One direct response to the financial crisis of 2008 was the creation of the Central Securities Depositories Regulation (CSDR)—one of the three pillars standing alongside Mifid II and the European Market Infrastructure Regulation (Emir). Rolled out in 2014, the program is designed to serve as something of a safe haven for European assets. 

One of the most significant mandates was the CSD obligation to offer two different types of accounts to clients: a fully segregated one, in which individual assets get their own respective accounts, and an omnibus, in which the assets are commingled.

Eric de Nexon, head of strategy for market infrastructures at Societe Generale Securities Services (SGSS), says that CSDR has the potential to bring some positive effects to the market, despite being constantly amended and—hopefully—improved upon since it came into force three years ago. “First of all, it shows the will to harmonize the framework for CSD activities, as was the case for central counterparties (CCPs) with Emir,” he says. “Secondly, this regulation is strengthening the regulatory framework that applies to CSDs and partially to their participants.” 

De Nexon says regulators recognize for the first time the systemic aspect of CSDs by strengthening the level of resources required for them to face their liabilities, but also their governance considering the relationship with their users. “We should also note that this regulation ‘re-authorizes’ the CSDs at a European level, upgrading the level of compliance of all CSDs and allowing a level playing field among them,” he says. 

While all of this sounds promising, there are key components that remain unclear, even after several amendments to the regulation. Some of these areas have proven too critical to be ignored and have precipitated a range of views among the sell-side community as to how they should be addressed. 

The Case of Segregated Accounts

The European Securities and Markets Authority (Esma) has published two papers this year—the first, a guideline, released in March, and the second a Q&A, published in April—that attempt to end the debate around segregated accounts and resolve their complicated nature. 

Polina Evstifeeva, a member of Deutsche Bank’s global transaction banking’s market advocacy team, tells Waters that a major part of the CSDR is a set of regulations outlining the rights depositories have to segregate their assets and maintain them through the chain. “The idea was to provide more protection to clients,” she says. “The regulators considered some options: Option one was full segregation through the custodial chain, while the second was no segregation at all.” 

However, the regulation does stipulate the level at which CSDs need to segregate the assets or how many accounts they need to maintain. Soraya Belghazi, secretary general of the European Central Securities Depositories Association (ECSDA), explains that while the rule also creates a common framework with the principle of investor choice, the reality is that in Europe, each local market has different preferences. Therefore, a unified approach cannot be achieved. 

“Some markets use a lot more segregated accounts than others,” she says. “It doesn’t impose a single model, but it keeps some room for market preferences.” 

In Greece, for example, banks are familiar with working with full segregation, even at the infrastructure level, using the so-called indirect holding system, while larger markets—such as France or Germany—traditionally work with segregation at the bank level, rather than the infrastructure level. “Regulators have realized that this is more complicated than they initially thought,” Belghazi says. “Just think: According to a study we did in 2015, there are four primary segregation models in Europe.”

Belghazi says that apart from segregated and non-segregated markets, there are also hybrids in between. “In some markets, they use sub-accounts to segregate, and the infrastructure doesn’t know the name of the end-investor,” she explains. “The banks will segregate, and legally speaking, it will be a segregated account, but only the intermediary will know the identity of the client.”

In other markets there are fully-independent accounts and CSDs have access to the identity information of the end-investor. “The legal frameworks in Europe are different,” Belghazi says. “In one market, you have a higher level of asset protection by using a segregated account, but in other European markets, the level of legal protection is the same whatever type of account you maintain at the CSD, and there’s no difference if your bank decides to segregate.” 

The bottom line is that as far as segregation is concerned, there is no single model, which ultimately means there is no direct correspondence between asset safety and segregation. The situation gets even more complex if the industry takes into account other regulations that define client segregation, such as Emir or the asset management regulation.  “They adopted a different approach in various pieces of the European law—there are inconsistencies and overlapping rules that make it even more complex than it is today,” Belghazi says. 

Changing CSDs

The choice to separate accounts gives end-investors the power to better protect their assets. Where things get tricky, though, is that creating separate accounts introduces a precedent that has multiple implications on business, administration, operational and technical levels, mainly for CSDs, sub-custodians and banks, according to SGSS’s de Nexon. 

“We are concerned that CSDs will be authorized to provide banking services, leading them to compete with their own participants,” he says. “There is a real issue concerning the level playing field between CSDs and custodians, and also the fact that it will lead to a change in their risk profile.” 

For example, he says, Euroclear has €28 trillion ($31 trillion) in assets under custody, illustrating its scale and potential risk from a systemic perspective. For de Nexon, if CSDs develop banking services, it means they will face counterparty and market risks, in addition to traditional operational risk deriving from their core services. “The domestic monopoly of some CSDs may be at risk,” says de Nexon. “Issuers will benefit from the free choice of places of issue.”

Jesús Benito, CEO of Iberclear, says CSDs are currently in the process of changing their organizational outlook, an administrative burden that could potentially lead to a radical transformation in the way CSDs operate in the near future. “From an organizational perspective, we have to change the boards to include more independent representation,” he says. “We also have to designate chief risk officers, chief compliance officers and chief technical officers and implement a user committee, as users should be represented.”  

