Custody, clearing and settlement of financial instruments: recent developments impacting compliance officers

Regulatory Change: the Global Custodians and the Central Securities Depositories Perspective

Olivier Goffard – Head of Compliance & Ethics – Euroclear Group

Denis Caprasse – Head of Compliance – The Bank of New York Mellon SA/NV

Forum Compliance - 20 April 2016

Agenda

1. Who are we?

2. The fundamentals of the custody and securities settlement operations

3. The regulatory framework for the Central Securities Depositories

4. The regulatory framework for Global Custodians

5. The inherent compliance risks for CSD’s and global custodians

6. The regulatory change landscape

7. CSD Regulation – The main regulatory challenge for the CSD’s

8. The key regulatory changes and their impacts on the Global Custodians

9. The need to go beyond the regulatory requirements – The adoption of principles reflecting the specifics of the Global Custodians and CSD’s

10. Conclusions

2

1. Who are we?

3

Euroclear - Our business

• Euroclear provides settlement, safekeeping and servicing of domestic and cross -border securities, from bonds, equities and derivatives to investment funds.

• We connect over 2,000 financial market participants across the globe and ensure securities transactions are processed safely and efficiently. As an open and resilient infrastructure, we help clients cut through complexity, lower costs and mitigate risks.

• Headquarters in Brussels!

4

Euroclear in a few figures Systemic role for financial markets

5

Global client franchise

6

Euroclear Belgium (CIK) (CSD) vs Euroclear Bank (ICSD)

Euroclear Belgium (CIK) Euroclear Bank

Created for which type of security:

Domestic securities International securities

Are they a bank or

not?

No, but direct link with

Central Bank

Yes, with a network of

commercial bank as

cash correspondents

Clients? Can be individuals (in some CSDs), issuers,

banks…

Only financial institutions and some

corporates

Services? Settlement, basic asset

servicing, asset

optimization

Settlement,

enhanced asset

servicing, asset optimisation

The Bank of New York Mellon at a Glance

7

Our Capabilities

8

2. The fundamentals of the custody and securities settlement operations

9

A simple example (1/3)

• Let’s consider Mr John Doe

• He has a small investment portfolio composed of securities issued on several markets around the world

• The issuers have registered these shares with the respective national Central Securities Depositories (CSD’s). The CSD’s have to maintain the shares registers

• As a securities holder, John Doe is entitled to

– Buy/sell

• Trading i.e. the placing and the processing of an order

• Clearing i.e. the matching between the buy and sell orders

• Settlement i.e. the effective delivery of the securities

• The securities will be subject to ‘corporate events’ or ‘corporate actions’

– Voluntary events e.g.

• Exercise of voting rights

• Subscribing to the issue of new shares reserved to existing shareholders

– Mandatory events e.g.

• Dividend distribution

• Securities splitting

• Redemption of securities reaching maturities

10

A simple example (2/3)

• There will be taxation implications

– Stamps duties

– Withholding taxes

• There will be fees

– Brokerage fees

– Custody fees

• Mr John Doe is a sophisticated investor and wishes to further generate revenues

– He may enter in a securities lending arrangement whereby he will lend his securities to a third party who in turn will give some collateral (either in securities or in cash)

• Some markets may be subject to restrictions

– Tax Holding restrictions depending on the tax status of the ultimate beneficiary owner

– Investment holding restrictions

– Disclosures requirements once specific holding thresholds have been reached

• Transactions may be subject to additional specific requirements

– Transactions reporting (MiFID, EMIR )

– OTC trades may need to be routed through a CCP

11

A simple example (3/3)

• Mr John Doe holds his securities portfolio with the Retail Bank SA/NV

• The Retail Bank SA/NV will rely on specialised institutions for the asset servicing of the securities held by its clients and the securities held in its own securities trading and investment portfolios

• The Retail Bank SA/NC will engage with a Global Custodian who operates worldwide and who will be able to provide services for securities issued on numerous markets

