Hello, and welcome to the first in the series of J.P. Morgan securities services global custody, CSDR podcasts. This one is titled, "Reflections on CSDR cash penalties." My name is Emma Johnson and I work in J.P.Morgan’s securities services global custody, industry developments team. And I'm joined by my colleague, Doug Bambrick, who is the global custody regulatory change lead, and has led securities services implementation efforts for CSDR. In this podcast, we'll be discussing the cash penalties regime, which went live earlier this year on the 1st of February.

Emma Johnson:

Doug, to help set the scene. Would you be to give an overview of CSDR's cash penalties regime and how it works in practice?

Doug Bambrick:

Thanks, Emma, cash penalties are a tool introduced as part of CSDR to incentivize timely settlement. And charges are applied according to the value of the trade with different rates applied for different asset classes and liquidity classification. For each transaction, the CSD is responsible to identify the fail reason, determine the at fault party, provide reporting to participants on a daily basis and on a monthly basis to collect and distribute the net cash amounts.

Doug Bambrick:

A key feature of the CSDR regime is that CSDs are not permitted to retain any part of the cash penalty. And instead, this is credited to the participant that did not cause the fail. Some participants are therefore making money each month from this process. Although it also means those participants need to introduce processes to handle the penalties, regardless of whether they themselves cause any fails.

Emma Johnson:

Thanks, Doug.

Emma Johnson:

I think it's safe to say that this is a substantial piece of regulation, which has required significant planning and preparation across the securities industry. How smooth has the implementation been?

Doug Bambrick:

It's fair to say that implementation has not been without its challenges, which have been experienced across the whole industry. In some ways, and in retrospect, this is perhaps not so surprising. CSDR penalties are a brand new type of post-trade process, akin to a trade settlement or a corporate action. But unlike those other processes, have not had the benefit of years or decades to evolve a working market practice. Even where penalties have existed before, the scope, scale and manner of processing has been developed for CSDR from scratch with the industry all going live together on the 1st of February.

Doug Bambrick:

Individually, CSDs, custodians, and investors completed testing of their own systems in UAT ahead of the production dry run in the latter part of last year. However, UAT is not the same as production and it is during the dry run that most issues started to become apparent as the clinically designed UAT test cases were replaced with large volumes of production messages from multiple sources, differences in formatting, duplicate messages, and often late reports. With these issues on the daily messages, this also gave very limited opportunity to prove out the monthly process and no clean end to end process from daily to monthly was able to be completed across the industry ahead of go live, resulting in issues at all levels being carried into the live environment.

Doug Bambrick:

Definitely the process has improved over the last few months, both in terms of the messaging we receive as custodian and our own processing, but there is still work to do at CSDs and at all levels of the custody chain.

Emma Johnson:

Doug, I think you make an important point that this is a regulatory requirement that impacts all factions of the securities industry with considerable interdependency between providers and consumers of services, which ultimately serve the investors. As you mention, a number of issues have been identified post go live. What are the main issues that need to be resolved and how is J.P. Morgan and the wider industry reacting?

Doug Bambrick:

In many cases, the actual issues will originate with either the CSD or a sub-custodian.

We're continuing to see examples of late reporting, reporting with key data missing, which adds to the challenges which custodians face. To help address this, JP Morgan are actively engaged and leading in a number of industry task forces focused on creating efficiency through standardization. The first of these task forces is focused on the processing calendar. Under the current process, monthly penalties are reported by CSDs on the 14th business day of the month with actual payment being debited or credited on the 17th business day.

Doug Bambrick:

Even without the sometimes-differing definitions of business days between CSDs, this three day life cycle for a penalty to be reconciled and reported through the custody chain has proven very aggressive indeed. As a custodian, J.P. Morgan and our industry peers are advocating that the actual payment date at CSD should be extended to allow for these processes to be carried out while maintaining consistent value date throughout the custody chain.

Doug Bambrick:

The second task force focused on messaging standards is intended to identify and agree key messaging requirements, which either need capturing as a standard or for which in existing standard, such as SMPG is not consistently being followed. Related to this, we are also working with industry groups, such as the Association of Global Custodians on market processing standards, including handling of reconciliations and corrections for both daily and monthly penalties.

Doug Bambrick:

The third and final task force relates to reference data. CSDs are challenged by the lack of a single authoritative source of security reference data to help them determine both the scope and the amount of any penalties. An ideal solution could be a central pan European source of security and pricing data to give the required transparency. But the task force will also seek to identify any other opportunities for greater consistency and transparency.

