SECURITIES SERVICES, REGULATION
Regulatory outlook in securities services 2023
16 June 2023
Now a twice-yearly update, this deep dive into regulation impacting the post-trade landscape from Deutsche Bank’s Boon-Hiong Chan and Britta Woernle provides an update on accelerated settlement, digital assets and client asset protection. This article summarises the main global and regional regulatory developments, and how they are shaping the post-trade world
Shortening settlement cycles
Asia is a market of accelerated settlement cycles, with China Interbank Market’s (CIBM) government bonds on settlement cycles of T+0, T+1 and T+2. T+3, and a special service where settlement on the trade date plus four or more days, where four days is the minimum ((T+n (n >=4)), were subsequently rolled out to allow sufficient funding time for global investors.
In 2021, India announced it would introduce a T+1 settlement cycle for listed equities, a process which was completed in early 2023. Although no other Asian markets have any formal plans to move to T+1, the Philippines is expected to migrate from T+3 to T+2 in the near future.
The US and Canada will introduce T+1 in May 2024, and they could be followed by several markets in South America, who are currently consulting on whether to adopt T+1. Transitioning to T+1 in the US will cause challenges, however. There is a 12–14 hour time-zone difference between Asian markets and the US, meaning Asian investors trading US securities will need to issue no-error settlement instructions in time for T+1 9pm US EST settlement (9am T+1 Singapore/Hong Kong).
Meanwhile, the UK has launched an accelerated settlement taskforce to assess how T+1 or T+0 could benefit the UK, with a final report expected at year-end.1 The Association for Financial Markets in Europe (AFME), an industry body, has also established its own T+1 taskforce to explore the pros and cons of shorter settlements in the EU, with an impact assessment expected to be published in December 2023. Both Taskforces stress that improvements to settlement efficiency are a prerequisite to introducing T+1.
However, implementation of T+1 in the EU could be more complex than that of India and the US. This is because of the unique nature of European markets, which have a number of different currencies, market infrastructures, and distinct legal frameworks.
While there are benefits to T+1, the transition requires an industry-wide adoption of new technologies and operational processes to overcome time-zone driven settlement issues together with problems that may arise in asset servicing, securities borrowing/lending and FX execution. Markets will ultimately need to weigh up the advantages and disadvantages before pursuing T+1 or not.
Digitalisation and digital assets
Regulatory scrutiny of digital asset classes is intensifying, especially following the failure of several crypto-exchanges, most notably FTX.
In May 2023, the International Organisation of Securities Commissions (IOSCO) published a consultation report containing policy recommendations for crypto and digital asset markets2, in areas including custody and client asset protection, market manipulation and conflicts of interests. The proposals could have significant implications, with one being that crypto- asset service providers – including bank operated crypto custodians – will have to place client assets in trust, in segregated bankruptcy remote accounts, or equivalent – unless the provider expressly takes legal or beneficial title to the client’s assets.
On 9 June, the EU Markets in Crypto Assets Regulation (MiCAR) has been published in the EU Official Journal,3 entering into force 20 days later. MiCAR will then apply as of 30 December 2024 except for the electronic money tokens (EMT) and asset-referenced tokens (ART) titles which become effective already on 30 June 2024. MiCAR aims to create a holistic regulatory framework for crypto-assets markets that preserves financial stability and protects investors. Among others, MiCAR defines:
- Categories of crypto-assets;
- The scope and type of crypto-assets that are regulated under existing frameworks;
- A licensing and authorisation regime;
- Roles and responsibilities of crypto-assets issuers and service providers; and
- A supervisory framework for the crypto-asset ecosystem.
The EU’s DLT Pilot Regime, which lets financial market infrastructures (FMIs) test DLT in the issuance, trading and settlement of tokenised securities, has been live since 23 March 2023. Elsewhere, the European Council is updating its rules to extend tax reporting requirements to cover crypto assets, while the UK Treasury has recommended that unbacked crypto trading be regulated as if it were gambling.
The US is also pushing ahead with its own rules on digital assets. On 15 February 2023, the Securities and Exchange Commission (SEC) issued a ‘Safeguarding Rule’ proposal that broadens the application of its existing rules governing custody services provided by investment advisers. The rule, which is expected to come into force next year, seeks to restructure the way that qualified custodians provide custody services, as well as the nature and scope of advisers’ responsibilities with respect to custody. The Custody Rule will also be extended beyond client funds and securities to include any client assets – including digital assets.