• The Global Custodian will hold the accounts in the name of Retail Bank SA/NV

– Securities accounts

• Omnibus accounts

• Segregated accounts

– Cash accounts

• The Retail Bank SA/NV and the Global Custodian will however need to ensure that there is clear segregation of the securities belonging to the Retail Bank SA/NV itself (its own securities portfolio) and the securities belonging to the clients of Retail Bank SA/NV

• For each specific market, the Global Custodian has the option

– To have an indirect market access through a Sub-Custodian i.e. a third party provider of assets services on a specific market

– To have a direct market access through a CSD

– The Global Custodian and the CSD will need to ensure the segregation of assets is maintained throughout the custody chain 12

Are there many stakeholders involved in the custodychain…? Yes

Instruction

Broker

Global Custodian

John Doe

CSD

Dealer

Local Custodian

Trade

(Purchase - Sale)

Instruction (Buy)

Instruction

Instruction

Settlement

Instruction

Global Custodian

Instruction

Local Custodian

Instruction

Retail Bank SA/NV

BNY Mellon

Euroclear Belgium/Euroclear Bank

13

European trading and post-trading still very fragmented

TradingOMX

Irish

Stock

exchange

EURONEXT BMEDBAG SIXOSLO

BORS

BATS Chi-X

Turquoise (LSE)

Etc

Clearing

EMCF LCH CLEARNETEure

xNA

X-Clea

rNA

EuroCCP

EMCF

Settle-ment

VP

CBFEUROCLEAR GROUPIber-

clearSIS VPS

Other CSDs

BNY Mellon CSD

Sweden

Finland

Denmark

France

Belgium

Netherlands

Portugal I reland Germany Spain Suisse Norway Pan EuropeanUK Italy

LSE BORSA

Italia

CC&G

MT

14

3. The regulatory framework for the Central Securities Depositories

15

Euroclear Bank regulatory landscape

• Financial Market Infrastructure (FMI) in line with CPMI/IOSCO standards

• Systemically Important Financial Institution (SIFI)in Belgium

• Authorised as EU credit institution and subject to standard banking regulations (Belgian banking law, Capital Requirements Directive…)

• Subject to specific legal and regulatory requirements in its role as a CSD. Will apply for a CSD licence under the EU CSD Regulation

• Designated Securities Settlement System under the EU Settlement Finality directive which aims to reduce the systemic risk associated with participation in payment and securities settlement systems, and in particular the risk linked to the insolvency of a participant in such a system.

• Subject to specific rules on recovery and resolution (BRRD) that aim at continuity of its critical operations in case of financial difficulties (included in the NBL)

16

CPMI-IOSCOPrinciples for Financial Market Infrastructures (PFMIs)

• Objective: to safeguard financial stability

• The PFMIs are part of a set of 12 key standards that the international community considers essential to strengthening and preserving financial stability (FATF principles or G20/OECD principles on corporate governance are part of the 12 as well)

• Not legally binding, but the NBB uses the PFMIs as a framework to exercise its oversight of FMIs

• Issued by Committee for Payment and Settlement Systems (CPSS) bringing together Central Banks and International Organization of Securities Commissions (IOSCO) that brings together the world's securities regulators

• There are 24 Principles applying to all systemically important payment systems, central securities depositories, securities settlement systems, central counterparties and trade repositories.

17

CPMI-IOSCO Some of the 24 principles

18

What they says about compliance? While business-line management serves as the first “line of defence”, the adequacy of

and adherence to control mechanisms should be assessed regularly through independent compliance programmes and independent audits.

An FMI is well placed to observe the performance of its participants and should promptly identify those participants whose behaviour demonstrates a lack of understanding of, or compliance with, applicable rules, procedures, and risks of participation.

The risk of the unexpected application of a law or regulation, usually resulting in a loss.

It can also arise if the application of relevant laws and regulations is uncertain.

It also includes the risk of loss resulting from a delay in the recovery of financial assets or a freezing of positions resulting from a legal procedure.

How do they definelegal risks?

CPMI-IOSCO Focus on Principle 1 – Legal basis

1. The legal basis should provide a high degree of certainty for each material aspect of an FMI’s activities in all relevant jurisdictions.