Operational Change

For the CSDs, the industry expects significant changes to their IT and operations departments in three key areas—settlement, reconciliation, and collateral management—since clients may require an additional level of account segregation. 

Benito says that on a technical level, this means the market will experience an increase in securities accounts. “This could affect the efficiency in netting,” he says. “The more segregated accounts, the more transactions are going to be settled.” 

Thanos Kagiaras, manager of post-trade and prime services at the Association for Financial Markets in Europe (AFME), agrees. “If that number increases, then the number of settlement instructions also increases,” he says. “That way, the complexity and the cost of processes are going to skyrocket.” 

Evstifeeva adds that funds should be aware that this brings consequences that firms might want to avoid. “If you do the reconciliation, you have to reconcile against all of the separated accounts,” she says. “So, naturally, this creates a set of operational questions—would that increase the operational risk, or cost more money?” 

The answer is yes, she says, because firms need to employ people to manage these reconciliations. “You can’t rely only on technology—you have to have humans to do the checks and verify that everything went correctly,” she adds. 

The technical and operational side effects have been identified in the settlement process as well, which are expected to shift as CSDs may need to internalize part of their settlement activity, which must report to the authorities. This change could prove inefficient, according to Kagiaras. “Today, brokers can send settlement instructions to settle a block of shares, and once this block is settled in a CSD you can allocate it based on clients’ original instructions,” he says. “Sending one settlement instruction has less risk and costs less than sending several for the same instrument.”

The third affected area is tri-party collateral management services. “The collateral engine holds the assets in the omnibus accounts,” says Evstifeeva. “If you are not allowed assets in the omnibus accounts, that would mean that agents would have to open separate accounts for each of their customers; it challenges the core of the service.”

Kagiaras adds that this asset segregation is important. “A tri-party agent has to move securities between the accounts of the collateral giver and the collateral taker, not only in its own books but also in the books of all relevant parties throughout the custody chain,” he explains. “This creates extra cost complexity and delays and may become an impediment to the use of a tri-party agent, while the impact on liquidity will be large and should not be ignored.”

Collateral Damage

If settlement, reconciliation, and collateral management are the direct “victims” of asset segregation, the Target–2 Securities (T2S) platform is the collateral damage. 

The love child of the European Central Bank (ECB) that has been praised by market participants and politicians for its operational success and its utmost importance to the markets’ unification in Europe has become the battlefield of various custodians in the race to maintain or discard omnibus accounts. ECSDA’s Belghazi says that T2S was meant to add greater protection to the market, as it standardizes settlement and removes cross-border costs. 

“In itself, segregation is not a problem in the sense that CSDs are already offering the possibility to their clients to create as many accounts as they want,” she says. “The problem is not the number—it’s the lack of harmonization of segregation rules. One segregation in one country is not the same as a segregated account in another country.” This complexity, she adds, creates risks and makes it difficult to transact across borders. 

SGSS is one of the participants that strongly opposes full account segregation in T2S. “If we have to open all accounts it would be a nightmare,” de Nexon says. “It could have an impact on the process, performance, and cost of the platform.”

De Nexon says that for the time being the system based on segregated omnibus accounts is entirely safe and meets clients’ safety requirements. “It was proven to be secure during the financial crisis as no incidents were reported,” he argues. 

There are a number of thoughts on how Europe could overcome national segregation mandates, which could curb T2S benefits. One of them is to build an additional platform connected to T2S, through which countries like Denmark could connect using its fully segregated accounts. According to SSGS, the most efficient way to manage the relationship of direct holding CSDs with T2S would be to interface their current platform with T2S. This way, firms can settle the instruction on an omnibus account on T2S and automatically rebalance it to the retail account on the CSD platform, referred to as the “layered model,” according to de Nexon. 

For now, the temporary solution appears to be connections. “What CSDs are encouraged to do right now is to have links with one another,” Belghazi says. “By connecting, they can avoid handling different kinds of reference data, which can become a very risky and costly process.” 

Segregation in Question

To make sense of the issue, AFME has worked with its members and external legal counsel to draft generic language to disclose the level of protection associated with the use of omnibus and segregated account structures. Kagiaras says this language can be adopted in every jurisdiction, according to domestic insolvency law, and can be used to comply with the mandate.

During its research, AFME found asset segregation reappeared in different contexts, which will require harmonization. Its analysis concluded that in the end, segregation is not as helpful as regulators want it to be. “From a legal perspective, account segregation does not add protection to the client’s assets or to the safety of assets,” Kagiaras says.

Furthermore, Deutsche Bank’s Evstifeeva says she wonders why regulators introduced the option of full segregation in the first place. They said it would be much easier to identify the items belonging to the clients, although she says a  law firm looking at 90 countries found that segregation made sense in only four jurisdictions. It’s clear that this issue is not yet settled.