Introduction

The Central Securities Depositories Regulation (CSDR) was introduced by the European Parliament and Council in 2014 to harmonise settlement standards and improve settlement efficiency across the region.

The regime aims to provide a common set of requirements for central securities depositories (CSDs) operating across Europe following the Global Financial Crisis (GFC) in 2008.

CSDR requirements have been implemented across three phases: 

• Phase 1: In 2017, firms were required to offer the option between omnibus and individual aggregated accounts 

• Phase 2: In 2019, firms were required to report internally settled trades 

The Settlement Discipline Regime

Following two delays from the European Commission, Phase 3 of CSDR – known as the Settlement Discipline Regime (SDR) – came into effect on 1 February 2022. SDR introduced a set of requirements to address settlement fails including cash penalties and mandatory buy-ins, although the latter was delayed by ESMA for three years amid market warnings it could lead to increased costs and reduced liquidity across asset classes. 

Through the implementation of cash penalties, the regulator was hoping to deter participants from settlement fails and ensure they settled trades in a timely manner. However, the European ETF market, in particular, has been grappling with the challenges posed by CSDR. 

CSDR and ETFs

Despite the threat of fines, European ETFs have experienced an increase in settlement failures since the introduction of Phase 3 of CSDR with one in 10 transactions needing correcting or failing, according to data from SWIFT.

This is largely because many ETFs offer exposure to underlying securities from several jurisdictions, especially global and regional equity strategies.

As a result, authorised participants (APs) appear happy to face severe penalties for settlement failures which they are passing on to investors via wider spreads, especially when compared to the costs of an ETF creation. 

The situation could become even more acute if Europe follows the US in moving from a T+2 to a T+1 settlement regime, an issue that could drive a further increase in the number of settlement failures across the continent. 

“Because settlement of newly created units is contingent on the settlement of the underlying constituents, this can often lead to settlement delays in a T+2 environment, due to time zone differences, market holidays and cross-border settlement complexity,” the Association for Financial Markets in Europe (AFME) said. “These challenges would be even more pronounced in a T+1 environment.”

The question now is whether the regulator will view mandatory buy-ins, a process that contractually requires APs to source securities elsewhere in the event of a settlement fail, as the solution to the poor settlement rates. This part of CSDR is an area market participants continue to be firmly against.