The regulations governing market activity have been constantly evolving, but the ESMA directive implementing the Central Securities Depositories Regulation (CSDR) will potentially have quite an impact on traded credit.
The aim of CSDR is to improve depositary and settlement practices of financial assets across the European Union. One aspect of this new regulation focuses on failing settlement, i.e. trades for which the securities are not delivered within the standard settlement period.
Currently within the bond market, the standard trade settlement period is on a T+2 basis; meaning that when an investor buys a bond from a trading bank, they can typically expect the physical delivery of the asset within two working days of the trade being executed. However, trades do fail to settle from time to time and there is nothing alarming about that. There are many reasons why there may be a delay in settlement, one of them being that market-makers do not have to own bonds that they sell to investors at the time they are purchased.
Market-makers are expected to provide liquidity and in the course of their day-to-day activity, they will often sell a bond they do not actually own, which is known as selling short. They might decide to sell the bond short because they know they can find the bonds elsewhere, or later at a cheaper level. Sometimes a trader can run a short position for days or weeks if they believe the market is likely to weaken.
A problem can arise when a trader tries to ‘cover’ a short position, only to find that there are none of the bonds needed available. The selling bank will then fail to deliver the bond for an extended period of time, which is one thing CSDR is trying to address.
We should stress that failure to deliver is relatively rare and there is a process, called a ‘buy-in’, that enables an investor to enforce the settlement. Currently, the buy-in process is not mandatory but can be initiated by the buyer, and involves instructing a third party to source the bonds for guaranteed delivery; this of course can require a substantially higher trade price than originally agreed, which is costly to the selling bank. Naturally, buy-ins are normally associated with less liquid securities, with the process being discretionary in nature involving extensive dialogue between the buyer and seller to try and resolve the issue before going down the contentious route of involving a third party.
CSDR introduces mandatory buy-ins, so it is a considerable change to current market practice. The new regime will enforce that the buy-in has to be initiated seven days after a trade fails to settle, with expected settlement seven days later. Given the price premium expected for guaranteed delivery in a buy-in, we can expect that market-makers will only be making short offers of bonds they own or for which they are certain they will be able to find. Traders will be less inclined to show short offers for less liquid bonds in the market, as there would be less certainty they could be covered within a short timeframe. This means less liquid securities, particularly smaller and lower rated issues, could see their level of liquidity decline, while bid–offer spreads could also increase.
The International Capital Market Association published a market study in 2019 and the conclusions were clear; the new mandatory buy-in regime will worsen liquidity and bid-offer spreads in the high yield market could substantially increase. We would tend to agree, and we think this may be an example of heavy-handed regulation as, in our own experience, the number of trades that remain unsettled for long periods is very limited.