A string of European regulations are rich in potential for tension between CSDs and their users over responsibility for settlement failures, shortcomings in the exercise of shareholder rights, and especially the loss of investor assets. With other regulators adopting similar ideas, and inter-operability spilling the risks across borders as well, the scope for regulatory disputes between CSDs and their users is widening. But John Siena, the lawyer who manages regulatory challenges for BBH outside the United States, and reports on them to the Association of Global Custodians (AGC), says the European experience suggests regulatory pressures increase dialogue and deepen mutual understanding.
“Custodians are looking for a good, fruitful dialogue with the central securities depositories (CSDs),” says John Siena, Assistant General Counsel, Head of Asia-Pacific legal issues and adviser on regulatory strategy at Brown Brothers Harriman (BBH) in London, and chairman of the Europe Committee of the Association of Global Custodians (AGC). “We are always looking for transparency on pricing and risk from the CSDs but also automation, predictability, reliability and low costs. But we need collaboration too, especially on regulatory issues.”
This last concern is not unexpected. John Siena is by professional background an American lawyer, but one who has spent the last 18 years in London interpreting European regulatory requirements for Northern Trust, BNY Mellon and (twice) BBH. He has not lacked for work since he arrived in London at the turn of the century since, whatever else it excels at, the European Union (EU) is a formidable manufacturer of regulations for the financial services industry.
CSDs and custodians must work together to mitigate settlement risk
One of them – the Central Securities Depositories Regulation (CSDR) – affects CSDs, and especially their relationship with custodian banks, directly. CSDR requires all CSDs in Europe to obtain a licence to operate, and specifies performance and operational criteria they must meet, including transparency, capital and openness to different type of customers. It also set a common settlement timetable of trade date plus two days (T+2), which all European CSDs now meet.
What has proved challenging to all participants in the securities markets is the settlement discipline CSDR introduces. If transactions fail to settle in a CSD by T+2, the failing counterparty must pay a penalty fee to their counterparty, through the CSD. If settlement continues to fail for a specified period, a mandatory buy-in process is initiated, by which either the stock exchange or the central counterparty clearing house (CCP) buys the missing securities and obliges the original seller to make up any price difference. Clients of CSDs also have the right to demand their securities, including collateral, are held at the CSD in a segregated account.
These account structure and settlement discipline measures are potentially expensive for the custodian banks, brokers and clearing members which act on behalf of fund managers and their investor clients in settling securities transactions at European CSDs. Custodians are, unsurprisingly, looking to the CSDs to make it easier to open and close segregated accounts and risk-manage and automate the settlement process to the point where penalties and buy-ins are extremely unlikely to occur. The discussion is not yet resolved. “CSDs have a key role in terms of how those rules play out,” says Siena. “The more we can do to reduce the possibility of a penalty or a buy-in, the better.”
CSDs can facilitate the exercise of shareholder rights
But CSDR is not the only regulation which is testing the relationships between the custodians of Europe and the CSDs of Europe. The second iteration of the Shareholder Rights Directive (SRD II), which aims to make it easier for shareholders to influence the management of the companies in which they are invested, casts CSDs into a second vital role in making a reality of that ambition. CSDs are, after all, the entities into which securities are issued, and maintaining the integrity of the issue is a core function of every CSD. This places them between issuers and investors but, again, it is the custodians which are answerable to investors.
“Regulators perceive a challenge to the ability of investors to exercise their rights, so the Directive puts pressure on every link in the chain between the issuer and the beneficial owners to facilitate the exercise of those rights,” explains Siena. “It mandates transparency for issuers too – in other words, allowing issuers to find out who their shareholders are. It prescribes detailed requirements around how and when issuers are able to get that transparency, including its form and content and the means and timing of communication. Time-frames are compressed.”
Traditionally, investors have looked to custodians to help them collect entitlements such as dividends, respond to corporate actions such as mergers and rights issues, and vote their shares at annual and extraordinary general meetings of shareholders. John Siena thinks CSDs can help custodians fulfil those duties by running digital shareholder voting services and publishing prompt and accurate corporate action information. “At a minimum, CSDs in Europe are going to have to collate a lot of information,” he says. “The agents of the issuers are going to communicate through the CSD, so the CSDs are absolutely in the middle of all this.”
