What is a buy-in, and how do they work? What is cash compensation? The challenges of buy-ins and cash compensation CSDR Level 1 and mandatory buy-ins The Level 2 ESMA Consultation Paper: the 3 options for a buy-in mechanism The challenges with the options Conclusion (the need to amend the Level 1 text) CSDR Mandatory Buy-ins

1. The post trade challenges of implementing CSDR settlement discipline:
Mandatory Buy-ins
Post Trade Forum & Trade Show
Vienna, September 10th 2015
Andy Hill

2. Overview
 What is a buy-in, and how do they work?
 What is cash compensation?
 The challenges of buy-ins and cash compensation
 CSDR Level 1 and mandatory buy-ins
 The Level 2 ESMA Consultation Paper: the 3 options for a buy-in mechanism
 The challenges with the options
 Conclusion (the need to amend the Level 1 text)
CSDR Mandatory Buy-ins

3. What is a buy-in and how do they work?1
 A buy-in is a contractual remedy in the event of a settlement fail
 It provides the purchasing (failed-to) counterparty with the right to obtain the securities
from a third party (via a buy-in agent)
 The original transaction is then canceled and any differences in price (or costs) settled
between the original two counterparties
 The objective is to restore both counterparties to the economic position they would have
been in, had the original transaction settled as intended
1See also: Buy-ins, how they work, and the challenge of CSDR
CSDR Mandatory Buy-ins

4. Examples of the buy-in process
CSDR Mandatory Buy-ins
Figure 1: the original transaction
100 Bonds
98.50
Figure 2: a standard buy-in
100 bonds 100 bonds
0.75 99.25 99.25
A
BA Z
B
Market

5. Examples of the buy-in process
CSDR Mandatory Buy-ins
Figure 3: a standard buy-in where the buy-in price is below the original transaction price
100 bonds 100 bonds
0.50 98.00 98.00
A B Z Market
Figure 1: the original transaction
100 Bonds
98.50
A B

6. Examples of the buy-in process (‘pass-ons’)
CSDR Mandatory Buy-ins
Figure 5: settling the buy-in chain
Pass-on 100 bonds 100 bonds
0.75 0.50 99.25 99.25
A B C Z Mar-
ket
Figure 4: original inter-connected transactions
100 bonds 100 bonds
98.50 98.75
A B C

7. The cost of being bought-in: the buy-in premium
CSDR Mandatory Buy-ins
Figure 1: the original transaction
100 Bonds
98.50
A B
Figure 6: the cost to the failing counterparty due to the buy-in premium
100 bonds 100 bonds 100 bonds
99.00 0.75 99.25 99.25
A MarketB ZMarket

8. Cash compensation
CSDR Mandatory Buy-ins
Figure 1: the original transaction
100 Bonds
98.50
A B
Figure 7: cash compensation where the reference price is higher than the original transaction price
0.75 99.25
Figure 8: cash compensation where the reference price is lower than the original transaction price
0.50 98.00
BA Market
Price
BA Market
Price

9. The challenges of buy-ins and cash compensation
 The buy-in process can be time consuming for all counterparties concerned
 Finding buy-in agents can be difficult, particularly as there is little incentive and no
obligation
 Buy-ins can has a distortive impact on market pricing, mainly due to required premium
and signaling of ‘distressed buyer’
 Where the buy-in price is significantly higher than market, this can lead to disputes
 Buy-ins are not always executable, particularly where securities are illiquid
 Buy-ins may not be enforceable in some jurisdictions
 Setting the cash compensation price can be contentious
 Cash compensation can disadvantage the failed-to purchaser
CSDR Mandatory Buy-ins

10. CSDR Level 1 (Article 7) and mandatory buy-ins
CSDR Mandatory Buy-ins
 A buy-in process must be initiated after 4 days of failing from intended settlement date (7
days for less liquid securities, and 15 days for SME instruments)
 What a buy-in is, or its purpose, is not defined
 Buy-ins are executed at the CSD participant level (which in most cases will not be the
same as the trading counterparties)
 If the buy-in is unsuccessful (with the opportunity for deferral), cash compensation shall
be applied
 Where the buy-in price is lower than the original transaction price, the difference is paid
to the receiving participant by the failing participant (i.e. the ‘wrong-way round’).
 The start legs of securities financing transactions are brought into scope (except for very
short-dated SFTs)

11. The challenges of CSDR mandatory buy-ins
CSDR Mandatory Buy-ins
 How to replace a contractual right of trading counterparties with a mandatory obligation
of ‘participants’ who are not party to the original transaction?
 How to ensure enforceability against counterparties outside of the EU (and preserve a
level playing field)?
 How to manage and mitigate risks to both the trading counterparties and the CSD
participants?
 How to ensure that the provision to pay the cash difference in the wrong direction (a free
‘put’ for the purchaser) does not lead to market manipulation?
 How to manage thousands of buy-ins being initiated every day?
 How to preserve market liquidity and stability2?
2 See: CSDR Mandatory Buy-ins Impact Study

12. ESMA Consultation Paper on the Operation of the Buy-in Process (Level 2)
CSDR Mandatory Buy-ins
 In August 2015, stakeholders were asked to respond on three options for a buy-in process
put forward by ESMA:
(i) Trading level execution
(ii) Trading level with fall-back execution
(iii) CSD participant level execution

13. CSDR Level 2 buy-in options
CSDR Mandatory Buy-ins
Original transaction
Trading
Venue
Level
Trading
Counterparty
Level
100 bonds
98.50
CSD
Participant
Level
CSD
Level
A B
Trading
Venue
Partici-
pant X
Partici-
pant Y
CSD

