Securities settlement: the guessing game
Just as most securities trading in the front office is based on guessing, considerable effort in the post-trade securities environment is devoted to guessing the outcome of regulations and industry initiatives. But regulations in particular can have unintended consequences and in Europe harmonisation efforts have run up against national protectionism. Those who try to predict the future do so at their own peril.
The European Central Bank’s (ECB’s) Target2-Securities (T2S) was conceived as a platform to enable central securities depositories (CSDs) to use a common technical service that would execute settlement instructions. T2S will provide delivery versus payment for securities against central bank money. CSDs will maintain their relationships with intermediaries, investors and issuers, as well as their asset servicing function (such as the management of corporate actions), according to the ECB. Once the post-trade industry overcame the shock of the idea a central bank was building a settlement system, the guessing game began.
Initially this was of the “it will never happen” variety; akin to closing one’s eyes and hoping something nasty will go away. However, the ECB ploughed on and seven years after its decision to put T2S into development the industry seems to have finally accepted the reality of T2S. Along the way there have been complaints by CSDs about discrepancies in the regulatory treatment of different T2S participants, speculation that the number of CSDs would fall and suggestions that many financial institutions would become direct connectivity participants (DCP), thus bypassing agent banks.
T2S is an important project for the Eurosystem and for Europe and will affect every participant in the post-trade space. It will become a key component of the European market infrastructure and is designed to address the costly fragmentation of securities settlement market infrastructure. Put simply, the core intention of T2S is to enable efficient and integrated securities settlement.
At an address in Frankfurt during May 2012, which marked the first CSD signings of the T2S Framework Agreement (which sets out the rights and obligations of the CSDs under T2S), Mario Draghi, ECB president, said: “The fundamental objective of T2S is to contribute to making Europe a better place to invest, by fostering a single market in post-trade services. It will make financial markets safer and more efficient, and it will increase transparency in the post-trade environment.”
Draghi pointed up that financial market integration must be complemented and supported by the integration of the underlying infrastructure – T2S brings an operational dimension to integration. It provides the integrated infrastructure necessary for creating a single market for settlement services in Europe.
In theory, this should lead to commoditisation of securities settlement processing and considerably lower costs. Additionally, an integrated funding process from a single liquidity/collateral pool will deliver material efficiencies to the industry.
“T2S is a very disruptive initiative, but it is needed,” says Ronny Cosijns, partner at Capco, a global business and technology consultancy. “The European post-trade securities environment is like a ‘dinosaur industry’ and there are too many vested interests.”
Such vested interests have perpetuated the existence of around 30 CSDs in Europe, a fragmentation that has made securities settlement costly, particularly compared to the US market. One of the main topics of conversation regarding T2S has been the idea that it will lead to a reduction in the number of CSDs. To date this hasn’t happened and indeed recently the number of CSDs has increased.
CSDs are not only facing changes as a result of T2S, but are also the subject of the latest piece of regulation from the European Commission, the CSD Regulation (CSDR). This aims to create a pan-EU status for CSDs, common governance rules and allow issuers of financial instruments to choose where to settle, regardless of the location of the CSD. The regulation introduces an obligation of dematerialisation for most securities, harmonised settlement periods for most transactions in such securities, settlement discipline measures and common rules for CSDs. The proposal is under consideration by the European Parliament and the Council.
Among the proposals are the harmonisation of the settlement period to a maximum of T+2, the imposition of penalties on market participants that fail to deliver their securities on the agreed settlement date, user choice in terms of which CSD they can settle in and a passport for authorised CSDs, which will enable them to provide their services in other member states.
Together, T2S and CSDR are transforming the European post-trade landscape. There are different business models being mulled over by global custodians and CSDs. T2S is purely a settlement platform; asset services such as corporate actions processing are not included. Custodians may decide to change nothing and continue with existing subcustody networks. Alternatively, they may retain subcustody networks but consolidate how many providers they use in Europe. There is also the possibility to operate on an account operator basis whereby they have their own account within T2S that is either operated by one or more subcustodians, or by themselves. Finally, they may opt for direct participation (DCP) and build a complete solution for T2S.
