While the move to T2S is ushering in greater efficiencies to the settlement process, new regulation governing central securities depositories (CSDs) raises significant considerations for broker dealers and global custodians, says Richard Willsher
T2S was introduced to reduce the cost and inefficiencies of securities settlement within the eurozone. CSDs now outsource their settlement function to the T2S platform. T2S harmonises aspects of settlement, improves its timing and introduces common functions across the region. This in turn fosters competition and reduces the cost of inward investment into the Eurozone. In particular, greater efficiencies were introduced to larger securities market participants who can now hold their own accounts directly with a foreign CSD, while smaller players may still need to appoint a local custodian.
This is the new T2S world in a nutshell. Meanwhile the Central Securities Depositories Regulation, (CSDR), which generally took effect in September 2014, provides the rules framework for CSDs within the T2S environment and how they interact with each other. In doing so, it changes the way in which some CSDs are permitted to operate and in turn affects the services that they can supply to their clients.
The combination of T2S and the CSDR regulation allows for a single point of access to the pan-eurozone CSD system from a client’s jurisdiction. For example, a German client could hold an account with the German CSD, Clearstream Banking Frankfurt (CBF), that it could use to hold, say, French securities, which would then be held in a Clearstream account with Euroclear. This highlights an important structural distinction between the role of so-called issuer and investor CSDs. The issuer CSD is that which is located in the place of issue for a security and is the repository for those securities in a local market. The investor CSD is that based in the foreign market, such as CBF in this example, allowing their clients to hold French Securities in their account. Although the existence and relationship between investors and issuer CSDs is not in itself new, the effect of CSDR is to strengthen those links and make them more resilient.
Banking restrictions on CSDs
CSDR draws another important distinction, that between CSDs as forming a settlement infrastructure and their possible role as lenders. CSDs going forward will have to fulfil significant additional requirements in order to provide banking services and to take risk through, for example, providing credit. Their role must now be to work, maintain and protect the settlement process. As this limits their role, it also restricts the services available to clients.
This can be of particular concern to broker dealers who may have previously looked at T2S as an opportunity to go direct to a single Investor CSD. Now they continue to need to source their funding from elsewhere, likely commercial banks, unless they have sufficient resources of their own.
CSDR further compounds the situation – CSDR requires the settlement in central bank money wherever possible and in fact most European CSDs, with the exception of ICSDs, already employ central bank funds. T2S requires that settlement has to be made through a dedicated cash account (DCA) in T2S, operated by a central bank. A prerequisite to such DCA is an account at one eurozone central bank. As only banks can do this, broker dealers cannot have accounts directly with CSDs unless they are a bank or have a separate cash provider with the appropriate credit appetite
Consequently, those who do not have central bank accounts will continue to need an agent bank as part of their solution in order to access T2S.
Rights issue funding
A further consequence of CSDR’s redefinition of the role of CSDs affects investors who elect to take up their rights in rights issues. It remains the case that an investor electing to take up these rights in its home market pays a subscription fee to the issuer CSD upon settlement date.
However, the situation is quite different if the investor wishes to exercise its rights in another country. In this case, the issuer CSD receives a commitment from the investor CSD, not from the investor. This means that the issuer CSD could face the risk of non-payment by the investor. As under CSDR it is not permitted to take payment risk, the investor has to pay the CSD for its rights on election date rather than on settlement date. In other words, investors must pre-fund their take up of their rights even though they will not receive value until settlement date which could be some time in the future. This can be of particular concern to global custodians acting on behalf of their fund clients. Moreover, if the issuer fails to deliver securities on the settlement date (S), it is a mandatory requirement of CSDR that the buyer of the securities must initiate a buy in process on a S+4 basis.
“Given the restrictions that CSDs now operate under, investors and others involved need to understand the nuances and risks they face,” explains Mike Clarke, Director, Global Product Management, Global Transaction Banking Product & Technology Management at Deutsche Bank.
“The T2S environment was created to foster competition – it is doing this and is absolutely changing the dynamics of the market,” he continues. “It is allowing issuer and investor CSDs to evolve. However, once you begin to look at the details of the regulations governing CSDs, you need to be aware of some of the consequences. You need to consider what is the best way to access T2S.”
He points out that CSDR affects broker dealers and global custodians in different ways. The regulations indeed aim to streamline the settlement process, apparently eliminating the need for agent banks in doing so. But, because of the roles of issuer and investor CSDs, in practice it may be necessary to maintain an agent bank to provide credit and/or to manage business in a particular local market.
Further regulatory impact
One overarching objective of recent financial market regulation like CSDR is to protect and to assist investors. This is also the purpose of two other pieces of regulation: the Alternative Investment Fund Managers Directive (AIFMD) and the Undertakings for the Collective Investment in Transferable Securities (UCITS), which is in its fifth iteration. Investors, and those acting on their behalf, cannot however view these in isolation because together they pose considerations of risk and reporting.
In our next article in this series on T2S, we will consider the implications of these regulations and examine what they mean in terms of long-term, pan-eurozone account maintenance and risk in the T2S environment.
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