CSD Regulation: Potential buy in regimes and principles for settlement discipline

Annex 1 of the response from the German Banking Industry Committee (GBIC)

Background to Industry Work

On 5th June 2014, AFME hosted a cross industry workshop to discuss and seek agreement on models and principles for the proposed CSDR settlement discipline regime

Representatives from the following trade associations were present: AFME, AFTI, EACH, EBF, ECSDA, FESE

Breakout sessions focussed on the following topics:

Buy in regimes

Settlement penalties

Agreement on a number of key principles and potential solutions for settlement discipline regimes

The group deemed it important to meet and discuss findings further with National Competent Authorities and ESMA, to highlight areas of complexity that were covered and discussed, and describe potential models reviewing pros and cons of each

1

Buy-in regimes: objectives and current regimes (1/2)

Buy-in: key objectives

Buy-ins are a way to enforce the delivery of securities bought/sold under a trade agreement. If the seller fails to deliver the securities to the buyer on time, he is bought in by the buyer, whereby a third party delivers the securities to the buyer, and the seller is charged the corresponding costs.

The main objective of a buy-in is to: Protect the buyer, by ensuring that the buyer receives what it is contractually entitled to. From the perspective of a buyer, a buy-in preserves the original terms of the trade, so that the buyer receives the

securities which it has purchased, and pays the original purchase price. The buyer may in addition receive a compensation for any additional costs (administrative etc) that the delayed delivery

may have generated, but should not make an undue profit as a result of the buy-in. A subsidiary objective is to reduce risk /number of ageing outstanding settlements (alternatives exist)

Buy-ins occur between trading counterparties (buyer-seller) and in case of CCP cleared transactions between the CCP and the failing clearing member. Settlement agents/CSDs provide a service for the delivery of the securities vs. cash, but do not become party to the

trade CCPs become – through open offer/trade novation - counterparties to the trade as the seller to every buyer, and the

buyer to every seller, and also settlement counterparties/input settlement instructions Exchanges provide a service to execute transactions, but do not become party to the trade

2

Buy-in regimes: objectives and current regimes (2/2)

Current buy-in regimes

OTC markets (neither cleared nor traded on a regulated trading venue)

Buy-in provisions are often already included in contracts between OTC counterparties/market conventions (e.g. ICMA)

Currently, there are very few OTC buy-ins due to the costs and complexities involved. In many cases a buyer may see little benefit in executing a buy-in, and prefer to wait until the seller is able to deliver the securities.

CCP cleared markets

CCPs usually have buy-in provisions and mechanism in their rules: These rules are different per market/instrument/CCP; in the case of equities, the settlement discipline under the Short

Selling Regulation (SSR) only limits the harmonisation to the extension period across CCPs. CCPs initiate/enforce buy-ins to manage their open risk Given their role of aggregator, CCPs play a key part in settlement (especially for equities), and are key counterparties for

settlements and related fails

The settlement netting process impacts the buy-in process: As gross trades are netted into a net settlement instruction, there is no direct correlation between the settlement price

and the original trading price. The characteristics of the netting model also play a role The CCP executes cash settlement where required/needed. The reference price is calculated based on the last available

closing price (as used in margin calculation) or any other price depending on specific circumstances at the discretion of the CCP. It should allow sufficient compensation for the buyer without any loss, but should not lead to any potential gain to any of the parties

Exchange traded transactions which are not CCP cleared

Need for further analysis on current rules/processes

3

Buy-in regimes: Key principles /suggestions

Buy ins should be conducted at trading level, not at the level of settlement intermediaries or CSDs. It should be noted that trading chains are not always identical to settlement chains, and that trading sizes/prices can be different from settlement sizes/prices (e.g. as a result of netting)

Buy-in should be conducted by: For CCP cleared transactions: by CCPs against their failing clearing members according to the CCP rules For OTC transactions: by the Buyer against the seller according to contract/industry rules For trading venues/non CCP cleared: Trading venues to stipulate rules for their members

Buyer against seller according to rules of the trading venue

Any buy-in method should prevent and avoid duplicate buy-ins across chains of CCP/OTC transactions, in order to ensure only one buy in is executed, and avoid excessive costs/impacts. See next slides for potential methods.

