Growing competition in the post-trade clearing and settlement infrastructure, brought about by MiFID, could dramatically reshape Europe's custody market. Writer Frances Maguire

The introduction of the Markets in Financial Instruments Directive (MiFID) did not greatly affect trade confirmation processing but it brought a new level of complexity to the back office, and clearing and settlement in general, that has not been fully played out. Some would say MiFID's influence is just beginning to take hold. What happens in the next 18 months will dramatically reshape Europe's clearing and settlement landscape, and ensure that the single market emerges as an internationally competitive marketplace for the future.

The political will for this is coming from the regulators and much of what happens depends upon the decisions made by the European Commission to ensure that cost and risk are driven out of the clearing and settlement process. Although further regulation may come to ensure the self-regulatory Code of Conduct for Clearing and Settlement is fully followed through, this may all be swept aside by the new model for settlement that Target2 for Securities (T2S) could bring, and further still, by the discussions of the establishment of a central counterparty (CCP) for European securities clearing.

Opening up opportunities

Julien Kasparian, head of market infrastructure solutions in the UK at BNP Securities Services, says that MiFID has opened up opportunities and now that the fragmentation of securities trading it has caused has been played out, the necessary interoperability has either been implemented or will be very soon.

However, Mr Kasparian adds that the complexity MiFID has brought to the post-trading environment is much greater than that on the trading side. He says: "The European landscape has dramatically changed since the implementation of MiFID, with two new pan-European central counterparties, EuroCCP and EMCF. In addition, there are all the incumbent CCPs that are trying to set up interoperability to safeguard their own market liquidity or win some new liquidity."

X-Clear and London Clearing House recently initiated an interoperability agreement, which was followed by another between X-Clear and EMCF. X-Clear has announced it will definitely move across Europe. It will implement the interoperability for the UK, and EMCF will offer access to Chi-X, among Europe's most successful new multilateral trading facilities (MTFs).

Changing preferences

Mr Kasparian says that some brokers initially considered self-clearing but this quickly dropped off when the full impact of connecting to the pan-European CCPs was defined, along with the realisation of the different models being implemented and the investment needed in the constantly changing landscape. For this reason, BNP Securities Services has seen a high take-up of its clearing services, particularly for Chi-X and its competitor Turquoise, and is clearing for between 15 and 18 firms.

However, Mr Kasparian believes the risk model created by the new landscape is not being fully considered and that, in the future, this may become an issue in considering whether the industry should still move to a more centralised model.

"At the moment, there is a real struggle between the CCPs. We do not actually know where it is going to end up. As a clearing participant, even if we may benefit from the fragmentation today, we actually push and sponsor the implementation and the benefits of a harmonised clearing house because the point of the interoperability and the CCPs connecting to each other raises a kind of risk we clearly have not identified before," says Mr Kasparian.

"It looks fine at this stage, but we do not know the endgame and as a clearing participant to all these CCPs we might end up in a situation where, if one of them goes bankrupt, we have to handle that and close out all of the positions."

Mr Kasparian says that although the code of conduct is pushing for interoperability, it is still too new a concept to ensure that the industry is managing the risk correctly. However, he would not push for a single CCP, as in the US, because it undermines competition and he believes it would be quite hard to have only one CCP in Europe. "While too many of them might be detrimental, it is still necessary to have the choice and a minimum of two would work better. Maybe one would work as long as it was user-driven and maybe another one that kept innovating and where they manage a certain level of sophistication that would be paid for by the different MTFs,"

he says.

Temporary upheaval

BNP Securities Services' aim is to protect its clients and it knows that this upheaval is not going to last. There will be additional changes and mergers but Mr Kasparian believes that 2009 will be the year of CCP interoperability and that a significant number of interoperability agreements will be put in place.

"By Q2 2009, we will hopefully have confirmation of the future of LCH.Clearnet. This will have a major impact and at the end of this year we will see the trend. We will be in a position to foresee which CCPs have the capacity to stand and which ones will definitely disappear," says Mr Kasparian.

BNP Securities Services offers several levels of back-office servicing, ranging from local settlement services and a single connection to all the CCPs, to a full lift-out of the back office.

"If a single simplified solution and one point of access to the CCPs and the entire settlement process is not enough, we will discuss solutions where we simply insource the client's back office. This is the maximum service we offer," says Mr Kasparian.

BNP has seven insourcing clients, some of which had moved to this model prior to MiFID, due to the market changes already occurring, and which have already reaped the benefits of the solution because of the implementation of MiFID.

Chris Pickles, head of marketing for investment banking at BT and former chairman of the MiFID Joint Working Group, a group created by five industry associations which disbanded after 2007, says that the key work has been done and implementation is in full swing. He says MiFID was brought in to remove the hurdles that prevented competition in a protectionist environment with national barriers, to reduce trading fees to investors and to create an internationally competitive single market.