Received wisdom has it that the pricing dynamic that is introduced by T2S will affect the subcustodian business and there will be consolidation. Custodians that are active in only one market will find it increasingly challenging to profitably deliver competitive services to their customer base and are likely to reconsider their continued roles in this industry.
This view is, unsurprisingly, promoted by the larger custody banks. But to date very little change has occurred and in reality consolidation of custodians is a concept that has been discussed for more than a decade.
There have been recent moves, but not many. In April, Citi Securities and Fund Services entered into a definitive agreement to acquire ING’s custody and securities services business in seven Central and Eastern European markets, representing €110 billion in assets under custody. If approved by regulators, the transaction will include ING’s local custody and securities services businesses in Russia, Ukraine, Bulgaria, the Czech Republic, Hungary, Romania and Slovakia.
The idea that CSD numbers would consolidate as a result of T2S is another one that hasn’t yet been proved correct. Earlier this year BNY Mellon announced the formation of its own CSD as a result of the changes coming to the post-trade environment.
“T2S is clearly a game changer for the industry, fundamentally altering how market participants interact with the European market infrastructure,” says Nadine Chakar, executive vice-president, head of product strategy, global collateral services at BNY Mellon. “As a result, it will have an impact on the business models of all those participants, including (international) central securities depositories, subcustodians, global custodians and multi-direct clearers.”
While the harmonisation around settlement facilitated by T2S should enhance the service that clients receive in that area, for T2S to be a complete success, there also needs to be harmonisation on portfolio servicing – tax, corporate actions and proxy voting, for example. The regulators are also keen for competition in this area to improve servicing.
BNY Mellon received regulatory approval to launch its Issuer Central Securities Depository (CSD) in early 2013. The CSD, BNY Mellon CSD SA/NV, is designed to offer issuer, settlement and safekeeping services for all market participants across Europe and the wider global marketplace. It will provide users with access to integrated services across the full spectrum of the securities value chain, which will allow them to accommodate new requirements mandated by, for example, the European Market Infrastructure Regulation (Emir).
Emir requires margin and default contributions that are posted to a central counterparty (CCP) to be held with a securities settlement system where possible. The London Stock Exchange Group is taking advantage of this requirement by establishing a new CSD in Luxembourg. JP Morgan’s collateral management business has selected the new CSD to provide settlement, custody and asset servicing services.
“The entry into the CSD market by commercial banks was not anticipated by many people,” says Diana Chan, chief executive of EuroCCP. “If effective competition among CSDs happens, commercial realities will lead to concentration. But it will be a few years before they do compete on a level playing field. At the moment, national company laws effectively require issuers to use a CSD in their home country, so we don’t yet have true competition.”
The CSDR will provide a regulatory environment for effective competition, she adds. But until it comes into effect, CSDs can raise prices by imposing a surcharge for T2S settlement without necessarily losing market share.
Bruce Babcock, head of global proxy business development at Broadridge, says at the CSD12 conference in Saint Petersburg earlier this year, it was clear many CSDs have realised acquisition is difficult because of the many national interests in place across Europe. “To maintain relevance as a CSD, organisations need local expertise combined with cross-border capabilities. For this reason, I think the future will be characterised by collaboration.”
Many of the smaller CSDs, says Babcock, are developing their own capabilities, such as collateral management, in order to stay relevant. As they move into the global custody space, so too are global custodians moving into the CSD space. The big question for subcustodians is how they provide value in the post T2S world when settlement is commoditised and their clients may want to undertake settlement themselves.
Paul Symons, head of public affairs at Euroclear, says CSDs in Europe are being hit simultaneously by one of the biggest IT structural changes in the form of T2S and by regulatory change via CSDR. “As part of CSDR, all CSDs will have to introduce settlement discipline regimes, which will require additional technical changes for CSDs. It also represents a big structural change in market practices as well. This is a challenging environment for market participants and financial authorities.”
