Cruising on the settlement highway

In its move towards the creation of a single market, the European Union has included securities settlement in its legislative efforts. Compared with the US market, costs of settlement transactions in Europe are exorbitant.

 The project’s current aim is to reduce settlement cost to between €0.28 and €0.32, and its launch date is 2013. While at the trading and clearing level, competition has been developed and fostered also by regulation and voluntary codes, such as the Markets in Financial Instruments Directive (MiFID) and the Code of Conduct, no significant development has been achieved in the settlement space.

New trading venues

The code was designed to facilitate the implementation of MiFID, which, among other initiatives, allows for the choice of settlement locations. Both were instrumental in the creation of new trading venues, new central counterparties (CCPs) for clearing and new relationships between the two. One thing that is common to all, however, banks say, is that they all use the same central settlement depositories (CSDs).

Lack of competition has also been accompanied by fragmentation of securities settlement systems (SSS) – there are 18 of them in the euro area. No policy maker aiming to unify and harmonise its financial markets can allow such a situation to continue. The European Central Bank (ECB), after having launched the Target 2 initiative to harmonise cash transactions, two years ago embarked on a similar initiative to create a common infrastructure for the settlement of securities in the eurozone, namely, T2S.

Highway system

“You have to look at T2S as building a highway system,” says Diana Chan, chief executive of EuroCCP, which provides clearing and settlement services to newly launched trading platform Turquoise. “The greatest benefit is about liquidity, it will allow people to move more quickly from one jurisdiction to another.”

Such a “highway system” becomes even more crucial as countries now entering the EU will in all likelihood join the euro in the future. As with all harmonisation projects, requirements and conditions should satisfy market participants. The ECB has involved market players in the discussions and after the initial period of consultations, Gertrude Tumpel-Gugerell, member of the executive board of the European Central Bank, is positive that the project will be accepted and be beneficial for the whole market.

Others are also sceptical and believe that the initiative is a vague piece of work that needs to be developed over time. They point out that the rate at which the market moves is much faster than the rate at which regulators introduce new policy, and that therefore there might be a mismatch between political will and effectiveness. Market inefficiencies have been a serious concern for others besides European policy makers. The first to suffer the consequences of a sub-optimal market are its players, and CSDs recognise this too. This is why Euroclear has embarked on a consolidation exercise and has so far acquired five local players in northern Europe, with the Finnish and Swedish CSDs to be incorporated at the end of the year. Euroclear aims to create a unified platform for currencies beyond the euro, which would reduce costs while also providing custodian services. Despite the significance of the acquisition plan, Euroclear’s efforts don’t seem to overshadow the potential effects of T2S. On the contrary, custodian banks seem suspicious. Florence Fontan, head of international affairs at BNP Paribas, says: “I don’t think that any consolidation project by the CSDs that is now on the table can achieve what T2S can achieve, in either geographical scope or cost.”

Doubt over plans

Custodian banks don’t seem to have much faith in CSD-led harmonisation plans and are unconvinced that any radical solution will come from this direction – despite the fact that many of them sit on CSDs’ boards. “The market knows that CSDs don’t necessarily give the best price, but until now we never had the power to change things,” says Ms Fontan.

And it’s not just a matter of price. T2S will allow custodians to link up directly to the system, considerably reducing communication times. Their account will still have to be with a CSD, which will be T2S’s client, and banks will therefore still pay a fee to the relevant CSD, but the communication time will be significantly reduced.

This will not make immediate economic sense for all custodians, as it requires a certain amount of investment – but, as The Banker has learned, it can be expected that the big players, which are already present in a number of markets, will create a direct link from the very first day of operations.

The system will also allow banks to get rid of multiple bilateral connections with settlement houses, thus reducing IT and personnel costs. If now a custodian bank that has a relationship with 15 CSDs needs 30 connections, two with each, one for settlement and one for custody services, with T2S this number of connections will be reduced to 16, as only one settlement link will be needed.

Significant advantages will also come for local custodians that wish to expand their activities beyond the national borders.

Under threat 

If the benefits are there to be grasped by the most ambitious, the majority of CSDs will have their relatively calm and unchallenged world threatened by the European project. Larger custodians will achieve economies of scale thanks to T2S and will access local markets in an even more efficient way, challenging smaller local competitors. They will have the alternative of exiting the custody business – which will become more competitive with T2S – or increase their investment in the sector and potentially service the entire eurozone. Furthermore, additional consolidation might come from universal banks that have an in-house custodian activity to support their own business as they might wish to outsource it, thanks to the more favourable conditions, and concentrate on their core business.

“The biggest players, such as Bank of New York Mellon, will benefit from T2S because it will accelerate market consolidation,” says Mr Bodart.

Broker dealers and non-European banks may also find it easier to access the euro ­market and there might be a business case for self-clearing in a second development phase, some custodians say. This would mean that brokers and banks would also have to manage all corporate actions and intraday liquidity.

Even more significantly than in the case of custodian banks, CSDs’ business models will be challenged. With margins reduced by the new infrastructure, to which they will very likely end up outsourcing settlement services, local CSDs that base the majority of their income on such activities are also posed with radically different alternatives.

They would either be pushed out of business, be absorbed or merge with other CSDs; or they can go up the value chain and expand their activity to cover asset servicing.

 Blurring the line 

Added-value CSDs will then compete with custodian banks, blurring even further the distinction between the two. “The definitions of custodians and CSDs are out of date,” continues Mr Freeman. “If you look at MiFID in the trading areas, some of the brokers feel more like exchanges and some of the exchanges are turning themselves into post-trade providers, owners of clearing and settlement services and technology providers. People find different niches according to what they are good at.”

T2S is bound to revolutionise the settlement space and most players hope it will bring efficiency and higher volumes to the market. The more sceptical among them had better arrive prepared by 2013.

As Ms Fontan puts it: “The European Central Bank is supporting T2S, the central banks are supporting T2S, the market is ­supporting T2S. More and more broker dealers are supporting the project and its economic sense has been validated. If the CSDs want to continue to have clients, they will have to use it.”