There is a long five years before the European Central Bank’s Target 2 Securities, which looks to create a single settlement layer for cross-border securities transactions in Europe, comes to pass. At the same time, the EC is demanding that the barriers to efficiency identified by the Giovannini Group be addressed by free market solutions. The central securities depositories (CSDs) across the Continent face an uncertain future where the separation of their asset servicing businesses from their settlement revenues puts them in direct competition with custodians.
Aware that they face great challenges to their deep-rooted business models, a group of CSDs across Europe have announced a new venture to cooperate on cross-border business, but it remains to be seen if their approach, and those of their competitors, can shield them from the coming changes.
Launching in the first quarter of 2009, Link Up Markets is a joint venture between Germany’s Clearstream, the Hellenic Exchanges Group of Greece, the Swiss group SIS, Denmark’s VP Securities Services, Norway’s VPS, OeKB of Austria and the Spanish company Iberclear.
The partners will develop an ‘adaptor’ for the clearing links between the CSDs, so rather than maintaining six connections, one with each partner, they will have one, to the central translator, Link Up Markets. The eventual goal is that Spanish investors can access Danish securities through the Spanish infrastructure and vice versa.
It is, says Tomas Kindler, CEO of Link Up Markets, “a showcase for horizontal interoperability” that can deliver cost savings of up to 80 per cent for cross-border transactions.
“You have to see Link Up Markets in the context of the ongoing initiatives, be it self-regulatory, be it public or be it regulatory,” says Mr Kindler. “We clearly see Link Up markets as a facilitator to these initiatives. First of all, they all have a common goal: integrating European financial markets, increasing efficiency, etc.”
In fact, the initiative will “heavily leverage” Target 2 Cash, the precursor to T2S that ad
dressed cross-border cash business.
Need to adapt
Target 2 Securities aims to put in place a single settlement platform for use by member CSDs, theoretically decreasing their operating costs and allowing for reductions in cross-border fees. Though, as Mr Kindler explains, there is a significant downside for CSDs, as they necessarily lose their settlement revenues.
“What’s going to happen with Target 2 Securities is that settlement and central bank money will be centralised on a single technical platform run by the Eurosystem, so the CSDs in the Eurozone, those who are going to participate…will lose 30-50 per cent of their revenues typically associated with settlement,” Mr Kindler says.
“And in order to survive, they have to change their business model. They have to become, basically, custodians, in the sense that they have to service foreign securities i.e. they have to build up cross-border servicing capabilities.
“When you listen to the ECB, they specifically invite the CSDs to compete, to move up the value chain and to service whatever assets are in the scope of Target 2 Securities,” he adds.
Link Up Markets, Mr Kindler says, is a project designed to enable those seven CSDs to do just that, simplifying the cross-border settlement interactions between them. “From a CSD perspective, right now I think there are three ways to do it,” he adds. “You can join Euroclear’s platform insourcing. That, in a nutshell, means you end up with an empty shell as a CSD.
“The second way is that you can go to bed with agent banks, there’s at least one example, Monte Titoli, which have RFP’ed their still-to-be-built-up cross-border business among agent banks. And now you have Link Up Markets, which is an equal partnership of members on the same level, and it allows you to transform your business while maintaining it.
“We are planning to deliver the first phase in 2009, which means that the CSDs have at least four years to prepare for Target 2 Securities… So we can assume that the participating CSDs have understood the need to change their business models in order to survive in the long term.”
Treading on T2S’s toes
While it is clear that Link Up owes it existence to T2S, some analysts have noted that this initiative, and Euroclear’s, appear to step onto T2S’s turf. Mr Kindler insists that this is not the case. The single platform will simply replace the various local settlement engines at the CSDs, if they sign up to T2S, that is.
“Of course, each individual CSD has its own positioning vis-à-vis the Target 2 Securities project and will decide on its own whether to join or not in accordance with its customers, et cetera. What Link Up Markets is not is an agreement that we’re all going to join Target 2 Securities. That’s up to the individual CSDs,” Mr Kindler says.
