While the consultation continues on how the EU might achieve a harmonised infrastructure for cross-border transactions, Frances Maguire finds that another highly charged debate is going on: should ICSDs and CSDs compete with global custodian and agent banks?
When is a bank, not a bank? When it’s an international central securities depository (ICSD). At present, both Europe’s ICSDs, Euroclear and Clearstream, are banks, and despite moves by Euroclear to restructure its banking and its depositories into separate entities, and the European Commission’s accusation that Clearstream is abusing its “dominant supplier position”, the fact still remains that both ICSDs offer “bank accounts” to their securities customers that do not pay interest.
Historically, the ICSD banking licences and accounts came about simply to extend the services of the ICSDs in securities processing. But increasingly – especially now the regulators and market participants are trying to redraw the fragmented clearing and settlement infrastructure of the EU – the question is: should utilities compete with their users?
Several sub-custodian, or agent banks believe CSDs should consolidate and remain as utilities – monopolistic, for limited profit, and user-governed or owned, such as the Depository Trust Clearing Corporation in the US.
Sophie Gautié, EU representative at BNP Paribas Securities Services, says: “The role of the CSD is well understood worldwide. CSDs were created by market participants to facilitate finality of settlement among institutions and ensure finality of issue. Banks are providers of intermediary services and are better placed to be liquidity and credit providers. As in the world of payment, CLS Bank and Target for instance, there is a division of roles and risks between the central platform and its participants.”
Regulators wade in
The debate was given a more formal platform last summer when the European System of Central Banks and the Committee of European Securities Regulators (ESCB-CESR) drafted some market practice guidelines, now in final draft, in the form of 19 standards. The ESCB-CESR, representing the regulators of both central banks and the ICSDs/CSDs, proposed that if settlement structures in Europe are to be regulated, the regulation should cut across function rather than market sector; that “systemically important providers”, regardless of whether they are banks or CSDs, should be regulated in the same way. The group suggested the definition of “systemically important provider” included the larger agent banks – those that either had more than 25% of a national market share or 5% on a pan-European basis. But in the latest version of its standards, now up for consultation, it is left to national regulators to decide which providers should be deemed systemically important.
This is a critical point for all concerned. If this were to become law it would seriously impact the market – in effect, it would reverse the trend towards consolidation, as smaller banks would actually fare better without the additional standards imposed for having a large market share.
There has been much debate as to whether Europe’s clearing and settlement infrastructure should be regulated or whether it should be left open to market forces to re-shape it. The threat of more regulation for larger players is in some ways a case of the regulators going too far and meddling with the free market forces that normally create competition. Already the European agents banks have said in their earlier responses to ESCB-CESR, that these issues should be left to the monopolies and competition agencies and not be dictated by the regulators.
Sticking points
Two other standards also caused concern within some custodian banks, as they appeared to be making onerous demands upon the banks that were more akin to the ICSD rather than to the commercial banking world.
Standard 9 proposes that systemically important providers fully collateralise credit, similar to the ICSD model. The impact this would have on European cross-border settlement is significant. It would effectively take commercial bank credit out of the equation. Euroclear already collateralises the majority of its business, where banks extend credit. The cost of collateral to banks’ institutional customers would most likely increase the cost of cross-border settlement, and put the banks at an unfair disadvantage to the ICSDs, in pricing these services.
Diana Chan, a vice-president at Citigroup Global Transaction Services, says: “The question is how best to regulate credit risk exposure. Prudential banking laws ensure that banks manage credit risk. Utilities do not usually extend credit, and the proposal is to allow them to extend credit if it is collateralised. The ICSDs are exceptions, but should the exceptions become the rule?”
Standard 13 goes further in aligning large market participants with ICSDs and CSDs by proposing that commercial banks should put governance arrangements in place to “fulfil public interest requirements and promote the objectives or owners or users”; this is a requirement usually made of utilities such as the CSDs and central counterparties (CCPs), which tend to have quasi-monopolistic positions, not banks, no matter how large they are. As one agent bank reportedly put it: “Should Microsoft be forced to be user-governed?”