Symons questions the capacity for domestic CSDs to innovate in an environment of such change. “All of the various mandatory initiatives are consuming IT and human resources at CSDs. At the domestic level, CSDs are mainly reacting to these changes to the system, rather than innovating.”
This is occurring in a much more competitive landscape, as many of the initiatives are designed to open up competition for CSD services. “CSDs are losing control of their core settlement services so must look elsewhere for revenues. They could consider servicing a wider range of securities, providing more issuer services, and/or develop collateral management services.”
However, says Symons, some time in the future there will be consolidation. In the short-term, the perverse effect of new regulations like Emir and the Alternative Investment Fund Managers Directive has been that some commercial entities have converted into CSDs. “This is a new world of regulatory change, structural intervention, market change and competition for CSDs – some of it from their large customers. During the next three to four years, the world will change substantially for CSDs.”
It’s a whole new world of change for banks, too. The possibility of becoming a DCP – connecting directly to T2S in order to settle securities transactions themselves – was originally mooted as the way most large banks would go. However reality has set in for some.
“To begin with, all of the CSDs and many central banks will be direct participants along with some of the very large custodians,” says Harry Newman, head of market initiatives, Emea, at Swift. “Quite a few banks will sit on the fence and wait to see how T2S works before they decide whether to be a DCP. I think many institutions have realised the cost of direct participation is not insubstantial. Over time, it is possible that the large custodians will want to process their own transactions on T2S and will opt for direct connectivity. Meanwhile, a larger group of financial institutions with cash accounts in Target2 will look for a similar arrangement in T2S, but will have a slimmer connection and will leave the processing to another organisation, such as the larger custodians and CSDs.”
T2S is resulting in a huge upfront cost to the industry, says Richard Scavetta, T2S programme director at Citi. “This in turn will drive consolidation as smaller players will not find it economically rational to invest.” In the short to medium term, he says, the impact of T2S may be somewhat disruptive as the industry works through the build, testing and migration phases. “T2S must achieve its goal of serving as a catalyst for harmonisation if the industry is ever to recover its investment. One encouraging example is in the drive towards T+2 settlements across Europe. Another area is the good work coming out of the Corporate Actions Sub-Group. But ultimately the markets will need to achieve a much greater deal of harmonisation if T2S is to live up to its potential.”
Robert Almanas, managing director for international services, SIX Securities Services, says much of the strong interest to be a DCP has dropped off significantly among banks. “When financial institutions originally thought of the costs involved in T2S the big headline was that costs would go down. But now they are looking at the total cost of ownership, rather than just an explicit settlement fee. The fact that interest in DCP is waning suggests that they are looking more closely at the all-in costs for adaptation.”
As banks work more closely with infrastructures they are asking questions about how these organisations are adapting their systems for T2S. “If you expect to connect to T2S through a domestic relationship and want to use that relationship for settlement and custody in other assets and markets that will involve a strong element of asset servicing,” he says. “The question to ask is whether that domestic provider has the capability of providing these services at a fair price.”
Graham Ray, director, global product management, direct securities services for Deutsche Bank says there is a small number of banks interested in becoming DCPs. However, these institutions are evaluating how this connectivity channel changes their existing investor services relationships. “If a bank is a DCP but still uses a local subcustodian for certain value-added functionality, it needs to analyse the optimal messaging flow to ensure it is not duplicating efforts and increasing costs.”
Ray says the analysis should also consider consolidation for settlement and the subsequent management of inventory for asset servicing. “This operating model will raise questions whereby transactional and positional message flows will need to be considered, but here is where a subcustodian adds value to the client relationship by providing the solutions to achieve optimal and cost-effective flow of data.”