Buy in rules and processes/timelines need to be harmonised/synchronised across markets and venues

Buy in process of pre-advices & notifications must be automated, including any reporting from CSD/CCP: CCPs already have this process in place for cleared transactions; each CCP has individual standards/reports. Potential need to create an industry-wide formatted message for notifications/ executions.

Settlement partialling, which could occur both before and after the buy-in procedure is initiated, should ideally be made mandatory, even for OTC activity, from a certain moment (e.g. issuance of a buy-in pre-advice), to allow maximum opportunity to settle ahead of buy-in. There should be a minimum delivery value threshold agreed per asset class. (note: This will require market infrastructures and industry participants to provide an automated mechanism, which may not exist in all markets currently. )

Where securities are undergoing a (voluntary) corporate action, there should be a mechanism for buyer and seller to agree to the delivery of the corporate action proceeds. Sellers need to protect entitlements requested by the purchaser.

Cash compensation should be applied where a buy in is not possible or appropriate . Neither buyer nor seller should gain from the process. The cash compensation should be equivalent to the original cost or cost of buying those securities at the prevailing market price. For CCP cleared trades the reference price for the cash compensation is based on the last available closing price (as used in margin calculation) or any other price depending on specific circumstances at the discretion of the CCP.

ESMA may seek to establish guidelines to ensure uniform, reasonable administration costs for buy-ins. They could be similar to the admin fees charged by CCPs under the Short Selling Regulation (SSR).4

Buy-ins in the context of transaction chains

Market activity is interconnected at trading and settlement level. Fails to deliver by one party often cause subsequent fails further along the chain.

This is particularly relevant for intermediaries (e.g. market makers) who provide two-way liquidity and thus are dependent on their counterparties.

In the workshop, particular emphasis was placed on ways to ensure that buy-ins are minimised (in transaction chains) where possible and costs/timings are well calibrated, while ensuring compliance with CSDR and with the key principles of a buy-in (page 4)

For transaction chains, several models were reviewed to determine the best way to initiate and execute buy-ins: at all points of the chain, at the start, at the end and considering where a CCP is involved.

The output was: Two models which could potentially work, and 3 models (included in appendix) that would not The following scenarios have been kept simple deliberately (similar shapes/dates/sizes) to facilitate

the discussion

5

Buy-in at end of the chain with pass-on of costs

How it could work

Each party in the chain can issue a buy-in notice upon failure to receive (S+1,S+2, S+3 tbd) While E will stipulate in his notice that he wants to execute a buy-in to receive the actual securities, parties D,C,B can (after verification):

‘pass on’ the buy-in notice for the quantity they expect to receive themselves indicate in the notice that they will pass on any buy-in costs further down the chain (implying that they will not do an actual buy-in)

The result will be that the buy-in will be executed only once (between D and E). E will receive the securities, D will receive the costs/fees invoice, which he then will pass (after consideration of his own trade price) on to C, C to B, B to A

Pros

Avoids issues around multiple buy-ins

Avoid issues around identifying start of the chain/central utility

Works for shapes/partials etc, though receiver needs to accept partial delivery (see recommendation on mandatory partialling)

Further consideration required

Clear definition of timing of notification/execution + need for automation of the notification/execution/pass on process

Does not work where a CCP is one of the parties in the chain (see next slide)

What is the impact on related transactions with different settlement date/what with equal/opposite trades?

What is the impact on economics of the trade, especially for repo’s and liquidity drying up?

Conclusion: Potential option for OTC activity, but need for automation/clear definition on timing and exemption for SFT’s

6

BE

Final BuyerDC

A (Initial Seller)

1000 secs 1000 secs

Traded position

Actual position

Delta

TP = -1000 AP= 0 D = -1000

TP = 0 AP= 0 D = 0

Buy-in notice

Actual Buy-in

1000 secs

TP = +1000 AP= +1000 D = 0

Not OK (but expected)

OK (no position)

OK (no position)

OK (no position)

OK (covered)

1000 secs

Buy-in notice

Buy-in notice

TP = 0 AP= 0 D = 0

TP = 0 AP= 0 D = 0

Pass on of fees/costs

buy-inagent

Pass on of fees/costs

Pass on of fees/costs

PREFERRED

MODEL

Settlement chains with CCPs: CCP performs the buy-in

7

buy-inagent

How it could work

The CCP shall be the entity that executes the buy-in procedures (no ‘pass on’ possible for the CCP) against B

The CCP will execute the buy-in and deliver the securities downstream to D (who then delivers to E)

D (who cannot buy in the CCP), should have the right to revert to E to either extend the period before buy-in or suspend the buy-in until the CCP has performed the buy-in and delivered the securities to D, who then delivers to E

B will be charged the costs and fees by the CCP, which he can then be charged back to A Pros

Avoids issues around multiple buy-ins

Avoid issues around identifying start of the chain/central utility

Works for shapes/partials etc, though receiver needs to accept partial delivery

Further consideration required

Interoperating CCPs cannot initiate buy-in against one another

Additional work is required in case the chain of CCPs is broken by a bank.

Clear definition of timing of notification/execution + need for automation of the notification/execution/pass on process

What evidence is required to allow D to revert to E to obtain an extension/suspend the buy-in, and be neutral re costs

What is the impact on related transactions with different settlement date/what with equal/opposite trades

What is the impact on economics of the trade, especially for repo’s and liquidity drying up ?

Conclusion: Potential option for CCP+OTC activity, but requires further analysis/automation

BE

Final BuyerDCCP

A (Initial Seller)

1000 secs 1000 secs

Traded position

Actual position

Delta

TP = -1000 AP= 0 D = -1000

TP = 0 AP= 0 D = 0

1000 secs

TP = +1000 AP= +1000 D = 0

Not OK (but expected)

OK (no position)

OK (no position)

OK (no position)

OK (covered)

1000 secs

TP = 0 AP= 0 D = 0

TP = 0 AP= 0 D = 0

Buy-in notice

Buy-in notice

Pass on of fees/costs

Pass on of fees/costs

Buy-in notice

PREFERRED

MODEL

Timing of buy-in process

Event Timing Comments

Notice of buy-in notification/pass on

Extension date minus x days (or SD + x days) ?

Balance generating multiple notifications with benefits of early warningRequires automation/standardisation of process if volumes of notifications increase as expectedDependant on length of extension period Incorporate a process for updated notifications following delivery of securities by sellerSpecify the method for the execution of the buy-in

Notice of start of buy-in procedure

End of last date of extension period Include timing of execution (start-end) and agentDefine what applicable market deadline is

Notice of execution of buy in

Day within the execution period to be determined by the executing/administering party taking into account market conditions and the interest of the receiving party.

Automate/communicate asap across the chain

Communication of buy-in result Day following the execution dateHow long is that period/optionality on choice between cash/deferment. The CCP is not required to give the choice.

8

Principles for a Settlement Discipline Regime (1)

The fining regime must be transparent and fines should be able to be passed back to the failing party, without disadvantaging others in the settlement chain. The model should be able to circumvent a CCP if they are an actor in the settlement chain and to take into account scenarios where counterparties have opted out of partial deliveries

Whenever possible, settlement fines should be forwarded to the aggrieved party. The CSD should be reimbursed for the cost of operating the regime

Counterparties should not be charged a daily penalty fee by both a CCP and a CSD for the same failing instruction

Fines should only be levied on matched transactions

Fines can be levied against either the buyer or the seller, depending on which party causes the fail.

On Hold instructions should be considered as fails after the Intended Settlement Date (ISD) and therefore subject to the same discipline

Technical standards should not prevent a harmonised settlement regime across European CSDs to be operated centrally (e.g. in the case of T2S CSDs) in the medium or long term.

We would support an ad valorem fee with a minimum and maximum cap , rather than a fixed fee approach. A different rate and appreciably lower rate should be applied to fixed income / higher value transactions when compared to equities.

For an ad valorem approach, a reference price should be provided by a central body in order to address the issues due to different cash values and cater for a equal balance between debited and receiving party.

11

Principles for a Settlement Discipline Regime (2)

The CSDs should provide on a daily basis to their participants detailed, up-to-date information on the status of their failing instructions. Actual payments of the fines and the reference price used should be part of the CSD monthly invoice process and provide sufficient detail to allow the costs to be passed back to the failing seller.

There should be an appeals process.

Settlement discipline should be considered for suspension, in conjunction with the relevant competent authorities, over major market events.

The working group recognises two distinct models when applying penalties. Each market could decide which is most suitable:

A gross model where all parties in the chain are fined by a CSD which then reimburses those parties who are pending receipts and deliveries.

A net model where the failing participant is debited by the CSD and the fine reimbursed to the end aggrieved party.

Potential model for Fixed Income transactions (awaiting outcome of ICMA considerations)

For US Treasury markets, there is a voluntary process for fail fines created by The Treasury Market Practices Group (TMPG).

Fines are calculated using an interest rate driven formula which would need to be calibrated by market.

A reference interest rate would be required. We could discuss further if ESMA wishes/likes the model.

12

Per Settlement Instruction

A B EDC

X Final BuyerZYInitial Seller

A EDC

X Final BuyerZYInitial Seller1000 shares 1000 shares 1000 shares 1000 shares

1000 shares 1000 shares 1000 shares 1000 shares

B

NP = -1000+1000+0=0 NP = -1000+1000+0=0 NP = -1000+1000+0=0 Indirect compensationNP = -1000

-1000 +1000 +1000-1000 -1000 +1000 -1000 +1000CSD

CSD

Fines to be paid Indemnity/compensation to be received

Net position = - failing deliveries + failing receipts + position on the participant account (*)

(*) position to be taken into account only if the participant doesn’t put any of its instructions On Hold

Failing settlement

Instruction sent to the participant to receive/deliver

Order / trade

13

Comparison of Per Settlement Instruction vs. Net position

Appendix

1. Criteria for an efficient/effective buy-in process

2. Info required to initiate/execute a buy-in

3. Options for buy in considered by the group but discounted

4. At what level should a buy-in be executed for OTC and for CCP cleared

Criteria for an efficient/effective buy-in process

Buy-in processes and timeframes should be: Fully transparent As simple as possible Scaleable/automated Harmonised (to the extent possible) across CCP and OTC activity Harmonised (to the extent possible) across markets info on buy-in execution should be quasi real time to avoid additional market risk for non CCP cleared transactions.

Costs of buy-ins should be minimised: Only used when other means to settle have been exhausted for non CCP cleared transactions. Avoid duplication and multiple buy-ins Be done at market prices or close thereto Not be construed as a penalty

Objectives of buy-in are to: Ensure delivery to the end buyer, not provide arbitrage opportunities be neutral to settlement intermediaries, market makers and CCPs not discourage trading activity, but encourage good settlement behaviour Reduce market risk Not negatively impact liquidity in the instrument

15

What info is required to initiate/execute a buy-in

Information on OTC buy-in notice/pass on (dummy example)

Buy-in notification/pass on

Name of sender/deliverer

Trade date: dd/mm/yyyy

Settlement date: dd/mm/yyyy

Nominal amount: xxxx

Security description: name of security

ISIN: XYZ… 

Price: xx.xxxx 

Net amount: xxxx EUR/GBP/USD 

Delivery details: delivering/receiving account

Other info which might be useful/needed

Date of last delivery

Date/hour of execution

Evidence of the fail/reason code

Buy-in agent/process

Deadline after which buy in will be initiated/executed

16

Option discounted - Buy-in at every point throughout the transaction

chain – multiple buy-ins

Comments/questions/issues

The amount of buy-ins largely exceeds the amount of securities needed. This will lead to:

Duplication of processes and costs

Manual/intensive

Surplus securities being bought in (4000 vs. 1000 needed), which then need to be sold again (impact on prices)

New open positions/market risks for intermediaries/market makers

Timing issues of buy-ins

Insufficient liquidity to satisfy all buy-ins, aggravating the process

Conclusion: this is not an efficient and effective method, and will lead to multiple buy ins where they are not required. This could significantly move markets and affect liquidity

17

BE

Final BuyerDC

A (Initial Seller) 1000 secs 1000 secs

Traded position

Actual position

Delta

TP = -1000 AP= 0 D = -1000

TP = 0 AP= +1000 D = -+1000

Buy-inBuy-innotice

Buy-innotice

buy-inagent

Buy-innotice

1000 secs 1000 secs

TP = +1000 AP= +1000 D = 0

TP = 0 AP= +1000 D = -+1000

TP = 0 AP= +1000 D = -+1000

Not OK (but expected)

Not OK (open position)

Not OK (open position)

Not OK (open position)

OK (covered)

buy-inagent

buy-inagent

buy-inagent

Deemed unworkable by cross industry group

Option discounted - Buy-in at start of the transaction: single buy-in +

onward deliveries - Deemed unworkable by cross industry group

Pros

Avoids most issues related to multiple buy-ins, i.e:

Single buy-in, (avoiding duplication of processes and costs)

Less manual/intensive provided notification process is automated

No more surplus securities being bought in

No new open positions/market risks for intermediaries/market makers

Less timing issues of buy-ins, if settlement process works efficiently

Cons/questions/issues

How to identify the start of a chain ?

Need to automate notification process

Existing settlements will still be in system, attracting penalties

Does not work well for partials/shapes

Will it work for cross-CSD settlements, and for chains where CCP’s are involved ?

Depot management/reconciliation issues

Conclusion: Theoretical option, with a number of practical issues/drawbacks

18

BE

Final BuyerDC

A (Initial Seller)

1000 secs 1000 secs

Traded position

Actual position

Delta

TP = -1000 AP= 0 D = -1000

TP = 0 AP= 0 D = 0

Buy-in notice

Actual Buy-in

1000 secs

TP = +1000 AP= +1000 D = 0

Not OK (but expected)

OK (no position)

OK (no position)

OK (no position)

OK (covered)

1000 secs

Buy-in notice

Buy-in notice

TP = 0 AP= 0 D = 0

TP = 0 AP= 0 D = 0

buy-inagent

Option discounted - Centralised buy- in process/agent

Deemed unworkable by cross industry group

Pros

Avoids most issues related to multiple buy-ins

Cons/questions/issues

What is the precise role of the central buy-in agent, and who is willing to act in this capacity?

The buy-in agent may be part of the transaction chain (esp. if they are a market maker/primary dealer)

Everyone needs to agree to this process: is this realistic ?

How/ on what basis will the agent identify chain transactions, and the best place to execute the buy-in

Are there constraints (privacy, other) in providing info the central agent, and vice versa

Speed/timings of creating and running this structure

What with shapes/partials/different settlement dates

Does not work where a CCP is involved (unless the CCP is willing to take on the role of the buy-in agent)

Conclusion: Theoretical option, with a number of practical issues/drawbacks + timing issues.

Even if it could work, the Central Buy In agent may become a consolidated centre of risk.

19

Central buy-in agent

BE

Final BuyerDC

A (Initial Seller)

1000 secs 1000 secs

Traded position

Actual position

Delta

TP = -1000 AP= 0 D = -1000

TP = 0 AP= 0 D = 0

Buy-in notice

buy-inActual Buy-in

1000 secs

TP = +1000 AP= +1000 D = 0

Not OK (but expected)

OK (no position)

OK (no position)

OK (no position)

OK (covered)

1000 secs

Buy-in notice

Buy-in notice

TP = 0 AP= 0 D = 0

TP = 0 AP= 0 D = 0

copy

copycopycopy

At what level should a buy-in be executed? (OTC)

Buy-in

20

Settlement location: Domestic & Cross-CSD (generic)

Type of activity: OTC

CS

DS

ettl e

men

t A

gen

tT

rad

i ng

/ C

l ear

i ng

A B C D E

MT CBFESES VP

SettlementSettlement SettlementSettlement

BNP CITI HSBC JPM DB

Sale Trade Sale Trade Sale Trade Sale Trade

Settlement impact / reporting

Settlement impact / reporting

At what level should a buy-in be executed? (CCP)

Settlement location: Domestic & Cross-CSD (generic)

Type of activity: CCP cleared (OEX)

CS

DS

ettl

eme

nt /

Ag

ent

Tra

din

g /

Cle

arin

g

A B Exchange/CCP D E

SettlementNetSettlement

NetSettlementSettlement

BNP CITI CCP (on agent) JPM DB

Sale Trade Novated Trade Novated Trade Sale Trade

Settlement impact / reporting

Settlement impact / reporting

CBFMT ESES VP

Buy-in

21