The post trade challenges of implementing CSDR settlement discipline: Mandatory Buy-ins

The post trade challenges of implementing CSDR settlement discipline: Mandatory Buy-ins Post Trade Forum & Trade Show Vienna, September 10th 2015

Andy Hill

Overview

What is a buy-in, and how do they work?

What is cash compensation?

The challenges of buy-ins and cash compensation

CSDR Level 1 and mandatory buy-ins

The Level 2 ESMA Consultation Paper: the 3 options for a buy-in mechanism

The challenges with the options

Conclusion (the need to amend the Level 1 text)

CSDR Mandatory Buy-ins

What is a buy-in and how do they work?1

A buy-in is a contractual remedy in the event of a settlement fail

It provides the purchasing (failed-to) counterparty with the right to obtain the securities from a third party (via a buy-in agent)

The original transaction is then canceled and any differences in price (or costs) settled between the original two counterparties

The objective is to restore both counterparties to the economic position they would have been in, had the original transaction settled as intended

1See also: Buy-ins, how they work, and the challenge of CSDR


http://www.icmagroup.org/assets/documents/Regulatory/Secondary-markets/CSDR-Settlement-Regulation/Buy-ins-how-they-work-and-CSDR__ICMA_July-2015-v4.pdf



Examples of the buy-in process


Figure 1: the original transaction 100 Bonds 98.50 Figure 2: a standard buy-in 100 bonds 100 bonds 0.75 99.25 99.25

A

B A Z

B

Market

Examples of the buy-in process


Figure 3: a standard buy-in where the buy-in price is below the original transaction price 100 bonds 100 bonds 0.50 98.00 98.00

A B Z Market

Figure 1: the original transaction 100 Bonds 98.50

A B

Examples of the buy-in process (‘pass-ons’)


Figure 5: settling the buy-in chain Pass-on 100 bonds 100 bonds 0.75 0.50 99.25 99.25

A B C Z Mar-

ket

Figure 4: original inter-connected transactions 100 bonds 100 bonds 98.50 98.75

A B C

The cost of being bought-in: the buy-in premium



A B

Figure 6: the cost to the failing counterparty due to the buy-in premium 100 bonds 100 bonds 100 bonds 99.00 0.75 99.25 99.25

A Market B Z Market

Cash compensation



A B

Figure 7: cash compensation where the reference price is higher than the original transaction price 0.75 99.25 Figure 8: cash compensation where the reference price is lower than the original transaction price 0.50 98.00

B A Market

Price

B A Market

Price

The challenges of buy-ins and cash compensation

The buy-in process can be time consuming for all counterparties concerned

Finding buy-in agents can be difficult, particularly as there is little incentive and no obligation

Buy-ins can has a distortive impact on market pricing, mainly due to required premium and signaling of ‘distressed buyer’

Where the buy-in price is significantly higher than market, this can lead to disputes

Buy-ins are not always executable, particularly where securities are illiquid

Buy-ins may not be enforceable in some jurisdictions

Setting the cash compensation price can be contentious

Cash compensation can disadvantage the failed-to purchaser


CSDR Level 1 (Article 7) and mandatory buy-ins


A buy-in process must be initiated after 4 days of failing from intended settlement date (7 days for less liquid securities, and 15 days for SME instruments)

What a buy-in is, or its purpose, is not defined

Buy-ins are executed at the CSD participant level (which in most cases will not be the same as the trading counterparties)

If the buy-in is unsuccessful (with the opportunity for deferral), cash compensation shall be applied

Where the buy-in price is lower than the original transaction price, the difference is paid to the receiving participant by the failing participant (i.e. the ‘wrong-way round’).

The start legs of securities financing transactions are brought into scope (except for very short-dated SFTs)

The challenges of CSDR mandatory buy-ins


How to replace a contractual right of trading counterparties with a mandatory obligation of ‘participants’ who are not party to the original transaction?

How to ensure enforceability against counterparties outside of the EU (and preserve a level playing field)?

How to manage and mitigate risks to both the trading counterparties and the CSD participants?

How to ensure that the provision to pay the cash difference in the wrong direction (a free ‘put’ for the purchaser) does not lead to market manipulation?

How to manage thousands of buy-ins being initiated every day?

How to preserve market liquidity and stability2?