Says Guilliame Heraud, global head of business development for financial institutions and brokers at Société Générale Securities Services: “Some institutions with high volumes will have real interest in settling directly through T2S. But at the same time they don’t want to manage asset servicing, so could opt for a solution where they use local custodians or outsourced solutions.”
T2S renews interest for banks to have local networks, because as settlement becomes more harmonised, asset servicing will consume a larger part of the securities value chain. “By having a local capability, you will be able to provide more value in your offerings,” he says.
Capco’s Cosijns sees some worrying developments when it comes to asset servicing in T2S. “Some global custodians are arguing for localisation as their business models have been built on the inefficiencies across different markets. They are trying to say that even with T2S, banks will need local custodians; that is not the approach the EC wants. The EC wants a single settlement platform, with direct access, to reduce end to end post-trade costs. Continuing with local custodians should not be the end goal. Uncertainty over this is why there is some inertia among banks regarding T2S moves.”
There are also problems related to the fact that T2S addresses only securities settlement and not asset servicing. “Institutions looking to access the European securities markets are looking for post-trade services that cover both settlement and asset servicing. At the moment, the CSDs have failed to document their service offerings for markets beyond their home ones, but their clients want these services across Europe.”
Heraud also points up the problems with this separation of settlement and asset servicing. “T2S is an opportunity for us to review our organisation and the way we access infrastructures and our settlement processes. There will be the need for more automation and centralisation. We can work on harmonising settlement, but at the same time T2S doesn’t touch on asset servicing. As a result we have to globalise the way we manage settlement processes, but combine that with managing asset servicing at a local market level. Integrating the two spaces is complex but this is the condition for making the most of T2S.”
For some custodians and CSDs there will be business to be made from screening their clients from the impact of T2S, because very few players want to make the changes necessary, says Swift’s Newman. “By providing a single settlement platform for securities transactions in euros, T2S should enable more information flow between the CSDs and custodians and their clients. This will be of interest to risk managers and also will enable stronger harmonisation. But there will be many who will seek to protect themselves from an investment spend – the longer they are screened from this necessity, the more time it will take for harmonisation benefits to come through.”
Earlier this year Clearstream released results of a survey conducted at a T2S conference in Frankfurt. More than half of the delegates, representing banks and financial services providers as well as securities settlement experts from the German market, said they believed T2S would offer totally new business opportunities.
Stefan Lepp, chief executive of Clearstream Banking AG, said at the time: “T2S entails investments of several hundred million euros, not only for the Eurosystem but also for market participants across Europe. It is in all our interests to ensure the numerous advantages offered by T2S become a reality.”
Others are also detecting a more positive attitude towards T2S. Says Chan: “When T2S was first mooted, everyone focused on the savings and cost benefits. But now a few people are talking about the opportunities for new business models, which is fantastic. T2S, Emir, the CSDR, are combining to enable more efficient business models and services to be developed.” These new services include collateral transformation and transportation. This also gives rise to collateral reporting, via the establishment of collateral reporting warehouses where information is consolidated to enable firms to track their collateral.
“T2S is a platform that will allow collateral to move seamlessly. As a result, organisations are devising collateral services that were just not possible without T2S. Since the crisis, financial regulators and market participants are wary of a Lehman Brothers-type scenario so counterparty risk awareness is heightened. More transactions now have to be collateralised,” she says.
Rob Mason, head of Emea securities operations, at Royal Bank of Scotland, says T2S will provide some very tangible benefits for Europe as a whole. “If it is simpler to trade and then settle trades in Europe, via a robust and efficient system such as T2S, we may well attract foreign investment from markets outside of Europe. At present, empirical evidence suggests it costs around four times as much to settle securities trades in Europe as it does in the US; investors tend to put their money where they get the greatest return and these transactional costs erode returns.”
Moreover, because of the single settlement framework, securities investments may be spread more evenly across Europe, rather than being focused in the large countries. “T2S might create a more level playing field. An investor can use his or her investment funds for securities in newer markets like Lithuania, for the same cost as in markets, such as Germany.”