It seems, as always, it is not competition that the banks are objecting to, but the need for a level playing field. And insisting that commercial banks are run like utilities so that the utilities can compete seems a strange answer to a problem that was never really there.
With such proposals on the table, a group of agent banks, led by BNP Paribas and Citigroup, formally established the Fair & Clear Group in mid-2002, when a number of institutions agreed on certain principles in answer to the EC’s first communication on clearing and settlement. An industry association was not originally intended. Today, Fair & Clear is an association of custodian banks engaged in providing post-trade securities services in Europe. It is seeking to promote the creation of a consolidated securities settlement infrastructure in Europe, supported by an open banking model.
Taking a slightly more relaxed view of the situation unfolding in Europe, Paul Bodart, executive vice president of Bank of New York, says: “Generally the standards are addressing the problems of the fragmented infrastructure within Europe. However, consolidation in Europe will lead to a much lower number of CSDs/ICSDs and the global custodians are likely to be directly connected to these. As a result, sub-custodians will be desintermediated. This will probably start with the markets covered by Euroclear, which, from 2008, will enable the settlement of securities in six jurisdictions, currently, on one platform.”
EU comparison
To a large extent the final draft of the ESCB-CESR standards are in line with the consultation document on settlement finality in Europe published in April by the EU. The EU proposes a law enabling free access to settlement system, regardless of location, and another law outlining the supervision and running of settlement systems, including risk management and capital adequacy provision. Other than that, the EU appears to want to leave well alone and encourage consolidation and competition to run its course.
Likewise, ESCB-CESR has dropped references to the dominant players of certain markets, recognising that it should concentrate its efforts on the management of risk and not deal with competition issues. The group also recognises the different roles CSDs and banks play and has decided not to rule on whether CSDs can take on credit but leave it to the national regulators.
Two facts remain. The banks believe that Euroclear and Clearstream still have an unfair advantage because they are able to cross-subsidise their banking activities with those of their central depositories. Neither banks pay interest on accounts – something commercial banks would not be able to get away with – but they do not lose business over it, as institutions need to hold such accounts for securities settlement in the depository, and need to be banking customers in order to have access to the full range of services offered by the ICSDs.
The other clear fact is that, Euroclear still offers the most viable solution to cutting the cost of cross-border settlement. In 2008, when its Single Settlement Engine has been built (at a cost of E350m), banks will be able to settle French, UK, Irish, Belgian Portuguese and Dutch stocks for one price, on one platform. Euroclear, it seems, holds the key, and will most likely place a central role in any new model for the EU.
Stalling tactic
Taking another view of the situation, Terry McCaughey, former global custody head at HSBC and now an adviser to investment management consultancy Citisoft, believes that much of the consternation among the agent banks is simply a stalling tactic. This would give them more time to prepare for what could become a changing business model in Europe.
He says: “The ESCB-CESR standards could be a way forward for Europe. Why should banks waste capital in creating market structures – and trying to reinvent the wheel? Why shouldn’t Crest become a bank one day? When the UK market dematerialised, HSBC had 60 people working in settlements – the launch of Crest reduced this to around 20, on twenty-fold volumes. It makes a lot of sense for banks if the CSDs extend their services; with dematerialisation in the UK, there really is less reason for registrars, this too could be taken on by Crest, to the benefit of the banks.”
In the meantime, Mr McCaughey adds, the custodian banks are shifting their business models – away from the transactional services utilities are aiming to provide and towards value-added services, such as back office outsourcing.
There are, as ESCB-CESR correctly pointed out, some very large banking players in domestic securities – so much so that the logical next step to cut costs in securities settlement would almost be to allow these banks to internalise order flow. Then it would be a very different question on the table – not whether CSDs should be banks, but whether banks should become CSDs.