2 See: CSDR Mandatory Buy-ins Impact Study

http://www.icmagroup.org/assets/documents/Regulatory/Secondary-markets/CSDR-Settlement-Regulation/ICMA--CSDR-Mandatory-Buy-ins-Impact-Study_Final-240215.pdf



ESMA Consultation Paper on the Operation of the Buy-in Process (Level 2)


In August 2015, stakeholders were asked to respond on three options for a buy-in process put forward by ESMA:

(i) Trading level execution (ii) Trading level with fall-back execution (iii) CSD participant level execution

CSDR Level 2 buy-in options


Original transaction

Trading Venue Level

Trading Counterparty Level

100 bonds 98.50

CSD Participant Level

CSD Level

A B

Trading

Venue

Partici-

pant X

Partici-

pant Y

CSD

CSDR Option 1: trading level execution


Trading level buy-in

Trading Venue Level


100 bonds 100 bonds ? Buy-in Px Buy-in Px


CSD Level

A B

Trading

Venue

Partici-

pant X

Partici-

pant Y

CSD

Z Mark-

et



Trading level buy-in: cash compensation

Trading Venue Level


? Reference Px


CSD Level

A B

Trading

Venue

Partici-

pant X

Partici-

pant Y

CSD

Mark-

et


Similar to how buy-ins are executed today

Minimizes risks for both trading counterparties

Does not involve participants who are not party to the original transaction

Disadvantages

Mandatory cash compensation still creates risk for purchasing (failed to) counterparty

May be difficult to enforce

May be illegal under CSDR Level 1


Advantages

CSDR Option 2: trading level with fall-back execution


Trading level with fall-back option: buy-in

Trading Venue Level




CSD Level

A B

Trading

Venue

Partici-

pant X

Partici-

pant Y

CSD

Z Mark-

et



Trading level with fall-back option: cash compensation

Trading Venue Level



? Reference Px

CSD Level

A B

Trading

Venue

Partici-

pant X

Partici-

pant Y

CSD

Mark-

et


Buy-in process at the trading level (same as today)

Cash compensation ‘fall-back’ ensures enforceability (albeit at participant level)

Disadvantages

Fall-back option of cash compensation at participant level creates additional risk for purchasing (failed to) counterparty

Fall-back option of cash compensation at participant level creates additional risk for selling (failing) counterparty

Fall-back option of cash compensation creates risk for the delivering participant (and a potential need for collateralization of deliveries)

May also be illegal under CSDR Level 1


Advantages

CSDR Option 3: CSD participant execution


CSD participant level buy-in

Trading Venue Level




CSD Level

A B

Trading

Venue

Partici-

pant X

Partici-

pant Y

CSD

Z Mark-

et

CSDR Option 3: CSD participant execution


CSD participant level cash compensation

CSDR Option 3: CSD participant level execution

Consistent with the Level 1

Disadvantages

Creates additional risk for the purchasing (failed to) counterparty

Creates additional risk for the selling (failing) counterparty

Creates risk for the delivering participant (and a potential need for collateralization of deliveries)

Creates risk for the receiving participant (and a potential need for collateralization or pre-payment of receipts)


Advantages

Market risk profile of the three options


Op

tion

1

Op

tion

2

Op

tion

3

Purchasing counterparty

Selling counterparty

Receiving participant

Delivering participant

No additional risk Some additional risk Significant additional risk

Timeline


End of September 2015: ESMA was due to submit finalized draft RTS to the EC3

Trialogues between the Commission, Parliament and Council to finalize the RTS in Q4 of 2015

Level 2 to be passed into law by end of 2015, and effective early 2016

An 18-24 month delay in implementing settlement discipline measures expected

3 The draft RTS specific to mandatory buy-ins are now expected to be delayed until November 2015

Conclusion


Buy-ins are a contractual remedy available to trading level counterparties in the event of a settlement fail. They are usually a right, and are not intended to penalize the failing counterparty.

CSDR makes buy-ins a mandatory obligation, rather than a contractual right

CSDR places the buy-in process at the CSD participant level, and not necessarily at the trading counterparty level

CSDR fails to define what a buy-in is, or its purpose, and seems to turn it into a penalty mechanism, rather than a contractual remedy

There is growing pressure from the market for the Level 1 text to be reviewed

Questions


About the author/presenter

Andy Hill is a Director in ICMA’s Market Practice and Regulatory Policy group. For seventeen years he has been a repo and money-market trader, and for ten years he was an Executive Director at Goldman Sachs. He has also worked as a consultant in the Aid and Development sector, primarily based in Cambodia, and previously served on the Board of the Cambodian NGO Education Partnership in Phnom Penh while under a Goldman Sachs Public Service Fellowship. He holds a BSc (Hons) in Business Studies from Cass Business School and an MSc in Poverty Reduction and Development Management from the University of Birmingham.

Email: [email protected]


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The post trade challenges of implementing CSDR settlement discipline: Mandatory Buy-ins

Economy & Finance

Transcript of The post trade challenges of implementing CSDR settlement discipline: Mandatory Buy-ins