?
The Central Securities Depository Regulation (CSDR) is a harmonized regulation for financial markets in the EU financial markets. Along with MIFID 2 and EMIR, the main objective of the CSDR regulation is to increase safety and efficiency, especially in securities settlement and settlement infrastructures in the EU. Thus, CSDR introduces:
- A passport allowing authorized Central Securities Depositories (CSDs) to provide their services across the EU
- A settlement discipline that includes cash penalties and buy-ins for failing transactions.
Settlement discipline appears as the rules imposed by the CSDR to avoid engaging a penalty process in the case of a late settlement operation.
How does the CSDR work in the Front-to-Back system?
CSDR can be either a credit or a debit flow. The credit is an indemnisation, the debit is a penalty.
The CSDR penalty is the total amount charged for transactions that were settled after the value date and exceeded a pre-determined threshold set by the client and the depository, calculated based on the sum of daily debit CSDR flows over a month. The securities seller can be mistaken if he/she does not deliver the securities to the buyer in time. On the opposite, the buyer is mistaken if he/she fails to deliver the cash for the trade on time. The CSDR indemnisation is the credit flow for which the counterparty is mistaken and must pay the CSDR amount to the other one.
Thus, the CSDR enters the post-trade market. Basically, the CSD computes the daily CSDR amounts by establishing the penalty rate:
The penalty rate is different depending on which party failed:
- If the seller fails to deliver the securities, the penalty rate ranges from 0.10 basis points (bps) to 1.0 bps due depending on the instrument type
- If the buyer failed to deliver cash, the penalty rate is the official interest rate for overnight credit charged by the central bank issuing the settlement currency (with a floor of zero)
Here are the characteristics needed to compute a daily CSDR amount:
- Quantities traded for the initial transaction(s)
- Penalty rate
Daily CSDR Penalty: Quantities x Penalty rate x Price
Monthly CSDR =
The CSD sends the CSDR amounts to the local custodians, and the local custodians send the information to the clients. The clients control the exactitude of the amounts and proceed to a reimbursement demand to the CSD in case of a debit CSDR over a threshold for which the counterparty was late to deliver (securities or cash depending on their buy/sell side) whereas the amount has been charged.
The Implications of the CSDR regulation
Overall, this measure reinforces the controls in the market:
- Favors transparency on the markets,
- Reduces the counterparty and operational risk,
- Imposes a harmonization of the settlement rules in the EU financial markets, especially for cross-border operations between two different countries in the EU,
- Reinforces the protection of the investors on their own assets
CSDR regulation has been the subject of numerous topics, especially for the ETF markets for which it could build inefficiencies. In both primary and secondary markets, ETF market makers could be impacted.
Contrasted effects for the ETF stock market
ETF can replicate on both primary and secondary markets. Market makers regulate ETF products. They regulate the bid-ask spread by ensuring continuous and efficient exchange between the buyers and the sellers. Basically, they can create and exchange ETF units (or ETF quantities) with investors in the stock market. Firstly, they buy them from the ETF provider and sell them the ETF underlying securities in counterparts with an equivalent valuation. Secondly, they sell the units to the investors in the stock market at an asking price (ask). They can do the reversal operation and buy the units at a bidding price (bid). This allows the ETF market data pricing (real price) to be closely linked – or equal – to its net asset value (NAV or valuation price).
CSDR includes a new parameter, the penalty. Imposing this parameter to the market makers indirectly could imply a wider bid-ask spread, thus higher costs for investors. Indeed, a late settlement can occur, for several reasons, often for a lack of security from one party. When it occurs, the penalty will make the price higher in the trading book from market makers, thus impacting investors. The more the late settlement, the more important the question about how much investors are willing to pay a higher price for these products.
Moreover, Euroclear (EOC) centralizes products in the CSDR scope, but CREST (which is a subsidiary of EOC and a local depositary in the UK) is out of the scope as the UK rejected CSDR regulation following its exit from the EU. A second question is: will EOC allow CREST to be outside the scope of CSDR regulations? Indeed, CREST will lead investors to make a trade-off between trading in EOC and trading in CREST. From Chancellor Rishi Sunak, ETF trades settling via CREST could have then a “competitive advantage”. Thus, this could help market makers trading in CREST keeping the bid-ask spreads tighter without the penalty parameter. Investors will focus the trading in CREST, and will favor the concentration on this market to the detriment of those in the EU.
The new solutions related to CSDR
As with most of the financial regulations so far, their introduction induced solutions or tools to answer compliance and regulatory needs. The introduction of CSDR induced the development of new solutions and tools facilitating the follow-up and management of operational risks. Bloomberg developed FailStation for settlement-exception management and enhanced the platform including a solution for CSDR penalties management. FailStation (FSTN) is a real-time management tool for settlement follow-up, from the pre-trade to the post-trade. It summarizes the settlement information in a single view and normalized format. It is widely used – over 150 custodians and brokers – for operational workflows and compliance by bringing real-time transparency.
The platform was enhanced by including a solution for CSDR regulation. The solution aggregates the trades having a penalty and allows the clients to prioritize the trades sorted by their penalty size. A notification can be sent automatically to both internal and external stakeholders followed by an initiation of the resolution process to minimize the penalties. The clients are also able to edit comments to enrich the settlement information.
Moreover, CSDR implied the development of many new tools or solutions among several financial actors. AMUNDI for instance develops a solution in their internal platform ALTO (Amundi Leading Technologies and Operations) that retrieves daily and monthly SWIFT copies of CSDR flows received by the custodians, to show an interface to the users of all penalties within a new table dedicated to CSDR indemnities/penalties management.
- Lomax J. (2021, 7th of December), Bloomberg launches new solution within FailStation for CSDR compliance, asset servicing times
- CSDR: what the buy-side needs to know – Settlement Discipline Regime, (2021, 3rd of November), simmons-simmons
- Eckett T. (2022, 8th of February), CSDR is here: Should ETF investors prepare for higher costs? , ETF stream
- Eckett T. (2021, 18th of January), Euroclear: CSDR directive to cause ETF settlement inefficiencies, ETF stream
- What is the role of the market maker for ETFs? (2017, October), RBC Global Asset Management
- Central Securities Depositories Regulation (CSDR), European Securities and Market Authority (ESMA)
- Eckett T. (2020, 4th of March), ‘More questions than answers’: CSDR impact divides ETF industry, ETF stream.