Denis Peters, Euroclear’s spokesman, says of the Link Up Markets initiative: “The goals of what appears to be an order- routing joint venture are to be applauded as we believe market-led efforts to reduce settlement costs in Europe are the best way forward.” Euroclear is consolidating the platforms of the French, Belgian, Irish, Dutch and UK CSDs. While this has required considerable capital investment, it does seem to present a more obvious route to reducing operational costs than Link Up Markets’ model.
As Mr Peters says, “we believe that platform consolidation is the most meaningful step in delivering sizeable savings since it is key in eliminating duplicative systems and running costs.”
It is a consideration that others have noted. As Andrew Howieson, MD at Tabb Group, the consultancy, notes: “I’ve heard [Link Up] described as more of a routing initiative. In other words, allowing the different front end mechanisms to accept settlement instructions and pass them between the people who are participating in this initiative, instead of being a fundamental change in the platform or in the practices underlying the platform. And I must say, that in that situation it’s hard to see how the fundamental cost structure can be addressed.
“Euroclear have been working for several years now on what, on the face of it, could be a very similar initiative. They’ve been looking to harmonise settlement practices across the markets that they serve,” Mr Howieson adds. “This could be a parallel to that, and they both, in a sense, are parallel to Target 2 Securities.”
Euroclear’s position on T2S is long stated and, if not controversial, certainly not the wholehearted support that the ECB would have liked. In creating a single platform, the company seems to have created that shared settlement engine that the ECB is looking to build.
“Euroclear does not disagree with the objective of T2S, i.e. to reduce cross-border settlement costs,” says Mr Peters.
“However, since T2S was announced in 2006, we continue to seek clarity on critical issues relating to this approach, namely, the benefits of separating asset servicing from settlement, the totality of costs, the allocation of risks and liabilities between participants, the system’s governance and economic feasibility, among others,” he continues.
“Euroclear remains neutral on T2S and is open to convincing arguments offered by the European Central Bank to decide, in consultation with our users/owners, whether to join T2S or not.”
Wait and see
Euroclear will take the same wait and see approach on whether it should take up Link Up Market’s offer to collaborate. “As we were not initially invited to join Link Up Markets, we look forward to learning more about it,” Mr Peters says.
“We are interested in understanding how much cross-border business flows between these CSDs, how this initiative compares with T2S, how the joint venture will bring down the cost of cross-border settlement by 80 per cent, as stated in the announcement, without eliminating platforms or harmonising market rules and practices across these markets,” he adds.
Link Up Markets’ Mr Kindler warns that the 80 per cent is a theoretical maximum, based on how the member organisations choose to price their new services. “In the end,” he says, “all of the commercial aspects are up to them.”
Unspoken as it may be, the reality is that they will seek to offer cost savings through the disintermediation of the pan-European custodians that currently own the cross-border space. Officially at least, most of the major custodians have said that they support the goals of T2S, and initially it is hard to see why, since a significant slice of their existing business is predicated on complexity.
T2S is supposed to iron out those difficulties, but, as Alain Closier, global head of Société Générale Securities Services, notes, there is still a long period of uncertainty before the project comes to fruition.
“T2S is expected to become live in 2013: this date is important and has to be borne in mind, as well as the fact it remains distant,” he says. “Six to seven years represents a long period of time, and this fact has to be taken into consideration when looking at consolidation of European Infrastructures, even if this initiative is a key aspect of this movement of restructuring the trading and post-trading landscape.
Increasingly complex
“My personal opinion is that things are becoming more and more complex,” Mr Closier says. “When I have a look at the various initiatives that tend to reorganize the financial sector in Europe, I get the feeling that things are becoming more and more complex: public initiatives as T2S, the Code of Conduct for Market Infrastructures and Mifid [Markets in Financial Instruments Directive], but also private initiatives as the merger of Nyse Euronext, the emergence of new trading venues and the ambitions of DTCC in Europe, are competing altogether and add complexity which at the end favour intermediation.
“Our final clients, banks, brokers or asset managers, facing the current trends, are requesting for more intermediation than ever, because the intermediates deal with this increasing complexity that characterises the post trade sector,” he adds.
