Banks See Market Liquidity Sapped by EU's Failed-Trade Fixby
Mandatory buy-in threatens functioning of markets, ICMA says
Law intended to reduce risk, cost of cross-border settlement
Banks, investors and even some finance ministries have renewed their attacks on a European Union law intended to prevent the failure of cross-border securities transactions, arguing that it will drive up costs and hurt liquidity.
Critics of the Central Securities Depositories Regulation have used a broad review of EU financial-services regulation to take aim at the law’s mandatory buy-in rules. If a broker fails to deliver a security on time and at the agreed price, the investor can ask a third party to acquire it, and the original broker will be forced to cover any cost difference. If the trade can’t be completed, cash compensation must be paid. The provision will drive up costs without achieving the goal of safer, more efficient markets, the critics say.
“Mandatory buy-ins remain a threat to functioning and liquid markets, and implementation will still throw up many challenges,” said Andy Hill, director of market practice and regulatory policy at the International Capital Market Association. “It remains highly questionable whether the adverse market impacts of mandatory buy-ins will justify any potential benefit.”
Currently, investors have the option to force a buy-in if they decide it’s the best way to rescue a failed trade. The EU law gives them no choice. The European Banking Federation, an EU-wide lobby group, says the requirement is based on the misconception that it is a “tool of settlement discipline,” rather than a “right under a trading contract.” The risk of being forced to pay for failed trades could hamper markets by dissuading some participants from entering into trades.
Making the system mandatory creates an obstacle to risk management and results in a “reduction in liquidity in the more vulnerable markets,” such as repurchase agreements and securities lending, “as market participants are discouraged from participation,” the EBF said. The rule will also reduce transparency, “as market participants will have an incentive to cancel and rebook transactions that are failing” at the central securities depository, the group said.
EU lawmakers adopted the CSDR in 2014 to reduce the risk and cost of settling cross-border trades. The 30-plus central securities depositories in the bloc had settled more than a quadrillion euros ($1.1 quadrillion) worth of transactions in the previous two years, according to the European Commission, the EU’s executive arm.
The Brussels-based commission said the new rules would make settlement “more efficient.” In its response to the commission’s call for evidence on financial regulation passed since the crisis, the U.K. Treasury drew a different conclusion.
“This can be expected to lead to a reduction in liquidity or increased transaction costs as a result of the cost of settlement fails being priced into the transaction,” the Treasury said. That will cause a poorer outcome in markets “where there is little evidence that settlement fail rates are high or are the result of a deliberate and voluntary action on the part of the failing party.”
The European Securities and Markets Authority earlier this month issued draft technical standards on “settlement discipline” that are needed to implement CSDR. Among its proposals was a 24-month phase-in period for the rules, which cover buy-in, to give firms time to prepare.
The industry response to ESMA’s proposals was largely positive, though its underlying complaints about the law remain.
Buy-ins are currently a rarely used option for most markets, according to ICMA. EU law now makes them compulsory after as much as seven business days from a trade failing to settle. ESMA has pushed the “extension period” out to the maximum from an original proposal of four days and has exempted securities financing transactions of less than 30 days from the scope of the regulation.
The Paris-based regulator also dropped a previous proposal for parties that aren’t directly involved in a trade, such as central securities depositories, to initiate buy-in.
“Market participants, particularly the sell side, have always thought that the buy-in at the trading level was the obvious choice,” said Stephen Burton, director of post trade at the Association for Financial Markets in Europe. “That’s because that’s what happens today and, crucially, because of the potential cost to all investors of the other proposals. We know from the text that the buy-in is mandatory, but we’re largely comfortable with where ESMA have landed even so.”
Among the remaining bugbears is compensation. The law insists that failed sellers give buyers cash compensation when a trade fails and a buy-in can’t take place because the securities can’t be found. Cash compensation is also due when the buy-in takes place at a higher price than the original trade. Conversely, when the buy-in occurs at a lower price, no compensation is due.
“This alone undermines the integrity of the regulation,” according to ICMA’s Hill. It is “likely to cause significant operational and risk management issues for liquidity providers and intermediaries once implemented.”
Darren Reece, a money manager at GAM Holdings AG in London, which runs about $124 billion, said anything that improves the settlement process is welcome.
“That said, this will probably reduce liquidity in the secondary market,” Reece said of the EU law. “It also won’t help with relationships, and they’re a key component of the market.”