CSDR Cash Penalties for Settlement Fails

The delayed settlement of transactions is a phenomenon typical of securities trading. However, the extent of such delays prompted the European legislator, at the latest since 2012, to counteract them through specific provisions in Regulation (EU) No. 909/2014 (Central Securities Depositories Regulation, CSDR) and Regulation (EU) No. 236/2012 (Short Selling Regulation, SSR). The settlement discipline rules under the CSDR also include cash penalties (settlement penalties), which are charged by the central securities depository to those participants in a settlement system who cause the delay.

Cash penalties as a pillar of settlement discipline

The penalty mechanism is one of the pillars of supervisory measures designed to promote so-called settlement discipline. According to the CSDR and SSR, the five pillars of settlement discipline – in addition to certain compliance requirements (Art. 6 CSDR), such as rules on the handling of settlement instructions, reporting obligations (Art. 7(1), Art. 9 CSDR) and the possibility of suspending a repeatedly defaulting participant (Art. 7(7) CSDR) – also include, in particular, a mechanism for the imposition of cash penalties (Art. 7(2)–(6) CSDR) and the implementation of buy-in procedures (also referred to as forced settlement, mandatory coverage or buy-ins) (Art. 7a CSDR, Art. 15 SSR).

Private-law character of cash penalties

Although the CSDR is also a public-law regulation, it obliges central securities depositories, as private-law entities, to establish a penalty system for their participants. Such obligations can only be stipulated and implemented by the central securities depository at the private-law level vis-à-vis the participants in the securities delivery and settlement system through its rulebook or general terms and conditions. The penalties themselves therefore have a private-law character.

Overview of custody and settlement structures

Issuers of transferable securities with their registered office in a Member State of the European Union (EU) or a Contracting State of the European Economic Area (EEA) are obliged under Art. 3(1) CSDR to have the securities recorded in a central securities depository (CSD) book-entry system if such securities are or are to be traded on a trading venue (e.g. the Frankfurt Stock Exchange or the Stuttgart Stock Exchange).

In Germany, recording in the CSD book-entry system traditionally takes place by the issuer delivering a global certificate to the central securities depository Clearstream Banking AG for collective safe custody. The CSD then records a corresponding credit in the securities account. The Electronic Securities Act (eWpG) allows issuers to dispense with a physical delivery if they issue the security as an electronic security. The CSD grants the entitled parties co-ownership in fractional shares of the securities included in the collective holding. This is generally intermediated via sub-custodians acting as depositary banks.

The settlement of securities transactions in the CSD book-entry system is carried out on the basis of settlement instructions issued by the parties involved, through the rebooking of the respective securities account credits by the custodians participating in the settlement. Settlement is carried out on a delivery-versus-payment basis, i.e. the transfer of the securities takes place simultaneously with the transfer of the cash.

Causes of delayed settlements

According to data from the European Central Bank (ECB), the monthly settlement efficiency – i.e. the proportion of transactions that could be settled on time by the intended settlement date (the delivery date) – of payment instructions processed via T2S averaged 94.3% by volume in 2023. In other words, 5.7% were not settled on time.

If settlement does not occur on the intended settlement date, this can have several causes. A study by the International Capital Market Association (ICMA) from 2021 found that the main cause was the seller’s inability to deliver the securities (71% of cases). In 27% of cases, the reason was incorrect settlement instructions, and in only 2% of cases it was due to the buyer’s insufficient cash balance.

Repeatedly postponed entry into application

The provisions on cash penalties did not apply from the time the CSDR entered into force in 2014. The European legislator intended them to take effect only at a later stage, together with the regulatory technical standards to be adopted by the European Commission. In 2018, the Commission adopted Delegated Regulation (EU) 2018/1229. This regulation, and with it the penalty mechanism, was initially scheduled to enter into force two years later, in 2020. The European Commission then postponed its entry into force to 2021, citing the considerable implementation burden for central securities depositories. It subsequently postponed it again to 2022, referring to the additional implementation difficulties caused by the events surrounding COVID-19. Ultimately, however, Delegated Regulation (EU) 2018/1229 entered into force on 1 February 2022, and with it the penalty mechanism within the meaning of Art. 7 CSDR.

Market Infrastructure Law | KRONSTEYN

Securities subject to cash penalties

The central securities depository must establish the penalty mechanism for the following types of financial instruments settled in its settlement system:

• Transferable securities, i.e. in particular shares and debt securities (bonds);

• Money market instruments, e.g. short-term promissory notes, financing facilities, treasury bills and notes, or commercial papers;

• Units in undertakings for collective investment in transferable securities (UCITS);

• Emission allowances.

No penalties are to be imposed on shares whose main trading venue is in a third country (e.g. the USA, Switzerland).

Calculation of the cash penalties

Under Art. 7(2), third subparagraph, CSDR, the central securities depository is obliged to impose penalty payments on those participants in the settlement system who cause delayed settlements. The penalties are calculated daily for each business day after the intended settlement date on which the transaction remains unsettled.

According to the detailed methodology set out in Delegated Regulation (EU) 2018/1229, the central securities depository must credit the penalties collected from the defaulting participant to the non-delivered participant. In this way, penalties are passed along a chain of transactions to the participant ultimately responsible for the delayed delivery.

The question arises whether, and to what extent, participants in the settlement system are obliged or entitled to pass on penalties received or paid to their clients on whose behalf they act, or to seek reimbursement from them. The CSDR does not contain any explicit provision in this respect. Absent contractual arrangements, the general principles of German civil law (BGB) would apply. A statutory obligation of the client to reimburse penalties paid by a participant will at least have to be rejected if the participant itself caused the late delivery, for example due to incorrect settlement instructions.

The amount of the penalties is determined under Delegated Regulation (EU) 2017/389. Its annex sets out different rates for various types of securities, which are to be applied to the daily market value in calculating the penalties.

As a rule, central securities depositories are also entitled to charge participants in the settlement system fees for operating the penalty mechanism.

Kronsteyn's legal services

Kronsteyn is a German law firm specialising on financial markets law. Please contact lawyer/attorney Hendrik Müller-Lankow for any requests.