CSDs and Participant Default

Abstract

Since the financial crisis there has been an increase in the degree and detail of regulation of CSDs, which are rightly recognised to be a core component in the smooth functioning of the financial system. One feature of the regulation of CSDs, as with other types of financial market infrastructure, is the requirement for default rules. The principal actions of a CSD when faced with a participant default will be to freeze the defaulter’s accounts and cancel processing of unexecuted instructions. These actions are intended to protect the settlement system, and also appear to be a response to insolvency laws which disallow movements of an insolvent entity’s property.

But the nature of ‘default’ has also changed since the crisis. In particular, there are new ways of dealing with failing firms, through resolution. This paper argues that how CSDs should react to the failure of a participating financial institution has lagged behind developments in the handling of financial firm failures. In particular, the freeze-and-cancel principle seems less necessary in the context of modern settlement processing, and at odds with the objective of resolution, which is to continue, or restore, critical functions without undue fuss or delay. Given that at least some participants in CSDs are intermediaries, whose accounts contain securities belonging to customers, the policy of freeze-and-cancel could add to the disruption caused by a firm’s failure rather than reduce it.

The paper argues that there is no need for freeze-and-cancel as regards client securities, or even proprietary assets. Furthermore, the process of resolution, which commonly involves the transfer of client-facing functions to a ‘bridge bank’, seems not to be fully catered for in CSD default or membership rules. Trying to create new arrangements in an emergency over a resolution weekend seems a poor way to achieve continuity. It is therefore suggested that CSDs should overhaul their approach to membership in relation to bridge banks, and facilitate the transfer of client accounts during resolution.

Keywords: Central Securities Depositories, bank resolution, freeze, default rules