The transparency prescribed by SRD II has also sparked multiple concerns about data privacy and protection, and about the risks and liabilities asset managers acting on behalf of investors are forced to assume under the Directive. “What kind of shareholder activism should be encouraged?” asks Siena. “There are investors and asset managers who do not want to be activist shareholders. Yet asset managers acting on behalf of investors are effectively being forced by SRD II to explain how they manage shareholder rights on behalf of their clients. They have to demonstrate that they have been effective owners, and taken an interest in the companies they invest in.”
Asset managers are looking to custodians to help them comply with that obligation, and the range and quality of CSD services can make it easier for them to deliver a good service at reasonable cost without disintermediating them from the relationship with the asset manager altogether. Naturally, this introduces a further degree of tension into the relationship between CSDs and the custodians which have long acted as gatekeepers to the services of the CSDs. But it is the risk created by another pair of regulations that is proving even more awkward to resolve.
Custodian bank obligation to make investors whole is a source of tension with CSDs
This is the requirement on custodians acting as depositary banks to funds issued under the Alternative Investment Fund Managers Directive (AIFMD) or the fifth iteration of the Undertakings for Collective Investments in Transferable Securities Directive (UCITS V) to make investors in those funds whole if their assets are lost. Though AIFMD is more forgiving for depositaries than UCITS V, both directives put custodian bank depositaries in a difficult position, because they are obliged to use CSDs to settle securities transactions and hold securities on behalf of clients.
Under both AIFMD and UCITS V, so-called “investor CSDs” are considered “delegates” to which depositary banks have entrusted the safekeeping of assets. Depositary banks are obliged by the directives to use “delegates” only where absolutely necessary, choose them carefully, check they are properly regulated, inspect their processes and procedures to make sure they are adequate to the task of keeping assets safe, ensure the assets are segregated from the assets which belong to the CSD-as-delegate itself, and monitor them continuously for signs of vulnerability. Yet meeting even these strict requirements provides no relief from the liability: depositary banks remain liable for any of their customers’ assets lost by any delegate, including a CSD.
“Absent satisfying a very high bar as a defence, depositaries are on the hook for restitution of `lost’ financial instruments, full stop,” explains Siena. “This restitution liability is not just for sub-custodians they choose to use but also for any investor CSDs they are obliged to use. We are on the hook not just for fraud and negligence leading to a loss of assets, which would be fair enough, but for assets lost by sub-custodians and investor CSDs, unless we can show that the loss was due to a cause external to the delegate and was unavoidable using all reasonable care. To manage the risk, custodians in their role as depositary banks are pushing for sub-custodians and investor CSDs to clarify what processes they have put in place. What kind of transparency do we need into the whereabouts of customer assets? What kind of disclosure do we need? What due diligence should we employ? If we are required to accept restitution liability for losses attributable to the investor CSDs, we have to consider the activities and the wherewithal of the organisations responsible for our clients’ assets. That includes capital adequacy and extensive due diligence.”
CSDs resent the inquisitive nature of the due diligence. Custodians resent the fact they are liable for risks they may not be able to control. Custodians may be forced to tell clients managing AIFs and UCITS funds that infrastructural and other risks in certain markets may preclude investment, as the legislation indeed intends. Depositaries are prevented from giving any delegate the benefit of the doubt. “For UCITS-compliant managers in particular, there is no contractual flexibility at all, while under AIFMD there is scope for `discharge from liability,’ or making findings that mitigate risks, but which must be disclosed to investors,” says Siena. “Outside the European funds world, as described by UCITS V and AIFMD, there is more scope for reaching a contractual understanding on liability in a market by negotiation between the parties.”
The global influence of European standards of asset safety for investors
UCITS V and AIFMD have for some time now functioned as the “gold standard” in asset safety to which all users of custodial services aspire. The RG 133 asset-holding rules set by the Australian Securities and Investments Commission (ASIC), for example, draws on the example set by UCITS V and AIFMD. Standards for the Custody of Collective Investment Schemes’ Assets, published by the International Organisation of Securities Commissions (IOSCO) in November 2015, name-checks AIFMD and UCITS V multiple times.
“Europe has been very influential,” says Siena. However, he is confident that other jurisdictions will maintain a clear distinction between the responsibilities of CSDs and the responsibilities of custodian banks. “I have not seen any evidence that other jurisdictions are buying into the idea that CSDs are just sub-custodians,” says Siena. “I do not see it being replicated and I do not think it should be. It creates confusion. It blurs lines. I think other jurisdictions continue to see a difference between market infrastructures and custodians.”
