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What is the purpose of the Settlement Finality Directive and the Financial Collateral Directive?
Directive 98/26/EC on settlement finality in payment and securities settlement systems (SFD) and Directive 2002/47/EC on financial collateral arrangements (FCD) are the two main Community instruments in the area of clearing and settlement and financial collateral. The SFD provides protection to both payment and securities settlement systems in case of the default of a participant to those systems and thus seeks to minimise systemic risk, whereas the FCD regulates and facilitates the cross-border use of financial collateral.
Why is it necessary to amend these two directives?
The Commission evaluated the two directives in 2005 and 2006 respectively. Following extensive consultation the Commission concluded that both directives work well and that Member States, market participants and other stakeholders strongly support them. The Commission does therefore not propose any substantial changes but propose to amend them in limited areas in order bring them in line with regulatory and market developments having occurred since the time of their drafting and adoption.
The main changes in the proposal concern, first of all, the explicit protection of the SFD to night-time settlement and linked systems, since pursuant to 'Directive 2004/39/EC on markets in financial instruments' (OJ L 145, 30.4.2004, p. 1) and the European industry-sponsored 'Code of conduct for clearing and settlement', systems are expected to become increasingly linked.
Secondly, the proposal seeks to broaden the scope of the protection provided by both directives by including credit claims eligible for the collateralisation of central bank credit operations in order to facilitate their use throughout the Community.
Lastly, this proposal seeks to introduce a number of other simplifications and clarifications to facilitate the application of the FCD and SFD.
Will the proposal lead to more stability in financial markets?
Ensuring the proper functioning of settlement systems in rapidly evolving markets is indispensable for the stability of financial markets, even more so in times of market turmoil. Whilst the Commission started preparing the proposal in early 2007, i.e. before the onset of the ongoing financial turmoil, the latter provides an additional argument in favour of the proposal: it would strengthen the existing tools for managing such situations. For example, the establishment of a harmonised legal framework for the use of credit claims as collateral in cross-border transactions would enhance market liquidity.
Why is it necessary to adapt the SFD to cater for a linked marketplace?
The SFD was drafted in the mid-1990s. The purpose was to prepare European payment and securities settlement systems for the euro and a more integrated market place. It did so well and has offered and continues to offer an essential safeguard against the default of a participant affecting a system.
However, since the time of drafting, legislation and markets have developed. In November 2007, MiFID entered into force. Moreover, since January 2008, the Code of Conduct for clearing and settlement is fully in force. While MiFID enables investment firms, regulated markets and Multilateral Trading Facilities (MTFs) to choose their post-trade location, the Code aims to make the user choices enshrined by MiFID not a theoretical possibility but an effective option. It does so by notably making it easier for service providers to gain access to and become interoperable with infrastructures in foreign markets.
These choices and facilities may herald a market place where post-trade systems are increasingly linked. The aim of the proposal is to ensure that the SFD is fully adapted to such a market place.
How does the proposal adapt the SFD to a market where more systems may be linked?
The proposal aims to adapt the protection afforded by the SFD to a market where more systems may be linked in a number of ways. First, it clarifies that systems can become participants or indirect participants of another system. Second, it introduces a definition of interoperable system. Third, it aims to protect systems from the risks of default in an interoperable system. Fourth, it clarifies that in case of interoperable system, the rules on the moment of entry and revocation shall not be affected by rules of the other systems with which it is interoperable. Fifth, it insulates collateral provided to a system from the default of an interoperable system.
Will this proposal facilitate the appearance of new links?
The Commission wants a European post-trading structure that is efficient and safe and where systems compete on an equal basis. The Commission is neutral as regards market structure provided that these regulatory objectives are met. The proposal accordingly only aims to ensure that a market structure where systems may be more linked remains safe. However, it is for systems to determine whether they want to exploit the opportunities offered by MiFID and the Code.
How many systems are currently linked?
A number of linked systems have existed for a number of years. The most notable link as regards securities settlement is the 'bridge' between Euroclear Bank and Clearstream International. Moreover, around 60 links exist between securities settlement systems, although only a third of those are actually in use.[1] Since the entry into force of the Code's part on access and interoperability, a large number of link requests has been made. So far, none of these have led to the realisation of an operational link, even though some links requests are close to being finalised. However, the Commission expects the market to evolve significantly in the years to come as an effect of MiFID, the Code and possibly the ECB's TARGET2-Securities project. The proposal aims to prepare the SFD for such a reality.
