Considered to be one of the most controversial aspects of the Settlement Discipline Regime (SDR), the buy-in regime is aimed at improving settlement efficiency. However, multiple participants have warned it could have significant negative implications on both trading and liquidity across asset classes.

Buy-ins, which are currently used at discretion as they can create unpredictable costs, are used by market participants to manage settlement risk in the case of failed trades, as the buyer goes to market to source the bonds from another party. Across the industry, talk of the UK potentially not adopting this aspect of the regulation is gaining momentum.

“We should expect implemented and in-flight regulations to be grandfathered as is, beyond the oversight moving from ESMA and the European Commission moving to the Bank of England,” said Emma Johnson, director of securities services regulation and market reform at Deutsche Bank, at a recent industry event in Stockholm.

“But we should be mindful that there may be some changes to UK statutory instruments. This is where Brexit poses challenges to existing and proposed EU regulations: MiFID, MiFIR, EMIR and CSDR spring naturally to mind. The expectation is that CSDR will be grandfathered as is, but there is ongoing debate as to whether the UK will adopt the buy-in. UK can decide not to adopt the buy-in regime and just have settlement penalties.”

Other industry experts confirmed to The TRADE they believe this could be a real possibility following the end of Britain’s transition period on 1 January 2021. Before that point, the UK has committed to applying the rules during the transition.

Controversial regime

In a joint letter to the European Securities and Markets Authority (ESMA) published in January 2020, a collection of trade associations called for a phased-in approach to the settlement discipline regime (SDR), as well as a deferral of mandatory buy-ins.

Within the letter, the trade bodies said: “Mandatory buy-ins are expected to lead to wider bid-offer spreads in the cash markets, reduce market efficiency and remove incentives to lend securities in the securities lending and repo markets, and may ultimately favour the settlement in non-EU CSDs of less liquid securities.”

Initiating a buy-in against a failing counterparty will become a legal obligation under CSDR, with limited flexibility on timing to complete the process. The payment of the difference between the buy-in price or cash compensation must also be made by the failing trading entity.

“Elements of the CSDR settlement discipline regime have been controversial, particularly the mandatory buy-in rules for failed settlements,” said Nick Bayley, managing director within Duff & Phelps’ compliance and regulatory consulting practice. “While some of the CSDR has already come into effect, implementation of the settlement discipline rules has been delayed to next year and the UK could still theoretically decide to not to implement those particular rules.”

After intense lobbying across the industry, European regulators pushed back the implementation date of SDR to 1 February 2021, however many believe this extension will not solve many of the industry’s problems.

Trade bodies unite in protest

Industry associations are still calling for a deferral of the mandatory buy-in regime until the effects of penalties and other measures to promote settlement efficiency are implemented.

In the letter from January, the trade bodies added that the European Commission should undertake an in-depth impact analysis on the buy-in regime during this period, and also proposed a replacement of the mandatory nature of the buy-in, with an optional right of the receiving party to allow a buy-in of a non-delivering counterparty.

“The UK has the most important OTC and quote-driven markets in Europe and many instruments, such as small-cap equities, do not trade on cleared order books in the UK but rely entirely on market makers to provide liquidity,” Bayley explained. “This makes the proposed settlement discipline regime a key issue for participants in those particular UK markets.

“The extent to which the UK will want to diverge from EU regulation over the coming years is still unclear but if the UK does adopt the CSDR’s settlement discipline regime, as I expect it will, it will hopefully do so cautiously.”

On 27 February 2020, the UK Government published its approach to the future relationship with the EU, which included its stance on financial services regulation.

“As many of us suspected, the government implies that it is looking to ease regulatory burden as the UK exits the EU. Being able to have more autonomy on regulatory affairs certainly looks like a “red line” for the UK government, as it looks to the UK’s future role on the global stage outside the EU,” said Mark Turner, managing director within Duff & Phelps’ compliance and regulatory consulting practice.

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The Investment Association (IA) and the International Capital Market Association’s (ICMA’s) Asset Management and Investors Council (AMIC) representing asset managers in Europe penned a letter to the European Commission requesting a different approach to introducing the requirements, specifically the controversial mandatory buy-in provision.

Both trade groups urged the European Commission to undertake a ‘robust market impact’ assessment of the buy-in regime before it is rolled out across Europe in early 2021, and in the absence of such an assessment, they have requested cash bond markets be excluded from the buy-in regime, to allow for close evaluation of the rule’s impact on liquidity and market pricing.

“Our members feel that such a cautious approach to phasing-in the mandatory buy-in requirements, based on the careful assessment of market impacts, will ultimately be in the best interests of investor protection, market stability, and the goals of the capital markets union,” said the IA and ICMA AMIC’s letter to the European Commission.

Initiating a buy-in against a failing counterparty will become a legal obligation under the Central Securities Depository Regulation (CSDR), with limited flexibility on timing to complete the process. This allows market participants to manage settlement risk in the case of failed trades, as the buyer goes to market to source the securities from another party. The payment of the difference between the buy-in price or cash compensation must also be made by the failing trading entity. Buy-ins have typically been used with discretion as they can create unpredictable costs.

ICMA and the IA, alongside various other buy- and sell-side trade associations, have been vocal in their concerns about the buy-in regime, specifically the potentially ‘devastating’ impact on bond market liquidity and increased costs of trading.