Emma Johnson:

Looking inwardly, what is J.P. Morgan doing to improve the process?

Doug Bambrick:

Despite these industry challenges, we have been issuing reports and processing payments each month since inception. And we've been providing reporting via a range of channels, including SWIFT, web-based reporting, and via third party providers such as AccessFintech. We continue to have an active technology enhancement program in place removing manual touchpoints in our process to industrialize the process and delivering change with direct client impact. For example, reporting enhancements.

Emma Johnson:

CSDR intends to improve the safety and efficiency of security settlement in the European economic area with the settlement discipline regime, introducing measures to prevent and address settlement fails. Whilst it's obviously early days, what impact do you foresee cash penalties having on security settlements rates?

Doug Bambrick:

So this is the main goal of penalties, to incentivize good settlement discipline. The cash penalties create a clear economic incentive. Individual penalties may vary in size from a few euro cents to tens of thousands of euros with the total impact across the industry estimated in the hundreds of millions. Even the existence of a penalty of any size, which must be accounted for is causing investors to devote time in understanding why trades fail and to focus on bringing these numbers down. The extent and of the impact and the timing remains to be seen, but it will depend on a number of factors.

Doug Bambrick:

Firstly, what the actual changes needed are, undoubtedly, there are some quick wins, but to the extent technical development is required by the trading parties or their service providers, there will undoubtedly be a lead time. Operational resourcing. Certainly there's still a focus of operational resources and management time on simply processing the penalties. This may mean that some of the work by parties to investigate root cause and put in required changes may actually still take a little longer while the process beds in. It's also worth noting, at least from the perspective of the JP Morgan global custody client base, that we are receiving more penalties in favor of our clients than we are paying.

Emma Johnson:

CSDR is currently subject to a review by the European Commission. And the draft proposal has recently been published. What changes might we expect to the cash penalties regime over time?

Doug Bambrick:

As it pertains to cash penalties, the changes advocated by the industry are for the most part, reasonably light touch. One benefit we might see could be additional clarity on transaction scope. For example, industry groups are advocating the removal of corporate actions, derivative settlement, and primary issuance activity from the scope. Over time, we may also see some modification to the penalty amounts, but generally speaking, the regime we have now it's likely to be around for the foreseeable future.

Emma Johnson:

Cash penalties is a significant milestone for CSDR. And as you have described, it has been a huge undertaking. Moving forward, what lessons can be learned for the future implementations of this scale and nature.

Doug Bambrick:

That's a great question. Putting into context, CSDR settlement discipline has seen possibly the largest change in European securities processing for quite some years and penalties on its own has been a major implementation for all parties in the settlement process. Within this context, I think the industry did simply underestimate the scale of issues that would be experienced first by CSDs in implementing their penalty mechanisms, then by participants within their processing.

Doug Bambrick:

But perhaps these issues are not all that surprising. The defined framework for processing the penalties allows three business days from the first notification of the monthly amount, from the CSD to actual movement of cash. To manage this, we've all implemented, automated reconciliation and reporting. And this works if all providers are sending their correctly formatted reports on the 14th business day, they fully reconcile STP to the daily penalties, allowing automated and complete reporting by the global custodian on the 14th, maybe 15th business day.

Doug Bambrick:

Experience has shown this is simply not realistic. Hence why industry groups are working with CSDs post implementation to possibly extend that calendar potentially even needing involvement of regulators to agree in alternative timeline. A contributing factor has also likely been the focus on buy-ins, which were only finally descoped from implementation in the final weeks ahead of regulatory go live after substantial industry pressure, for which JP Morgan also played a leading role. Cash penalties remain a challenge, but the issues remain relatively small compared to what would've been the impact of mandatory Buy-ins and whose presence perhaps served as the distraction from the scale of penalties.

Doug Bambrick:

Lastly, future implementations of this scale should consider clear success criteria ahead of implementation. Certainly if this was a discretionary initiative by one or more CSDs, instead of a mandatory requirement from a regulation, it is unlikely that the industry would've considered going ahead with implementation in light of the challenges seen in dry run. However, we had to progress due to the regulatory live date. To ensure that the entire settlement chain has sufficient opportunity to test their processes, participants would ideally have had opportunity to conduct their dry run testing in an environment that was relatively clean of CSD issues and been able to conduct at least one or two full clean monthly cycles ahead of the go live. This was not the case and the issues we are facing are very much a symptom of that.