“The securities trading layer is the most important driver of the post-trade space, and the fact that the new trading platforms, such as Chi-X and Turquoise, have looked to the banks, Fortis and Citi, respectively, to build at least some of their post trade infrastructure. It means the difference between infrastructure and custodians is becoming less clear,” Mr Closier says.
Consider the nature of the European custody business, and it becomes clear that supporting T2S is not necessarily just a bet on short-term upheaval. To understand why, it is important to look at the various regulatory initiatives currently in play in Europe compete with each other, while simultaneously striving for the same goal – i.e., reductions in costs, euphemistically known as efficiencies. While some, such as the Code of Conduct and interoperability guidelines, promote price reduction through competition, others, such as T2S, look to use a utility model.
Contradictions
“Moreover, the ECB approach for T2S includes its own contradiction, setting on one hand a monopoly for the settlement in Europe, and organising on the other hand the competition between CSDs and their users. Actually, the ECB distinguished the mandatory functions of the CSDs from the value added services that belong to the competitive area,” Mr Closier says. “In that context, the differences between infrastructures and custodians have a tendency to become less marked”.
And the situation is uncomfortable as they stand currently in the middle, most of their offer relying on their legacy functions.
“As borders fall, he says, “at the end, you have a larger but more competitive market, you support a price for complexity to enter that market but have also to be competitive in terms of fees vis à vis the customers.”
With margins squeezed, cross-border scale becomes all important, and few, if any, standalone national CSDs have the kind of international presence and assets that could enable them to get there. If they are unable to address this issue, or isolate themselves from the changes spreading slowly across Europe, far from disintermediating the agents, they could find themselves, like the Deutschmark, the Franc or the Guilder – an anachronism from a time of far less permeable borders.
GIOVANNINI BARRIERS TO CROSS-BORDER CLEARING &
SETTLEMENT
- National differences in IT interfaces and communication protocols
- National restrictions on the location of clearing and settlement
- Differences in national rules relating to processing of corporate actions
- Absence of intra-day settlement finality guarantees
- Practical impediments to remote access to national CSDs
- Settlement periods for equity markets not harmonised
- Differences in operating hour
- Differences in securities issuance practices
- National restrictions on the location of securities
- Restrictions on market makers and primary dealers
- Financial intermediaries cannot operate in all markets equally
- Provisions that taxes on transactions must be collected locally
- Absence of EU-wide framework for ownership of securities
- Differences in the legal treatment of netting
- Differences about legal conflicts.
CONSOLIDATING INFRASTUCTURE
Interoperability in the European Union seems to be a constantly moving target as new countries are considered for or granted accession, but for Alain Closier, global head of Société Générale Securities Services, the largest influence on European integration could come from outside Europe, as the major US exchanges, Nasdaq and the New York Stock Exchange, buy into European bourses – Euronext and OMX respectively; and the Depository Trust and Clearing Corporation, which runs the clearing and settlement monopoly in the US, has now set up a European subsidiary, EuroCCP.
“The EU is becoming larger than before… and it’s completely normal to consider the consolidation of infrastructure within these political perimeters,” he says. “But at the same time, the business perimeters are not necessarily these ones. For example, if we consider Euronext. The merger on the trading level was not inside Europe, but a cross-Atlantic merger with NYSE.”
While the ECB may be required to include the accession countries, the business case is unclear for market participants who do not share its vision. “We know the presence of US players in Europe,” Mr Closier says. “They are very important users of European infrastructure; it’s a very important, key point. These perimeters of consolidation, these cross-Atlantic perimeters of trading, could be in conflict with the political consolidation in Europe. Because adding a new small country from a business point of view is not very key.
“It’s a very important element of complexity, and a very real one in terms of business. US players are in Europe and, for them, the cross-Atlantic link could be more important than consolidating from a political point of view, all the countries in Europe. The ECB has to consolidate all the countries. For the ECB, a small country is as important as a big country.”
CLOSIER’S PROGNOSIS
- Public and private initiatives leading to increase in complexity
- Clients calling for greater degree of intermediation
- Trading platforms looking to banks to build post-trade infrastructure
- Huge fee competition to attract end clients
