The CSDR mandatory buy-in framework has been high on ICMA’s list of market-impacting priorities for a number of years and is likely to remain so leading up to the September 2020 “go live” date. Not only will the industry need to undertake extensive work to prepare for the implementation of mandatory buy-ins, it would appear that general awareness is another challenge, particularly among buy-sides. We suggest five reasons why the buy-side should care about mandatory buy-ins.

1) You will have to buy in your failing counterparties – whether you want to or not.

The regulation will require that in the event of an in-scope settlements fail, after four business days for liquid equities and seven business days for all other securities (including bonds), the purchasing entity must initiate a buy-in process against the failing seller. This is regardless of whether they want to or not, or even whether it makes economic sense to do so. Buying-in will be a legal obligation. Following four or seven days after the intended settlement date (called the “extension period”), the purchasing entity then has four (for liquid equities) or seven (for everything else) days in which to notify the failing entity, appoint a buyin agent, and complete (i.e. execute and settle) the buy-in. There is no discretion as to when the buy-in process is started, nor as to when it is completed. In other words, buying-in your failing counterparty is a legal requirement and not a right.

2) In the case of a fail, you may find your purchase being cancelled.

The regulation is also quite prescriptive on what should happen in the case that a buyin is unsuccessful. If the buy-in cannot be completed, the purchasing entity has a choice: have one more attempt at the buy-in (again subject to the four- or seven-day time horizon to complete the process) or go to “cash compensation” (noting that cash compensation is the default option). Should a second attempt at the buy-in also prove fruitless, then cash compensation becomes automatic. In the case of cash compensation, the original transaction is cancelled, and a payment is made by the selling entity to the purchasing entity based on a cash compensation reference price. This reference price can be determined by: the previous day’s closing price on the most liquid or relevant market for the underlying security; the previous day’s closing price on the trading venue with the most volume in the underlying security; or by a preagreed methodology.

Of course, regardless of how the cash compensation reference price is determined, the purchasing entity still does not get their securities. Not only could this mean having to replace the original transaction - either by attempting to repurchase the securities or by buying similar securities - it may also mean having to unwind any contingent transactions, such as swaps, foreign exchange, CDS, or a short-sale.

3) You may struggle to find offers.

The regulation is a major problem for market-makers and liquidity providers that rely on the ability to show offers in securities that they do not own. In the event that they are not able to cover any sale, either outright or through the repo market, the relatively short time span in which to deliver securities significantly increases the probability of facing a buy-in. As buy-ins are generally executed for guaranteed delivery, this means that the buy-in price is invariably higher than the prevailing market price, and this difference (effectively the “buy-in premium”) is a cost to the boughtin entity. However, the CSDR buy-in framework contains the potential for even further risks and costs to liquidity providers.

In a conventional buy-in, the difference between the original transaction price and the buy-in price is settled between the selling and purchasing parties, and can go in either direction, depending on whether the buy-in price is higher or lower than the original trade price. This ensures that the purchasing party is able to obtain their securities via the buy-in without incurring any additional costs, but it also means that they do not enjoy any additional economic benefits from being failed-to. The failing seller, meanwhile, will effectively incur any associated costs of the buy-in, mainly in the form of any buyin premia.

Unfortunately, the drafters of the “Level 1” regulation seemed to confuse the direction of the payment of the buy-in differential. Since this error was passed into law, it could not be changed, and so it was left to the “Level 2” regulatory technical standards (RTS) to correct it. Within the constraints of the Level 1 text it was possible to affirm the correct direction for the payment in the event that the buy-in price is higher than the original transaction price (ie from the seller to the purchaser), but not in the event that it is lower. In this case the differential is “deemed paid”. The upshot of this inadvertent asymmetry is that selling securities becomes akin to the simultaneous writing of an at-the-money put option that becomes active in the event of a buy-in. If the buy-in price is lower than the original trade price, the trade is cancelled and there are no payments, meaning that the seller incurs a loss equivalent to the differential (as well as the buy-in premia), while the buyer enjoys a windfall profit. The wider the difference, the greater the cost to the seller, and the bigger the windfall for the buyer.

Market-makers and liquidity providers will need to manage and price for this additional risk created by the asymmetry, meaning that where there is a risk of a sale failing, the offer price will need to be adjusted higher. The greater the risk of the fail, the bigger the adjustment and, in some cases, it may just make more sense not to offer securities unless they are held in inventory. This is borne out in ICMA’s 2015 impact study of mandatory buy-ins for fixed income markets, that suggests that bid-ask spreads for even the most liquid bonds will widen significantly. Meanwhile, further down the credit and liquidity curves, it will become much harder to find offers.

4) Being located outside of the EU does not make you out of scope.

While CSDR is EU regulation, the buy-in regime applies at the CSD level, not at the trading entity level. In other words, transactions intended to settle on an EU/EEA regulated (I)CSD will be in scope, and the regulation provides that CSDs, CCPs, trading venues, and CSD participants (ie settlement agents) have in place contractual agreements to ensure that all parties in the settlement chain are in scope; regardless of their domicile or jurisdiction. You might be in New York or Hong Kong, but if your counterparty fails to deliver securities on an (I)CSD, you are going to have to buy them in.

5) You could be bought in yourself – even though it’s not your fault.

As explained, selling securities that you do not hold in inventory will become far riskier under the new buy-in regime, particularly due to the payment asymmetry. However, selling securities you do hold also comes with a risk. For instance, it may be that you have loaned out your position on repo, with a view to recalling them in the case of a sale. But what if your securities do not come back in time (say, the repo recall fails), causing your sale to fail? You could find yourself getting bought-in. Some securities financing transactions (SFTs) are in scope of the regulation, but only those termed for 30 business-days or longer. Short-date (and presumably “open”) SFTs are not in-scope. In the event of a failing SFT recall leading to a mandatory buy-in against a failing cash sale, there may be scope to pass-on any buy-in costs through the existing contractual repo or lending agreement “close-out” provisions. However, these do not cover consequential losses, such as those that could arise as a result of the CSDR asymmetry.

What is ICMA doing about it?

ICMA has long advocated that the CSDR buy-in regime is ill conceived and that there are far better regulatory and market-led initiatives that could be effective in improving settlement efficiency, such as cash penalties (as well as pointing out that contractual, discretionary buy-in frameworks, such as the ICMA Buy-in Rules, have successfully been relied upon by OTC markets for more than four decades). However, the RTS were finally passed into law in September 2018, and it would seem that the regime will come into force in September 2020. Accordingly, ICMA is now focused on both raising awareness and supporting implementation. The ICMA Buy-in Rules are expected to play an important role in facilitating regulatory implementation and providing market best practice for buy-ins in the international non-cleared bond markets. For instance, ICMA is in discussion with the authorities about the possibility of using the ICMA Buy-in Rules as a contractual means to correct the regulatory asymmetry, which is a major source of increased risk for both sellers and lenders of securities.