14. CSDR Option 1: trading level execution
CSDR Mandatory Buy-ins
Trading level buy-in
Trading
Venue
Level
Trading
Counterparty
Level
100 bonds 100 bonds
? Buy-in Px Buy-in Px
CSD
Participant
Level
CSD
Level
A B
Trading
Venue
Partici-
pant X
Partici-
pant Y
CSD
Z Mark-
et

15. CSDR Option 1: trading level execution
CSDR Mandatory Buy-ins
Trading level buy-in: cash compensation
Trading
Venue
Level
Trading
Counterparty
Level
? Reference Px
CSD
Participant
Level
CSD
Level
A B
Trading
Venue
Partici-
pant X
Partici-
pant Y
CSD
Mark-
et

16. CSDR Option 1: trading level execution
 Similar to how buy-ins are executed today
 Minimizes risks for both trading counterparties
 Does not involve participants who are not party to the original transaction
Disadvantages
 Mandatory cash compensation still creates risk for purchasing (failed to) counterparty
 May be difficult to enforce
 May be illegal under CSDR Level 1
CSDR Mandatory Buy-ins
Advantages

17. CSDR Option 2: trading level with fall-back execution
CSDR Mandatory Buy-ins
Trading level with fall-back option: buy-in
Trading
Venue
Level
Trading
Counterparty
Level
100 bonds 100 bonds
? Buy-in Px Buy-in Px
CSD
Participant
Level
CSD
Level
A B
Trading
Venue
Partici-
pant X
Partici-
pant Y
CSD
Z Mark-
et

18. CSDR Option 2: trading level with fall-back execution
CSDR Mandatory Buy-ins
Trading level with fall-back option: cash compensation
Trading
Venue
Level
Trading
Counterparty
Level
CSD
Participant
Level
? Reference Px
CSD
Level
A B
Trading
Venue
Partici-
pant X
Partici-
pant Y
CSD
Mark-
et

19. CSDR Option 2: trading level with fall-back execution
 Buy-in process at the trading level (same as today)
 Cash compensation ‘fall-back’ ensures enforceability (albeit at participant level)
Disadvantages
 Fall-back option of cash compensation at participant level creates additional risk for
purchasing (failed to) counterparty
 Fall-back option of cash compensation at participant level creates additional risk for
selling (failing) counterparty
 Fall-back option of cash compensation creates risk for the delivering participant (and a
potential need for collateralization of deliveries)
 May also be illegal under CSDR Level 1
CSDR Mandatory Buy-ins
Advantages

20. CSDR Option 3: CSD participant execution
CSDR Mandatory Buy-ins
CSD participant level buy-in
Trading
Venue
Level
Trading
Counterparty
Level
CSD
Participant
Level
100 bonds 100 bonds
? Buy-in Px Buy-in Px
CSD
Level
A B
Trading
Venue
Partici-
pant X
Partici-
pant Y
CSD
Z Mark-
et

21. CSDR Option 3: CSD participant execution
CSDR Mandatory Buy-ins
CSD participant level cash compensation

22. CSDR Option 3: CSD participant level execution
 Consistent with the Level 1
Disadvantages
 Creates additional risk for the purchasing (failed to) counterparty
 Creates additional risk for the selling (failing) counterparty
 Creates risk for the delivering participant (and a potential need for collateralization of
deliveries)
 Creates risk for the receiving participant (and a potential need for collateralization or pre-
payment of receipts)
CSDR Mandatory Buy-ins
Advantages

23. Market risk profile of the three options
CSDR Mandatory Buy-ins
Option1
Option2
Option3
Purchasing counterparty
Selling counterparty
Receiving participant
Delivering participant
No additional risk
Some additional risk
Significant additional risk

24. Timeline
CSDR Mandatory Buy-ins
 End of September 2015: ESMA was due to submit finalized draft RTS to the EC3
 Trialogues between the Commission, Parliament and Council to finalize the RTS in Q4 of
2015
 Level 2 to be passed into law by end of 2015, and effective early 2016
 An 18-24 month delay in implementing settlement discipline measures expected
3 The draft RTS specific to mandatory buy-ins are now expected to be delayed until November 2015

25. Conclusion
CSDR Mandatory Buy-ins
 Buy-ins are a contractual remedy available to trading level counterparties in the event of
a settlement fail. They are usually a right, and are not intended to penalize the failing
counterparty.
 CSDR makes buy-ins a mandatory obligation, rather than a contractual right
 CSDR places the buy-in process at the CSD participant level, and not necessarily at the
trading counterparty level
 CSDR fails to define what a buy-in is, or its purpose, and seems to turn it into a penalty
mechanism, rather than a contractual remedy
 There is growing pressure from the market for the Level 1 text to be reviewed

26. Questions
CSDR Mandatory Buy-ins

27. About the author/presenter
 Andy Hill is a Director in ICMA’s Market Practice and Regulatory Policy group. For
seventeen years he has been a repo and money-market trader, and for ten years he was
an Executive Director at Goldman Sachs. He has also worked as a consultant in the Aid
and Development sector, primarily based in Cambodia, and previously served on the
Board of the Cambodian NGO Education Partnership in Phnom Penh while under a
Goldman Sachs Public Service Fellowship. He holds a BSc (Hons) in Business Studies from
Cass Business School and an MSc in Poverty Reduction and Development Management
from the University of Birmingham.
 Email: andy.hill@icmagroup.org
CSDR Mandatory Buy-ins