“The digital asset market needs to be underpinned by sensible regulation”
Major concerns for foreign financial institutions (FFIs) are the cash segregation requirement for bank custodians and the strict liability of custodians for losses at the sub-custodian or securities depository, i. e. qualified custodians would be liable not only for their own negligence, but also for any contingency down the chain (similar to AIFMD).
In Asia, regulators are focusing their attention on decentralised finance (De-Fi) too. Hong Kong’s Securities & Futures Commission (SFC) released its regulatory requirements for virtual asset trading platform operations, which became effective in June 2023. Similarly, the Monetary Authority of Singapore consulted on amendments to the Payment Services Act that would expand its coverage of cross-border money transfer services and digital payment token services. And finally, Thailand’s Securities and Exchange Commission issued regulations governing digital token offerings (ICO Portals).
This comes as the industry is expecting IOSCO to issue a regulatory consultation on De-Fi in H2 2023.
If the digital asset market is to grow in stature and rapidly institutionalise, it will need to be underpinned by sensible regulation.
What to continue watching for: client asset safety, exemplified by the US SEC proposed Safeguarding Rule
The SEC’s Safeguarding Rule modifies the current Rule 206(4)-2 Custody Rule under the Investment Advisers Act of 1940. This comes following a number of client asset safety issues.4 The provisions, which are extraterritorial in nature, will subject Registered Investment Advisors (RIAs) to heightened regulation, although its impact will also be felt by intermediaries and custodians servicing RIAs.
As the proposal currently stands, it would change the concept of liquidity and banking structure from its requirements for client cash to be segregated and kept in a bankruptcy remote manner by qualified custodians. It also extends the safekeeping obligations by custodians to include other assets like derivatives which cannot be held in custody for practical reasons.
For more information, we would recommend readers visit the US SEC’s microsite.5
New to watch for: regulating artificial intelligence
Artificial Intelligence (AI) remerged from a few winters in a series of awakening steps to the industry with the latest being Generative AI given a dominant form by ChatGPT from OpenAI. Similar to cryptoassets, AI in general and Generative AI in particular have started attracting regulatory attention to risks which will have an impact on the securities market. This will be an area to monitor.
Efforts to harmonise the EU’s capital markets are ongoing, while regulators are also looking to amend a number of existing rules.
A European Central Bank (ECB)-led initiative, the ECMS aims to harmonise collateral management processes in the Euro area. The ECMS will replace 19 different collateral management systems with a single system capable of managing the assets used as collateral in Eurosystem credit operations for all jurisdictions. The scheme, which is due to go live in April 2024, will help increase efficiency in the management of collateral and level the playing field among Eurosystem counterparties.
To facilitate the ECMS, the ECB Advisory Group on Market Infrastructures for Securities and Collateral (AMI-SeCo) endorsed standards for a Single Collateral Management Rulebook in Europe (SCoRE). SCoRE standards apply to debt instruments, equities and investment funds issued via European (I)CSDs and should be implemented by all relevant actors in the AMI-SeCo markets (the EU, the UK and Switzerland).
The compliance date of corporate action standards is April 2024 with the exception of those events which are only relevant to equities and investment funds for which the implementation deadline is November 2025, although CSDs may indicate an earlier deadline.
Capital Markets Union
The Capital Markets Union (CMU) is an all-encompassing framework aimed at facilitating deeper integration of EU capital markets so as to increase competitive investment and financing opportunities in the EU. The CMU Action Plan, published by the European Commission in November 2021, includes legislative proposals relating to the following areas:
- European Single Access Point (ESAP)
- Review of the European Long-Term Investment Funds (ELTIFs) regulation
- Review of the Alternative Investment Fund Managers Directive (AIFMD)
- Review of the Markets in Financial Instruments Regulation (MiFIR)
The CMU provides an opportunity to harmonise market practices and enhance technical integration. Revisions to the Shareholder Rights Directive II (SRDII) are also expected, which may include the introduction of a uniform ‘definition of what a shareholder is. Furthermore, there are plans for a harmonised framework for a withholding tax, which will promote cross-border investment.
A legislative proposal on withholding tax is targeted for July and is expected to contain measures on the use of digital processes, together with provisions on speeding up refunds and the support of relief at source.
MiFID II/MiFIR refit
In 2021, MiFID II Quick Fix entered into force, and was implemented by all of the EEA countries in February 2022. This introduced changes related to the annual cost and charges settlement, quarterly statement of client financial instruments and electronic client reporting.
