CSDR increases pressure on authorized participants in Europe’s fragmented ETF market

The European Commission proposed changes to the CSDR in March

Authorized participants (APs) have been feeling the brunt of the central securities depository (CSDR) regime since it came into effect in early February, with European regulators signaling that there are no plans to scrap cash penalties implemented for settlement defaults.

In March, the European Commission proposed a number of changes to CSDR, including confirmation that it would not implement mandatory buy-ins, but would proceed with settlement failure reporting requirements and the monetary penalty regime. .

Although the European Commission has admitted that compulsory redemptions could lead to increased costs, reduced liquidity in all asset classes and risks to financial stability, it has the option of reintroducing redemptions “if the rate of settlement failures is not improving”.

Reacting to the European Commission’s changes, Pete Tomlinson, director of post-trade at the Association of Financial Markets in Europe (AFME), expressed concern about the lack of clarity on what will cause the European Commission to reintroduce mandatory redemptions.

“AFME does not believe that mandatory redemptions are appropriate for any asset class or type of transaction and will have disproportionate negative consequences on market liquidity and efficiency which could harm the attractiveness and competitiveness of capital markets in the EU,” he added.

Federico Cupelli, Deputy Director of Regulatory Policy at European Fund & Asset Management (EFAMA), added: “Previous redemption rules were viewed negatively by APs in terms of reduced operational efficiency, leading to higher costs for investors and affecting the ETP’s ability to hedge against counterparty risk.

While market participants are outside the mandatory repurchase regime, for now cash penalties have started being levied against liquidity providers by central securities depositories (CSDs) for any settlement failures.

According to an industry source, cash penalties for an issuer’s ETF suite could total up to €2 million this year, a considerable sum for liquidity providers who price the range.

Cash penalties are a particular problem for ETFs that tend to have high settlement defaults relative to the underlying securities they track.

As Adrian Whelan, Global Head of Regulatory Intelligence at Brown Brothers Harriman, explained: “ETFs will likely be hit hard. The impact on ETFs should be particularly notable since ETFs generally have a high rate of settlement failure with respect to the creation and redemption of shares combined with the delivery of underlying securities.

“While equity ETFs can be settled in two days (T+2), the securities underlying the equity ETFs can take five or more days to deliver (T+5). The increased costs for ETFs in the event of failure could be passed on to investors.

Failures can occur for a number of reasons, including operational issues or a lack of liquidity in the market and the European Commission has even noted that “the scope of pecuniary sanctions…should be clarified”.

“These exclusions should cover trades that have failed for reasons not attributable to the participants and trades that do not involve two commercial parties, for which the application of cash penalties or compulsory redemptions would not be feasible or could have harmful consequences for the market, such as certain primary market transactions,” the European Commission added.

Market makers often don’t own the full basket of securities when pricing ETFs, which means there’s always a risk that they won’t be able to deliver on time and subsequently incur a fine. This problem is particularly prevalent in Europe where the market is highly fragmented across 30 exchanges in 25 countries.

“The cash penalty regime remains in place and could still potentially affect trading in the secondary market for ETP shares,” Cupelli warned.

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