2. An FMI should have rules, procedures, and contracts that are clear, understandable, and consistent with relevant laws and regulations.

3. An FMI should be able to articulate the legal basis for its activities to relevant authorities, participants, and, where relevant, participants’ customers, in a clear and understandable way.

4. An FMI should have rules, procedures, and contracts that are enforceable in all relevant jurisdictions. There should be a high degree of certainty that actions taken by the FMI under such rules and procedures will not be voided, reversed, or subject to stays.

5. An FMI conducting business in multiple jurisdictions should identify and mitigate the risks arising from any potential conflict of laws across jurisdictions.

19

4. The regulatory framework for Global Custodians

20

Custody Banks can be Different………

• Contrary to CSD’s, no specific regulatory regime – CRD/CRR (The Belgian Banking Act)

• Balance sheet mainly liability driven

• Often act in agency capacity not principal capacity

• No or low number of retail clients

• Non banking activity conducted in a banking entity

• Low levels of “Investment Banking” activity

• EU subsidiaries of US Banks

• Operate as banks, but often viewed as Financial Market Infrastructures

Custody banks are often subject to regulation that is designed to address issues that manifest themselves in activities undertaken by Investment or Retail banks, but doesn’t allow for any proportionate application to Custody Banks or for exemptions to be applied. This can cause difficulties in applying the regulations or result in a disproportionate regulatory burden.

21

5. The inherent compliance risks for CSD’s and global custodians

22

The key compliance risks for CSD’s and global custodians

Domains of higher inherent risk

• AML

– Reliance on a robust chain

• Client Asset Protection

– MiFID Ancillary services

• Competition law

– Limited number of players

• Outsourcing arrangements

• Business acceptance

• Fraud

• Fiduciary risk

Domains of lower inherent risk

• Conflicts of interest

– Network management

• Market Abuse

• FCPA/Bribery

• Data protection

• Data retention

• MiFID

– Investment services

• Tax (special mechanisms)

• Sales and marketing material

23

High Medium + Medium - Low

6. The regulatory change landscape

24

2017

DGSEU

US/Global CRS

SFTR

2016

CSDR Settlement Discipline

AMLD – Anti Money Laundering Directive BRRD – Bank Recovery and Resolution DirectiveCRS – Common Reporting SystemCSDR – Central Securities Depositary RegulationDGS – Deposit Guarantee Scheme

IRRBB – Interest Rate Risk in the Banking BookMAR – Market Abuse RegulationMiFID II – Markets in Financial Instruments Directive IIPSD II – Payment Services Directive IISFTR – Securities Financing Transactions Regulations

UCITS V – Undertakings for Collective Investment in Transferable Securities Directive V

Regulatory Change Landscape

MAR

4th

AMLD

PSD II

Info Accompanying

Funds Transfers

UCITS VLevel 2

Dates listed provide the main implementation date, and it should be noted that there may be additional key dates if implement ation is phased. For some changes dates are not clear yet, so an estimated date based on information available or a planned implementation deadline has been listed. Dates are subject to change.

UCITS VLevel 1

MiFID

I I

2018

BRRD MREL

Decision

NBBIRRBB

Limits to Shadow Banking

25

What is T2S?

• The European Central Bank created a single settlement platform, named TARGET2-Securities (T2S), for the settlement of all European securities against Central Bank Money

• T2S will be launched by country in 5 waves starting in August 2015 running to September 2017

• CSDs will outsource the settlement process to T2S

• Central Banks will outsource the operation of their cash accounts for securities settlement to T2S

• T2S will provide synergies and benefits to the bottom of the value chain

26

Client OptionsA client that wants to access the settlement, servicing and pricing efficiencies that T2S will offer has 3 options:1. He can connect directly to T2S (this is very expensive)2. He can connect via an ICSD (if he is a bank)3. He can connect via a Global Custodian or regional custodian that is directly connected

7. CSD Regulation – The main regulatory challenge for the CSD’s

27

28

The EU Regulatory context

• The EU is implementing around 40 directives and regulations to ensure that all parts of the EU financial markets are regulated consistently and that G20 and Financial Stability Board commitments are implemented.