"Opening up the market to competition has created new opportunities. Now we are also seeing changes on the clearing and settlement side, where CCPs are looking at how best to operate in a new, open environment, without monopolies and whether to partner or compete," he says.

Although the CCPs drew up the code of conduct to avoid regulation on issues such as openness, transparency, and unbundling, Mr Pickles says they did not fully follow through with keeping to their own code. It is only now the European Commission has threatened action that the interoperability agreements are starting to materialise.

According to Mr Pickles, change will start to come through now. "In the back office we have seen the Depository Trust & Clearing Corporation (DTCC) moving into Europe with EuroCCP and with its bid for LCH.Clearnet. If this competitive reshuffling results in greater efficiency and lower cost, as we have seen in the front office, that will be a positive move," he says.

T2S is designed to be the settlement system for the whole of the EU and if it is adopted it will change the roles of the existing central securities depositories (CSDs). Competition will start to change, Mr Pickles says – it will not be just between the CSDs but also the custodian banks.

Next-day guarantee

From November 2009, the Payments Services Directive will make next-day processing of all electronic payments obligatory. "How long will it take for the European Commission to say: 'If you can trade in a microsecond and move a payment next day, surely the next step is next-day settlement for securities and take risk and cost out of the system?'" asks Mr Pickles.

"Very soon it will no longer make sense to spend two or three days clearing securities and maybe the next move as we head towards 2012 will be to speed up the back office," he adds.

Tony Freeman, executive director of industry relations and market growth, Europe Middle East and Africa, at Omgeo, a provider of post-execution trade management services, says the biggest impact of MiFID has been the fragmentation of trading venues, as well as the different types of trading now available to fulfil the best execution requirements. As a result, many firms outsource much of their trading activity to brokers as best execution providers, and only the largest buy-side firms have invested in smart order-routing technology.

However, when trading on a market that is not a legacy market, which does not have the optimum post-trade data and processes in place, higher processing costs may be incurred. "Trading is no longer linear," says Mr Freeman. "There are multiple trading venues, choice in where to clear trades, and at some point there may be a choice of where trades settle and costs are not homogenous across the different platforms. The benefits of trading will be affected by the clearing and settlement process and outweighed by the cost of choice in the post-trade arena."

Promoting competition

According to Mr Freeman, fragmentation may encourage competition and narrower spreads in the front office but there is an open question as to whether choice in the middle and back office, where operational managers like simplicity, and linear processes can be beneficial or not in terms of cost. But whether the choice of settlement will decrease rather than increase with the implementation of centralised settlement through T2S remains to be seen.

"It depends whether the cost of T2S are added on or are a replacement of the costs paid today. Buy-side firms will not be direct participants of T2S so what is likely to happen is that a small number of very sophisticated and broad post-trade securities providers will emerge, because to make effective use of T2S you would have to be a big player and have the volume," he says.

"So it is going to be a fundamental challenge to the current market model and impact sub and local custodians greatly. There will be a dramatic reshaping of the custodial and CSD markets and many of these organisations will form alliances," says Mr Freeman.

"Over time, it will start to resemble the US market where there is one very big, very efficient settlement mechanism and a number of highly competitive post-trade providers, or agent banks to provide the access route, both for the buy-side and the sell-side firms, into the DTCC."

The regulatory prospective is that interoperability is not happening and he believes the regulators are already thinking about more mandated types of interoperability. "The code of conduct achieved some good in areas such as price transparency and account separation, which were not difficult to achieve, but not for the complex issue of interoperability. Further directives and regulatory initiatives, from Brussels and globally, are expected this year and next," he says.

Interoperability may prove harder than expected. Even if it is achieved and makes life easier in terms of price competition, it is likely that many brokers and fund managers have hard-coded systems, making the cost of interoperability greater at an infrastructural level. The complexity of interoperability also brings in an implementation cost, which is fairly standard in the front office but not so normal in the back office, according to Mr Freeman.

Change ahead

More dramatic change is likely. Along with T2S for settlement, there are proposals to build a central counterparty in Europe for clearing securities. The regulators are concerned about non-European infrastructures dominating the market, over which they have very little control, and which are subject to US regulation.

"The regulators want strong, robust, European infrastructures, and if they are not going to emerge through the commercial process there is a distinct possibility they will emerge through the regulatory process. I think we are at the end of the beginning, not the beginning of the end," says Mr Freeman.

Settlement in Europe is already set to change dramatically with the implementation of T2S. In terms of clearing, everything hinges upon whether interoperability can be made to work to the extent that it would negate the need for a central counterparty. The political will is there and patience, and time, is running out.

 

Chris Pickles, head of marketing for investment banking at BT and former chairman of the MiFID Joint Working Group

Chris Pickles, head of marketing for investment banking at BT and former chairman of the MiFID Joint Working Group

Tony Freeman, executive director of industry relations and market growth, EMEA, at Omgeo

Tony Freeman, executive director of industry relations and market growth, EMEA, at Omgeo

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter