September The CSD Regulation A guide for clients

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1 September 2014 The CSD Regulation A guide for clients 1

2 Contents Introduction 3 About this guide 3 Background 3 Provisions for securities settlement (Title II) 4 Provision of banking-type ancillary services for 5 CSD participants (Title IV) Other articles within CSDR which have a direct impact 6 on clients Conclusion 7 Annex 1: CSDR implementation timetable 8 2

3 Introduction At first glance, the CSD Regulation (CSDR) may look to be a specific piece of European Union (EU) legislation dealing with the prudential regulation of Central Securities Depositories (CSDs) only. However, the full title of the law is a Regulation of the European Parliament and of the Council on improving securities settlement in the EU and on central securities depositories. The CSDR, therefore, also affects market participants directly since it: covers the dematerialisation and immobilisation of securities and the settlement period for securities trades; and imposes a new and very wide-ranging settlement discipline regime on markets. The CSDR is in the process of being implemented and, as is common with most EU regulations, the implementation of its provisions will be phased. The vast majority of the CSDR s provisions can only come into force once the relevant Technical Standards and Delegated Acts have been implemented in around November/October About this guide The CSDR contains 76 Articles divided into six key sections (or Titles ) and an Annex. This guide focuses on the main areas that will affect our clients, namely: Background Following the financial crisis of , the European Commission made it clear that no financial product or market should remain without appropriate regulation and effective supervision. The G20 was instrumental in establishing the core elements of a new global financial regulatory framework that should make the financial system more resilient. This framework included reforms to strengthen the regulation of financial markets and infrastructures, especially through the compulsory trading and clearing of derivatives on well-regulated and transparent platforms. Although CSDs in the EU had performed well during the crisis and were regulated extremely tightly under domestic law and under international standards 1, they were not regulated consistently across the EU. The need for a consistent regulatory approach to settlement systems and settlement processes was made even more pressing by the development of the Eurosystem s TARGET2-Securities (T2S) project, initially covering 24 European CSDs. It was therefore inevitable and desirable that specific CSD legislation was implemented in the EU. The CSDR should be seen as complementary to, and consistent with, both the European Market Infrastructure Regulation (EMIR) in respect of CCPs and the Markets in Financial Instruments Directive II (MiFID II) in respect of trading platforms. Securities Settlement (Title II) this effectively covers all of the market-wide settlement provisions Provision of Banking-type Ancillary services for CSD participants (Title IV) The guide reflects our general interpretation of the CSDR, and should not be relied on as a compliance, or formal implementation, guide by others. In addition, it does not cover the contents or implications of the Regulatory Technical Standards and Delegated Acts which are currently being prepared by the European Securities and Markets Authority (ESMA), the European Banking Authority (EBA) and the European Commission. These will not be in force until late This paper should however, help you understand the likely implications of elements of the CSDR text for your business. Please see Annex 1 for more information on indicative implementation dates. 1 Initially the ESCB/CESR Recommendations and more recently the CPSS/IOSCO Principles for Financial Market Infrastuctures,

4 Provisions for securities settlement (Title II) The CSDR aims to improve the efficiency and safety of settlement in the EU through mandating both the recording of securities in book-entry form and the implementation of settlement discipline and buy-in regimes. Dematerialisation and immobilisation of securities The CSDR (Article3 (1)) requires that any issues of EU transferable securities which are admitted to trading or traded on trading venues should be represented in book entry form through immobilisation or dematerialisation. The vast majority of securities in Europe are already issued in such form. In the UK and Ireland, retail investors have had the option of holding their securities in dematerialised or certificated form. There are only around 3,000 certificated trades each day in the UK and Ireland combined. Euroclear UK & Ireland has been working closely with the registrars, the authorities and the market to ensure that a settlement model can be implemented by 2023 (for new securities) and 2025 (for existing securities), with minimal implementation effort for those clients who currently hold certificated securities. Further details of this model will be made available to the market for consultation in due course. T+2 settlement Article 5 requires all transactions in transferable securities executed on trading venues to be settled on a T+2 basis (i.e. two business days after trade date rather than three) with effect from January We believe that all EU markets (apart from the Spanish equities market) will migrate to T+2 on 6 October 2014, well in advance of the deadline set by the CSDR. There are working groups in place in most EU domestic markets to manage the technical details of the transition. There is also a helpful guide by the T2S Harmonisation Steering Group (HSG) on the migration to T+2. Although the CSDR gives the market some flexibility not to apply T+2 to transactions that are negotiated privately, members of the T2S HSG have recommended that market participants use T+2 as the default rule for settling overthe-counter (OTC) transactions (including eurobonds), unless the two parties to the transaction have agreed otherwise. The International Capital Market Association (ICMA) announced in May 2014 their intention to change their rules and recommendations on settlement cycles to T+2 unless otherwise agreed to allow for the orderly trading of all fixed income securities traded under ICMA rules. Settlement discipline The CSDR (Articles 6 and 7) aims to encourage clients to settle their trading obligations on intended settlement date, and requires CSDs and other market infrastructures to take measures to prevent and address settlement fails. In effect this means the mandatory implementation of a buy-in regime and a settlement discipline regime across a wide range of securities. This section of the CSDR will affect all clients of each and every CSD in Europe and will have a widespread market impact. Although the full details of the regime will only be known once the Regulatory Technical Standards are agreed next year, the CSDR already sets out a number of principles in a very detailed Article 7. Settlement fines CSDs will gather data on settlement fails for provision to the relevant Competent Authorities, as they do now, and will also publish aggregated data on an annual basis. CSDs must implement a penalty mechanism for fails which serves as an effective deterrent. The parameters of this mechanism, taking into account the liquidity of securities and the type of transactions, will be established by the Commission through a Delegated Act. But the intention of the CSDR is to cover fails in all transferable securities, money market instruments, UCITS and emission allowances. This is a very wide scope, and for many CSDs and markets will impose fines on a far broader range of securities than currently. A majority of CSDs already have a penalty scheme in place for late settlement, although the type of fees applied varies across markets (e.g. recycling fees vs. penalty fees, with some CSDs charging both). In most cases, the fines are charged to the first party in the chain (i.e. the party that caused the initial fail). However, the CSDR encourages fines to be credited to the non-failing client as compensation; fines should not be a revenue source for the CSD concerned. 4

5 The precise mechanics for this complex operation are still subject to discussion with ESMA and the Commission. But it is clear that the CSDR will introduce a harmonised settlement discipline regime which will require adaptation costs in many markets. Buy-ins The CSDR imposes a mandatory buy-in process on any financial instrument which has not been delivered within four business days of the intended settlement date. This period can be increased to seven days for illiquid securities and 15 days for transactions on Small and Medium Enterprise (SME) growth markets. CSDs will not execute buy-ins themselves (to protect their risk-profile). But the CSDR says that they may monitor the execution of buy-ins particularly when there are chains of transactions, to minimise the number of buy-ins executed. The market is working closely with the authorities to ensure that the Regulatory Technical Standards set out sensible and effective provisions in this respect. It is vital for market efficiency that multiple buyins or settlement fines are not applied across a single chain of securities transactions. The ability of a CSD, however, to identify accurately such chains (particularly in a crossborder context) is extremely limited. The market and the CSDs have been working closely with ESMA to identify whether and how fines could be passed on through complex transaction chains, which are frequently crossborder. Provision of banking-type ancillary services for CSD participants (Title IV) What the banking provisions actually say One of the most complex parts of the CSDR is Title IV (Articles 54-60), which sets out the detailed requirements for the provision of banking type of ancillary services to CSD participants. In effect these provisions deliver a legal framework to govern the provision of commercial bank money settlement by CSDs to their participants. In summary these provisions achieve the following effects. Restrictions on banking business A CSD is permitted to provide commercial bank money services to its participants either: through a credit institution under the Capital Requirements Directive (CRD IV), which is actually the same legal entity as the CSD; or through a separate legal entity, authorised as a credit institution under CRD IV, which is located either within, or outside, the group of which the CSD is a part. In either of the above options, the credit institution is subject to very tight restrictions on the banking business which it can undertake, and to a very intensive supervisory regime. The CSDR effectively creates the new status of a limited purpose bank for all CSD commercial bank money settlements, however those services are delivered. As set down in the CSDR, the credit institution/csd: can only undertake certain 3 banking services permitted under CRD IV such as: - providing cash accounts and accepting deposits from its participants; - providing cash credit for reimbursement no later than the following business day; - payment services involving the processing of cash and FX transactions; - guarantees and commitments related to securities lending and borrowing; - treasury activities involving FX, and securities related to the management of participants long balances; will be subject to an additional capital surcharge which reflects the risk resulting from its provision of intra-day credit; must report at least monthly to its Competent Authority on the extent and management of intra-day liquidity risk; and must have an adequate recovery plan in place to ensure continuity of service in crisis situations. Prudential requirements Article 59 sets down very detailed prudential requirements which are applicable to all credit institutions or CSDs authorised to provide such banking services. These include requirements to: fully cover corresponding credit exposures using highly liquid collateral (with minimal credit and market risk) and other equivalent financial resources; 3 In Section C of the Annex to the CSDR 5

6 establish and apply appropriately conservative haircuts and concentration limits on collateral values; and provide for effective reimbursement procedures of intraday credit and discourage overnight credit through the application of deterrent sanctioning rates. There is an exception to these limitations but it only applies where a third-party credit institution (i.e. not the CSD itself) is providing credit for settlements which are less than 1% of the value of a CSD s total annual transactions, and not exceeding 2.5 billion per year. We believe that only the EU s very smallest CSDs will be able to benefit from this exemption. The effects of these provisions The banking provisions will have effects on all those CSDs that currently provide commercial bank money settlement, not just those that have a banking licence today. Those CSDs which currently also hold a banking licence (such as Euroclear Bank, Clearstream Banking Luxembourg, Clearstream Banking Frankfurt, KELER in Hungary and Oesterreichische Kontrollbank (OeKB) in Austria) will have to comply fully with these provisions and will have to apply for authorisation under CSDR. Euroclear Bank does not expect to make material changes to its business as a result of these changes. The authorisation process will require discussion with a college of regulators, although the authorisation decision will remain with the CSD s Competent Authority. Those CSDs which currently offer their clients commercial bank money services of a value greater than the limitation set down in the exemption (described above) through the services of third party settlement banks, will probably have to restructure their services. This is because those third party banks, which are all full service banks under CRD IV, will have to comply with the limited purpose banking provisions of Title IV. This means that they will have to restructure and/or create new limited purpose banking subsidiaries to support commercial bank settlement in a CSD. This is likely to be uneconomic, so we expect such commercial bank services provided by CSDs to be either restructured or to be discontinued entirely. As an example, Euroclear UK & Ireland currently offers US dollar settlement for its clients supported by a number of US dollar settlement banks. It is looking to restructure its services in discussion with the UK and US authorities to achieve full CSDR compliance from the time of its authorisation under CSDR (which is expected in 2016). We do not believe that Title IV of the CSDR applies to those banks which provide correspondent or other banking services to those CSDs which are also banks, like Euroclear Bank. This is because Title IV only covers the provision of banking services to the participants of a CSD, not to the CSD itself. Other articles within CSDR which have a direct impact on clients There are three other aspects of CSDR which will have a direct impact on clients Internalised settlement Article 9 of the CSDR requires so-called settlement internalisers to report to their Competent Authorities on a quarterly basis the aggregated volume and value of all securities transactions which they settle outside of CSDs. ESMA is drafting technical standards to establish the forms, templates and procedures for the reporting and transmission of this information to the relevant Competent Authorities. These provisions do not apply to CSDs themselves since the definition of a settlement internaliser is an institution which executes transfer orders on behalf of clients or on its own account other than through a CSD. Protection of securities of participants and those of their clients Article 38 of the CSDR requires CSDs to keep records that enable a participant to segregate the securities of any of their clients if and when required by that participant. This is in line with existing practices across the Euroclear group today. However, Article 38(5) also places a new obligation on a CSD s participants to: offer their clients at least the choice between omnibus segregation and individual client segregation; and inform them of the costs and risks associated with each option. 6

7 Clients should consider carefully how they can best comply with these requirements. There is a specific exception granted for direct holding markets. We understand that Article 38 can only come into effect once a CSD has been authorised under CSDR (so, probably in 2016). Use of Legal Entity Identifiers (LEIs) Although not referenced at all in the CSDR, ESMA has suggested 4 that CSDs could use LEIs to facilitate the harmonisation of data collection and reporting across the value chain. We are supportive of the concept of LEIs and understand their value at the level of securities and derivatives trading. We are however, uncertain of how CSDs and their Competent Authorities would use such identifiers at the post-trade level and the effects on CSD clients and issuers. We continue to explore this issue with ESMA. Conclusion This document describes the main areas of the CSDR which will affect clients directly. The rest of the text of the CSDR applies predominantly to the authorisation and prudential supervision of CSDs themselves and, while a significant compliance burden, should not affect the delivery of services to clients in any material way. If you wish to discuss the implications of the CSDR for your business, please contact: your Relationship Manager Paul Symons and Ilse Peeters in our Public Affairs Department 4 In Question 29 of March 2014 Discussion paper on the Draft Technical Standards for the CSDR 7

8 Annex 1: CSDR implementation timetable The Table below gives you an idea of how and when the CSDR will be implemented. The dates are indicative as their application depends on forthcoming implementing legislation. Indicative date Event CSDR Articles 18 September 2014 Entry into force of CSDR, 20 days after publication in the Official Journal of the EU December 2014 Competent Authorities notify existing Article 69(1) CSDs to ESMA 1 January 2015 (or 1 January 2016 by derogation) T+2 introduced, although in effect nearly all EU markets (apart from Spain) will migrate in October 2014 Article 5(2) End 2015 November 2015 May 2016 Entry into force of Implementing Technical Standards, and Regulatory Technical Standards (RTS), and Delegated Acts 6 months after entry into force of the RTSs Article 9(1) setting out the reporting obligations for settlement internalisers. Article 6 and 7 setting out the measures to address and prevent settlement fails Articles 69(2) CSDs to apply for authorisation and to notify CSD links Article 69(3). Third Country CSDs to apply for recognition June 2016 (at the earliest) Authorisation of a CSD under CSDR Title III, Title IV and Title V applied September October years after CSDR enters into force Commission to prepare review report on various aspects of CSDR 1 January 2023 Article 3(1) Compulsory immobilisation or dematerialisation for newly issued transferable securities 1 January 2025 Article 3(1) Compulsory immobilisation or dematerialisation for all transferable securities 8

9 2014 Euroclear SA/NV, 1 Boulevard du Roi Albert II, 1210 Brussels, Belgium Tel: +32 (0) RPM Brussels number Euroclear is the marketing name for the Euroclear System, Euroclear plc, Euroclear SA/NV and their affiliates. If at any time in the future you prefer not to receive communications from Euroclear advising you of Euroclear products and services that may be of interest to you, please contact us at and specify on what product or service you no longer wish to receive marketing information. MA3167 Euroclear is a carbon neutral company PAS2060 certified in 2014

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