• Key EU focus has been on

– Capital Adequacy– Regulation of OTC Derivatives and mandatory clearing for some products– Regulation of Hedge Funds and Credit Rating Agencies– Effective Recovery and Resolution of Banks and of CCPs – The creation of a new Eurozone Banking regulator (the ECB) and

– Regulating all forms of trading and post-trading activity

CSD regulation – Regulatory objectives

29

EU CSDs

Financial stability

Safety

Cross-border efficiency

Harmonisation

EU Single Market

Competition and

Consolidation

•A strong and consistent

regulatory framework for

all CSDs

•Reforms of market structure,

Settlement Discipline, T+2

•Allowing EU CSDs to compete

on a consistent regulatory

playing field

•‘Passporting’ rights for CSDs

•‘Freedom of Choice’ for

Issuers

CSD Regulation – Some of the main elements

30

• From Jan 2023 for new securities

• From Jan 2025 for all transferable securities

• Only an issue for the UK and Irish Retail securities markets

• All securities that are traded on a trading venue must be recorded in book entry form in a CSD

• Freedom of issuers to choose their CSD of issuance

Mandatory Dematerialisation and

Immobilisation

• By 1 January 2015

• Already delivered across all the EU T+2 settlement

EU S

ecu

riti

es

Mar

ket

infr

astr

uct

ure

Con

sist

ent

regu

lati

on

of

CSD

s

• To qualify as a CSD, a company must offer 2 out of the following 3 Core Services

► initial recording of securities

► maintaining securities accounts at top tier level,

► operating a Securities Settlement System under the Settlement Finality Directive

(mandatory)

• CSDs can also operate a range of specified ancillary services

• CSDs can also offer limited purpose Banking Services

Definition of a CSD

• Governance rules

• Record Keeping, Outsourcing, Conduct of Business Rules

• Transparency and accounting segregation Rules

• Integrity of the Issue and Asset Protection Rules

• Risk, capital and Investment policy Rules

• Third Country rules

Prudential Requirements

8. The key regulatory changes and their impacts on the Global Custodians

31

Deposit Guarantee Scheme Directive

Summary

The recast Deposit Guarantee Scheme Directive came into effect on 3 July 2015 although not allMember States have yet transposed the Directive. The recast Directive seeks to harmonise thedeposit protection regime across the EU.

Impact for Global Custodians

• Client Base - As EU credit institutions, Global Custodians must adhere to the requirementsand determine whether their clients are eligible for coverage under the relevant depositguarantee scheme. Whilst generally very few clients are eligible for coverage, the work toclassify the client must be undertaken. Clients of Global Custodians generally don’t managethe level of their deposits with their Custodian or other service providers based on thecoverage level offered by schemes like the Deposit Guarantee Scheme, and the protectionoffered by the fund is therefore not always as relevant to them as other factors may be.

• Information provision requirements – the recast Directive requires information to beprovided to clients about the schemes prior to the provision of a deposit account, on depositaccount statements issued to clients or ad hoc mailings. Custody banks often deal withagents that act on behalf of the account holders, which means that an investment managerfor example could be provided with hundreds of letters about the deposit guarantee schemein relation to all of the funds that it manages.

• Technology development – Global Custodians are required to build out reporting capabilitiesrequired by the scheme operators even if the number of clients eligible for the scheme isvery small. This can have significant cost implications.

32

UCITS V

Summary

UCITS V introduced the requirement for UCITS funds to appoint a Depositary and the Directivesets out the standards to which the Depositaries must adhere to.

Impact for Global Custodians

Contracts – the Depositary relationship must be governed by a contract that contains veryspecific information laid out in the Directive. This required existing contracts to be renegotiatedwith clients.

Depositary Liability – if deemed liable for the loss of a custody asset, a UCITS Depositary isobliged to return a financial instrument of the identical type without undue delay. WhilstDepositaries have robust controls in place, this liability has in some cases resulted in capitalimplications under Pillar 2.