This does not mean custodians do not face other risks outside Europe. For example, in any market where a CSD cannot provide true delivery-versus-payment (DvP), regulators, investors and asset managers are likely to look to custodians to address the risk that securities are delivered before cash is paid, or vice-versa – as the Central Bank of Ireland did in a (now resolved) case involving Stock Connect, the inter-operability link between the Hong Kong, Shanghai and Shenzhen stock exchanges.
Inter-operability changes the nature of settlement and asset-servicing risks
In any inter-operability arrangement between market infrastructures, assets owned by investors in one jurisdiction will be accessed through an investor CSD in one jurisdiction which links to an issuer CSD in another, where the assets are deposited and immobilised. This potentially complicates depositary bank responsibility for the disposition of the assets as well as liability for their “loss.” It might also complicate the exercise by investors of their shareholder rights. Although this might be equally true of assets held by a sub-custodian bank, that does not diminish the importance to CSDs of obtaining greater clarity on how shareholder rights can be made effective through inter-operating market infrastructures.
“It is conceivable that we could have an arrangement in which the investor CSD is subject to one body of law and the issuer CSD is subject to another body of law and they may not entirely marry up in terms of clarifying shareholder rights across the two CSDs,” says Sienna. “That issue came to the surface in the preparations for Stock Connect, definitely. Fortunately, Hong Kong Exchanges and Clearing Limited (HKEX) provided a model for all financial market infrastructures in the speed at which they solved it, the transparency they provided, and their willingness to work with everyone to resolve concerns.”
As Stock Connect is replicated around the world, its lessons, including that level of engagement, need to be applied. “We want to make sure investors have effective rights through inter-operability arrangements,” says Siena. “Such as exercising rights in corporate actions or being able to bring investor suits and be confident they are recognised by the courts of the country in which the securities are issued or held. The industry will want to understand how the delegation models work, how the inter-operability models work, and the risk management around it. We want to approximate the European result everywhere but, until we do, the industry will look closely at any inter-operability arrangement and try to understand what their responsibilities are.”
CSDs and custodians need structured and continuous dialogue to solve problems together
Counter-intuitively, Siena thinks that opposed interests can actually improve the quality of the dialogue between custodian banks and CSDs. He argues that establishing who is liable for the costs of settlement failure and restitution of loss assets lifted European CSDs and custodians to a higher level of mutual understanding. The fact that large liabilities are attached to the relationship – via CSDR and AIFMD and UCITS V – obliged both sides to work together to mitigate them. “It feels it is no longer market infrastructure and participants, facing off against each other,” says Siena. “There is much more overlap in the way we have to interact with each other. We have a mutual dependency.”
The main obstacle to interaction of this kind is lack of time, so Siena insists it must be “structured,” chiefly via user groups. He points out that this obligation is not laid on CSDs and custodians alone but falls on all participants in CSDs. “I am not a dialectician,” he jokes. “But I do think positive outcomes can emerge through the process of dialogue. It is impossible to anticipate what is going to happen, or what is required, unless you have the rough-and-tumble of a healthy dialogue.”
Wednesday 10 April 2019
Expectations of CSD stakeholders: what have CSDs done to transform and meet expectations since WFC 2017? Have expectations changed in the last two years and, if so, how?
Moderator: Bruce Butterill
Nandini Sukumar, CEO, World Federation of Exchanges (WFE)
John Siena, Chairman, Europe Committee, Association of Global Custodians (AGC)
Gerard Hartsink, Chairman, Global Legal Entity Foundation (GLEIF)
Nasser Seddiqi, Director, market and financial operations, Moroccan market authority
Gokce Illiris, Head of international relations and corporate communications, MKK Istanbul
Eila Kreivi, Director, European Investment Bank (EIB)
 In Europe securities settlement in central bank money is centralised via the TARGET2-Securities (T2S) settlement platform operated by the European Central Bank (ECB). T2S is designed to further the integration of the national capital markets of the euro area. Accordingly, it enables any CSD to act as the CSD for any other securities settled via T2S. Because this permits settlement of the securities in a different CSD from those into which they are issued, it is referred to as the “investor CSD” model.