In November 2021, the European Commission published two proposals for the review of MiFID/MiFIR. A final text is expected in either Q3 or Q4 2023. The European Commission is focusing on three priority areas:
- Improving the transparency and availability of market data
- Improving the level playing field between execution venues
- Ensuring EU market infrastructures remain competitive internationally
In March 2022, the European Commission released its proposal for a revision of CSDR as part of the 2020 CMU Action Plan. One of the main discussion points here concerns the settlement discipline regime. As things stand, a two-step approach to settlement discipline is being adopted, under which mandatory buy-ins could become applicable – potentially from 2025 - if cash penalties do not reduce settlement fails in the EU.
The trilogue process and negotiations are currently underway with the European Council and the EU Parliament, with both having prepared their positions on the original European Commission proposal.
Having bounced back from COVID and lockdowns, a number of Asian markets are pushing ahead with exciting market reforms.
Sustainability and responsibility
The ASEAN Capital Markets Forum (ACMF) has developed the ASEAN Sustainable and Responsible Fund Standards (ASEAN SRFS)6 to support the growth of sustainable asset classes across ASEAN markets. SRFS introduces a template and minimum disclosure requirements around sustainability for collective investment schemes in ASEAN markets. So far, the Philippines and Thailand have imposed regulations, which are broadly aligned with the SRFS’s provisions.
Elsewhere, the Hong Kong Monetary Authority has published a discussion framework outlining a potential green classification framework, which would enable for financial products and investments to be labelled based on their sustainability credentials.7 The classification framework is based on the Common Ground Taxonomy (CGT), a joint initiative established by the People’s Bank of China and the European Commission, which aims to map out activities that can be designated as being green in both China and the EU.
And finally, the Securities and Exchange Board of India (SEBI) has launched a new Business Responsibility and Sustainability report targeting the top 1,000 listed companies. The rules introduce mandatory ESG disclosure obligations in what should help bring about greater transparency to public markets. In 2023, SEBI announced additional disclosure requirements for the issuers of transition bonds.
Connect and modernise
Connectivity schemes between the capital markets of Hong Kong and China are an area of focus for the industry.
Recent initiatives include Hong Kong Exchanges and Clearing Limited’s launch of the Hong Kong Dollar (HKD)-Renminbi (RMB) Dual Counter Model (Model) for listed equities and the Dual Counter Market Making Programme in its securities market.8 Similarly, the northbound leg of Swap Connect went live in May, which will enable global investors to access mainland interest rate swaps, in what will help generate a number of risk management benefits.
“China continues to liberalise its capital markets”
In another drive to modernise the Hong Kong market, the SFC consulted the industry on the operational and technical aspects of an uncertificated securities market (USM) which will allow investors to hold securities in their own name and without paper, as well as on the regulation of share registrars. A USM market will help usher in better legal protections and market-wide efficiencies.
Market connectivity projects are not just limited to Hong Kong and China. Thailand and Singapore have launched a Depository Receipt Linkage programme9, making key listed companies available to investors in their respective markets.
Singapore has also launched the National Stock Exchange (NSE) IFSC-SGX Connect (Gift Connect). Under this, SGX will link up with NSE IFSC to allow trading in NIFTY derivatives listed on NSE IFSC. In addition, SGX announced a memorandum of understanding with the Shanghai Stock Exchange to launch an ETF link through a master-feeder fund model10, building on its success with the Shenzhen Stock Exchange.11
Infrastructure enhancements are being made in Vietnam. For example, the Vietnam Securities Depository & Clearing Corporation (VSDCC) aims to launch a new CCP by January 2024, as the market continues to adopt industry best practices.
China continues to liberalise its capital markets. Most recently, it has permitted investors – under QFI – to access a wider range of futures.
However, India’s regulator SEBI issued a consultation calling for mandatory additional disclosures around ownership of, economic interest in, and control of objectively identified high risk Foreign Portfolio Investors (FPIs) that have either concentrated single group exposures and/or significant overall holdings in their India equity investment portfolio.12 Another SEBI circular was also released advising on the opening of direct market access to FPIs in exchange traded commodity derivatives.13
Boon-Hiong Chan, Head of Fund Services and Head of Securities Market & Technology Advocacy at Deutsche Bank
Head of Market Advocacy Europe Securities Services, Deutsche Bank