Asset Segregation – whilst the debate around requirements to segregate assets under AIFMD andUCITS V continue, the majority of Depositaries are opting to segregate assets through the custodychain. This has resulted in increased costs due to the number of segregated accounts that mustbe opened.

33

Bank Resolution and Recovery Directive

Summary

The Bank Recovery and Resolution Directive (BRRD) introduced new rules which will harmoniseand improve the tools for dealing with bank crises across the EU.

Impact for Global Custodians

Single Resolution Fund – contributions to the Single Resolution Fund (SRF) are based largely onthe level of liabilities a bank has, in addition to a risk based measurement. Global Custody bankscan have significant deposit balances that arise as part of the custody relationship. Usingliabilities as the basis for the SRF calculation can result in custody banks paying significantcontributions that are not reflective of the risk they pose, as the risk based adjustment does notbalance out the high starting point for the calculation based on the liabilities.

Bail-in – Global Custodians generally have none or low levels of clients that are eligible for coverage under the Deposit Guarantee Scheme, and a lot of the deposits on their balance sheet are therefore eligible for bail-in.

MREL – the majority of the Global Custodians are US banks operating through EU subsidiaries and will therefore need to consider MREL and TLAC requirements.

Operational Continuity – Global Custodians play a key role in the market and the regulators and resolution authorities are very focused on ensuring operational continuity in resolution situations.

34

Securities Financing Transactions Regulation

Summary

The Regulation on Transparency of Securities Financing Transactions (SFTR) is aimed at improving transparency in that sector to help identify potential risks associated with the transactions.

Impact for Global Custodians

Agency Capacity – the obligation to report securities financing transactions is on thecounterparties to the transaction. Global Custodians often act in an agency capacity and mayhave to provide additional information to their clients to facilitate their reporting obligations.

35

Limits on Exposures to Shadow Banking

Summary

Pursuant to a mandate in the Capital Requirements Regulation, the EBA issued new Guidelines onLimits on Exposures to Shadow Banking Entities which are expected to come into force after 1January 2017. The Guidelines contain criteria for setting limits to exposures to shadow bankingentities and the policies banks need to have to monitor their exposures.

Impact for Global Custodians

• Client Base - The definition of Shadow Banking entity is quite broad and includes all MoneyMarket Funds, including those that are established as UCITS, certain types of AlternativeInvestment Funds, Special Purpose Vehicles and Financial Institutions that are not establishedin countries that the EU views as having equivalent prudential regulation. The client base ofGlobal Custodians can often feature a lot of these entity types.

• Exposures – Global Custodians don’t generally have significant loan books or investmentportfolios, however exposures can manifest through overdrafts granted to these entities thatarise from time to time to support timely settlement. The need to limit exposures to theseentities to 25% of capital base could cause issues with settlement process as it exists today.

36

Central Securities Depositary Regulation – Settlement Discipline for Global Custodians

Summary

Whilst the Central Securities Depositary Regulation (CSDR) harmonises the authorisation and supervision of EU CSDs, it also introduces settlement discipline measures that are aimed at improving the settlement process that applies to other types of players including the global custodians

Impact for Global Custodians

Cash penalties – CSDR introduces cash penalties for certain failed settlements. Global Custodians as CSD participants will be required to charge their clients. This will require education of clients and also system changes to support the charging mechanism. There are also potential risks to Custody Banks that need to be mitigated to ensure that the timing of charging of fines from a CSD and the collection of the fine from the client does not create risk to the Custody Bank (e.g. Credit or Liquidity Risk)

Settlement Internalisation – where a Global Custodian has clients that are wishing to buy the same securities that another client wishes to buy, a practice called Settlement Internalisation is sometimes followed. This is where the movement of the securities is recorded on the books of the intermediary but instructions are not passed to the CSD. This practice can increase efficiency and reduce costs. CSDR introduces reporting requirements on entities who settle internally. This will potentially increase the cost and reduce the benefits of this practice.