“Liquidity is already very challenging and getting even more so,” ICMA said, summarising buy-side comments on the regime as part of a study in November. “This regulation, in its current form, is likely to mean that banks will not short bonds. This would have a devastating impact on market liquidity, function and asset managers’ ability to service their clients effectively. It is worrying that many in a front-office, markets-facing position know nothing or very little about this impending regulation.”

Earlier this month, multiple trade groups, including the IA and ICMA, also wrote to the European Securities and Markets Authority (ESMA) calling for a delay to the mandatory buy-in regime until its effects are understood more clearly. They suggested replacing the mandatory nature of the buy-in with an optional right of the receiving party to pursue a buy-in in the event of a non-delivering counterparty.

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In a joint letter to the European Securities and Markets Authority (ESMA), the collection of industry bodies called for a phased-in approach to the settlement discipline regime (SDR), as well as a deferral of mandatory buy-ins.

Buy-ins, which are typically used at discretion as they can create unpredictable costs, are used for market participants to manage settlement risk in the case of failed trades, as the buyer goes to market to source the securities from another party.

Initiating a buy-in against a failing counterparty will become a legal obligation under the Central Securities Depository Regulation (CSDR), with limited flexibility on timing to complete the process. The payment of the difference between the buy-in price or cash compensation must also be made by the failing trading entity.

The industry’s letter was co-authored by industry groups consisting of the Association for Financial Markets in Europe (AFME), the Investment Association (IA), the International Capital Market Association (ICMA), the Alternative Investment Management Association (AIMA), and the International Securities Lending Association (ISLA), among others.

While the letter supports the rules to drive greater settlement efficiency, the consensus among both buy- and sell-side firms is that the mandatory buy-in regime will have significant negative implications on both trading and liquidity across asset classes.

“It [buy-ins] will negatively impact the efficiency of European capital markets, leading to greater costs and barriers to investing in European securities,” the letter said. “Mandatory buy-ins are expected to lead to wider bid-offer spreads in the cash markets, reduce market efficiency and remove incentives to lend securities in the securities lending and repo markets, and may ultimately favour the settlement in non-EU CSDs of less liquid securities.”

To help ease the impact of the rules on market participants, the groups are urging ESMA to only introduce cash penalties on failed settled trades once market infrastructures, banks and their clients have built and test the required new messaging and technology.

They also called for a “deferral of the mandatory buy-in regime until the effects of penalties and other measures (e.g. prompt allocation/confirmation processes) to promote settlement efficiency are implemented”.

The letter added that the European Commission should undertake an in-depth impact analysis on the buy-in regime during this period, and also proposed a replacement of the mandatory nature of the buy-in with an optional right of the receiving party to allow a buy-in of a non-delivering counterparty.

“We support the imposition of a penalty regime under CSDR as an important step towards improving settlement efficiency in European capital markets. However, we continue to be concerned that the impact of a mandatory buy-in regime will have negative consequences that are damaging to market liquidity and efficiency and restrict the growth of capital markets in Europe,” the groups explained. “We respectfully request the authorities to consider a cautious, phased-in approach to ensure the successful implementation of the cash penalty regime and reconsider the mandatory nature of the buy-in.”

A study from ICMA in November last year found the majority of asset managers and pension funds surveyed expect a negative impact on bond market efficiency and liquidity as a result of the rules, when they come into force later this year.

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A majority 75% of asset managers and pension funds expect a negative impact on bond market efficiency and liquidity when the buy-in regime comes into force in 2020 under the EU Central Securities Depositories Regulation (CSDR), according to a study from the International Capital Market Association (ICMA).

Buy-ins, which are presently used at discretion as they can create unpredictable costs, are used for market participants to manage settlement risk in the case of failed trades, as the buyer goes to market to source the bonds from another party.

Initiating a buy-in against a failing counterparty will become a legal obligation under the CSDR regime, with limited flexibility on timing to complete the process. The payment of the difference between the buy-in price or cash compensation must also be made by the failing trading entity.

ICMA found that the buy-side is particularly concerned about bearing the increased costs of widening bid-ask spreads and decreased liquidity, which may come about as liquidity providers adapt to the regime. It was highlighted that offer-side pricing across fixed income could be negatively impacted as liquidity providers adapt to the regime.

Specifically, ICMA said bid-ask spreads of all bond sub-classes are expected to more than double, with covered bonds and illiquid investment grade credit seeing the biggest impact. For absolute price, the impact is most notable at the lower end of the credit spectrum, with significant increases for emerging market, high yield, and illiquid investment grade corporate bonds.

“Corporate bond markets rely heavily on liquidity providers shorting bonds that they do not own. This has always been the case. Liquidity is already very challenging and getting even more so,” ICMA said summarising buy-side comments on the regime. “This regulation, in its current form, is likely to mean that banks will not short bonds. This would have a devastating impact on market liquidity, function and asset managers ability to service their clients effectively. It is worrying that many in a front-office, markets facing position know nothing or very little about this impending regulation.”

Other comments from buy-side participants included concerns around solving disputes on the mandatory buy-in and cash compensation price, the difference in pricing between quotes depending on where trades are settled, and the ability for market makers to manage balance sheets.

The study concluded that the industry has low awareness of the new measure, which will impact bonds settled in Euroclear, Clearstream and other central securities depositories within the European Union.

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