What is the purpose of the provision on night-time settlement?
Since the SFD was adopted, more and more systems have introduced business days that start immediately after the closing of the previous business day. Such systems provide night-time settlement services, mainly designed to execute bulk and retail transactions. Currently, only transfer orders that are carried out on the same calendar day ('day of the opening of insolvency procedures’) are covered. Therefore, a strict reading of the SFD could suggest that a transfer order is protected only if the batch processing is finalised before midnight, whereas a batch running after midnight is not.
The purpose of the proposal is therefore to eliminate any uncertainty about the status of night-time settlement services. The reference to 'day' should accordingly be replaced by a reference to 'business day, as defined by rules of system'.
Why does the proposal extend the definition of participants and indirect participants?
Systems that are linked by means of access, i.e. one system becoming a participant in the other, currently do not fall under the protection of the SFD as a 'system' currently cannot be a participant. This is problematic as such access is likely to become more common as a result of MiFID and the Code. In order to protect transfer orders entered by a system into another system, the proposal extends the definition of a 'participant' to a 'system'.
Moreover, Article 2(f) SFD allows Member States to consider an indirect participant as a participant if it is warranted due to systemic risk and provided that the indirect participant is known to the system. This option is limited, as only credit institutions can be considered as indirect participants and as it only applies to payment systems. However, other institutions indirectly participating in a system may also represent systemic risk (e.g. CCPs, investment firms...). The proposal therefore expands the definition of 'indirect participant' by aligning it with that of 'participant'.
Why is there a provision on Electronic Money Institutions?
It is not sufficiently clear whether the definition of credit institution in the current SFD includes Electronic Money Institutions (ELMIs). This has led to divergent transposition into Member State law. While ELMIs are currently not of major importance, it may increase in the years to come. It should therefore be made clear that they fall under the scope of the SFD.
Will the proposal oblige central banks and market participants to accept all credit claims as collateral? Why?
No. The decision whether or not to use credit claims as collateral is entirely left to Member States and market participants. What the proposal does is to grant to those credit claims which are in fact used as collateral (according to the requirements set out by the collateral taker) the same level of protection enjoyed by other types of financial collateral. Furthermore, applying a harmonised set of rules to credit claims used as collateral facilitates their use in domestic and cross-border transactions.
Will the proposal lead to an increase in the (cross-border) use of credit claims collateral?
It is likely that by applying easier rules, credit claims will be used more frequently in the future. However, this basically depends on the demand in the market for other forms of collateral. In times of financial crisis, this demand and the subsequent use might be growing. There has already been some increase in the first months of 2007, pursuant to the decision of the Eurosystem to include credit claims as an eligible type of collateral for Eurosystem credit operations as of 1 January 2007.
How does the use of credit claims relate to securitisation?
There is no direct link between securitisation and credit claims; both can be used as forms of collateral. In the current financial turmoil that started with the sub-prime crisis and the problems with "asset-backed securities", securitisation has received a somewhat negative annotation. Investors that purchased the complex instruments created through securitisation were often not able to properly assess their risks because not enough information was available on the assets present in the pool backing the instruments. From this point of view, the solution of using credit claims collateral is much more transparent. As long they are not bundled together, the collateral taker is able to assess their creditworthiness on an individual basis before deciding whether or not to accept them.
What is the impact of the proposed amending directive on consumers?
There should be no direct impact on consumers, as credit claims by individual consumers are not covered, since the proposal envisages a carve-out of the forthcoming Consumer Credit Directive.
Why does the proposal not address the issue of "netting"?
It is generally recognised that the provision in Article 7 FCD on close-out netting has contributed largely to eliminate Giovannini barrier 14 (i.e. add more detail to explain to the uninitiated). The Commission believes that it is worthwhile to explore the netting issue further, and will do so, but this would go beyond the scope of the FCD and the current exercise.
Why does the proposal not address "conflict of laws"?
The proposal contains no amendments to the so-called "PRIMA-rule" in Article 9 SFD and Article 9 FCD, because there is presently no agreement in Europe if and to which the extent these provisions ought to be changed. This relates in particular to the question whether or not the Community should adhere to the Hague Securities Convention. A proposal by the Commission to sign the Convention has been blocked since 2003. As long as there is no agreement among Member States about which line to take, the Commission considers it for the time being not appropriate to introduce any new proposals to amend the current provisions.