37

9. The need to go beyond the regulatory requirements – The adoption of principles reflecting the specifics of the Global Custodians and CSD’s

The ISSA FCCP

38

ISSA FCCP – The Genesis

Transparency in Securities Processing

Background

Compliance has become a major focus for financial services, but the securities industry has been relatively lightly affected … so far.

There are four trends that have led us to question the compliance framework in which the industry works:

1. Increasing regulatory attention and focus on sanctions enforcement and counter-terrorism measures has led to new standards and processes in correspondent banking. Some of those standards are relevant for us too.

2. Concerns that the lack of transparency in securities trading have led the SEC to adopt new standards that depart from traditional guidance in Rule 613 and the Consolidated Audit Trail.

3. The settlements between US Treasury with Clearstream and BBH with FINRA have highlighted differing expectations between the industry and enforcement authorities.

4. The development of “scanning” practices in securities settlement will lead to significant operational friction if not accompanied by appropriate cross-industry standards.

39

ISSA FCCP – The Issue

What is the Issue?

Transparency in intermediated custody chains

• The global system under which securities are safe kept and settled is based on a clear distinction between beneficial and legal ownership.

• The practice of co-mingling fungible interests brings benefits to the market and to end investors because it creates large economies of scale, low transactional costs and promotes a degree of liquidity and mobility of securities and collateral that has become a cornerstone of market stability.

• To achieve that, the global system intermediates many players into securities custody transforming the legal ownership of securities interests multiple times.

• But the omnibus model also reduces transparency by substituting a record of the end investor’s identity for a record of the custodian’s or the broker’s identity.

40

ISSA FCCP - Introduction

The Compliance Working Group has Developed Principles to Govern Industry Practice

The principles are designed to become the securities equivalent of the Wolfsberg Correspondent Banking Principles.

The Compliance Principles are intended to cover conduct risks in general including measures to counter money laundering, terrorist financing, market abuse, corruption, fraud and the evasion of sanctions.

The Principles provide market participants with practical guidance on the question of transparency of ownership and control in intermediated securities custody arrangements.

41

ISSA FCCP - Content

Compliance Principles for Securities - Key Features

A Broad Scope

• The principles should apply globally to financial institutions active in the intermediation of securities.

Addressing Transparency

• The Principles aim to address the question of transparency of ownership interests because this is what distinguishes securities from other branches of financial services.

A Focus on Cross-Border Settlement and Custody

• The Principles focus on cross-border custody. However, the compliance principles that govern cross-border custody cannot be fully dissociated from purely domestic arrangements involving domestic investors holding domestic instruments denominated in the national currency.

Driven by Standards

• The Principles are driven by standards rather than information. Information is used to verify compliance with standards.

Retaining the Benefits of Current Practice

• The Principles do not question or influence the validity or fitness for purpose of the different legal mechanisms for vesting ownership interests. The aim is to future-proof the legal structures that we have.

42

ISSA FCCP - Content

Standards Drive the Principles

1. It is the responsibility of the Custodian to communicate its KYC standards and other requirements to its Account Holders.

2. It is the responsibility of the Custodian's Account Holder to comply with those requirements.

3. Where the Account Holder has clients who themselves accept deposits of third party client securities, the Account Holder should notify those clients that by holding securities cross-border they will be subject to the requirements of the jurisdictions in which the securities entitlements are held, including the standards of the relevant Custodian(s).

4. It is the responsibility of the Account Holder to sub-deposit securities with the Custodian only when the Assets Beneficial Owners have been subjected to satisfactory due diligence. On a risk-led basis, the Custodian should be entitled to verify that its due diligence requirements have been met.

43

Sub-Custodian Custodian

10. Conclusions

44

Conclusions

• The compliance challenges are less driven by conduct regulation but more by prudential requirements

• No or very little interactions with retail customers

• Regulation and supervisory oversight model not always adapted to the business model

• The custody industry has to position itself and propose best practice principles

• Regulatory relationship is key

45

Thank you

• Olivier Goffard

+32 (0)2 326 10 27

olivier.goffard@euroclear.com

• Denis Caprasse

+32 (0)2 545 89 34

Denis.caprasse@bnymellon.com

46