European securities will soon be settled on a central IT platform – Target2 Securities (T2S) – as part of the European Central Bank's initiative to harmonise post-trade standards. With the first wave of implementation scheduled for 2015, Duygu Tavan investigates how the T2S project is progressing and its consequences for the securities industry.

In Europe’s securities market, investors typically hold securities with national central securities depositaries (CSDs) through custodian banks. CSDs are responsible for the final phase in a trade, when transactions are confirmed and exchanged for cash, and hold the liquidity for these securities. As there are more than 30 CSDs operational in Europe, which have local legal standards, propriety messaging protocols and different settlement deadlines, there is a complex web of fragmented liquidity and standards that the European Central Bank (ECB) aims to smooth through a single IT platform on which securities settlements take place. That platform is known as Target2-Securities (T2S).

T2S is a single settlement system for all European securities – bonds, equity, funds – meaning CSDs will have to outsource the settlement part of their business to the ECB. T2S will be linked to the dedicated central bank cash accounts of market participants – the so-called Target2 (T2) – with the aim of increasing the velocity of the settlement and decreasing the collateral need. “This change is a new philosophy for the securities industry,” says Jean-Michel Godeffroy, chairman of the T2S programme at the ECB.

A fair target?

Under T2S, the ECB will charge everybody €0.15 per transaction. Reducing the cost of cross-border transactions is one aim. Another is to create more efficient collateral management in the eurozone, which is important, says Henry Raschen, head of regulatory and industry affairs for Europe at HSBC Securities Services, given the increased demand for collateral and high-grade securities under the European Market Infrastructure Regulation (Emir), Solvency II and the Capital Requirements Directive IV/Basel III.

By consolidating cash and securities accounts and concentrating this in a lower risk environment – ie, central bank money – banks could reduce their balance sheet costs, according to Alessandro Di Michele, general manager at Monte Titoli, the London Stock Exchange’s Italy-based CSD. “T2S will enable bank treasurers to see liquidity and securities in one single platform,” he says.

Such efficiencies could save costs, which could in turn be passed on to clients – brokers and/or issuers of debt or equity – sparking opportunities for firms to raise capital for innovation, expansion or consolidation.

Transformation period

Today, trades take place on a stock exchange, an electronic trading platform or over the counter; settlements take place at CSD or international CSD (iCSD) level. “There are various regulations that affect all steps of a securities transaction, from trading to clearing and settlement, for example, Markets in Financial Instruments Directive, Emir and the upcoming Central Securities Depositories Regulation [CSDR]," says Isabelle Olivier, Swift’s head of clearing and settlement for Europe, the Middle East and Africa (EMEA). "Once all of these are implemented, a trading platform could be connected to multiple central counterparty clearing houses, which connect to multiple CSDs that are connected to T2S.”

But until Europe attains this efficiency in post-trade service, its post-trade industry – especially CSDs – will have to go through a transformation period. “The landscape will transform fundamentally. Traditional divisions between various market players – such as CSDs, custodians and agent banks – will become less defined,” says Graham Ray, a director for global product management, clearing, custody and cash, at Deutsche Bank.

National CSDs will be the most affected, many commentators believe, as they will lose most of their matching and settlement activity to T2S, and therefore some of their revenues streams. “There are also serious limitations placed on these CSDs due to the incoming CSDR, which narrows the scope of services that CSDs can provide," says Virginie O'Shea, senior analyst at research firm Aite Group.

Robert Somogyi, senior vice-president for business management and strategy at Clearstream, says that CSDs face increased competition when national monopolies break down and will either have to establish links to other CSDs; develop cross-border asset servicing and other value-added services, such as collateral management; or downsize and focus on servicing the local market as an issuance utility, registrar or notary, for example.

Viva the evolution

Now, the evolution is taking shape. In January, BNY Mellon announced it would establish a CSD in Belgium. “The regulatory regime introduces change; launching our CSD is part of our response," says Chris Prior-Willeard, CEO of the CSD business at BNY Mellon. "We see T2S as a tool-kit offering solutions for the new market environment.”

Another entrant is a Luxembourg-based CSD owned by the LSE Group, which was announced in July and will launch next year. Its chief information officer Anoine Shagoury says the group wants to capitalise on the changes in regulation and is aiming to become an aggregator of the administrative capability of CSDs.

The Luxembourg CSD will use the existing technology, links, infrastructure and operations teams of Monte Titoli, which will link the new CSD to T2S. Mr Di Michele says the focus will be on the core business, custody and settlement, and although Monte Titoli is expanding through the new CSD, it will not become a bank. This approach gives it a competitive advantage over local and iCSDs, he argues. 

“It’s our plan to become an iCSD, but a very specific one, focusing on core services in international markets as an investor and issuer CSD, yet avoiding competition on banking-style services," says Mr Di Michele. "If you’re a bank, you take on risk, provide credit lines, lend securities and directly manage collateral. We’re not here to act as a principal. We focus on custody and settlement, safe-keep securities, service them and manage an efficient settlement system. We provide a single gateway to 18 securities markets around the world. With T2S, it will increase to 30, including major G8 countries outside of Europe.”

Local or international?

As one industry expert explains, there are four global collateral management service providers: Clearstream, Euroclear, JPMorgan and BNY Mellon. Clearstream and Euroclear both have CSDs (and iCSDs), BNY Mellon is entering this market and JPMorgan is client and partner at the new LSE CSD. JPMorgan is the first client and partner and will use the LSE CSD as its provider of settlement, custody and asset-servicing services for its international collateral management business, which the LSE Group otherwise would not have had. "So here, too, just like for BNY Mellon, the value seems to be in collateral management,” the expert says.

Not everyone is setting up a new shop. Both Euroclear and Clearstream are tweaking their business models. As Mr Raschen at HSBC Securities Services says, the iCSDs have not signed the T2S framework agreements. “International CSDs operate in commercial bank money and should be largely unaffected by T2S, which operates settlement exclusively in central bank money,” he says.

Both Clearstream and Euroclear have an iCSD, and have CSDs separate from that. For instance, Clearstream Banking, the iCSD, is based in Luxembourg, but Clearstream also has a CSD in Germany, which has signed the framework agreement, as has its CSD in Luxembourg. At Euroclear, its Belgian, Dutch, Finnish and French CSDs have signed the agreement, but its UK and Ireland and Swedish CSDs have not.

Local CSDs tend to have specific offerings, usually settlement, custody, asset-servicing and issuance services. As the settlement revenue diminishes, Euroclear and Clearstream may be at an advantage, as they offer services such as collateral management that they could incorporate into their T2S business model, the two iCSDs believe.

Clearstream and Euroclear

At Clearstream, the strategy is to offer clients the German CSD as a gateway to T2S, through which they can then also access iCSD services.

“We are using T2S as an opportunity to further integrate our iCSD and CSDs via a harmonised connectivity single window and at a competitive price. This means customers have the best of both worlds – settlement in both central and commercial bank money,” says Mr Somogyi. Clearstream will cover most of the technical adaptations to keep the effort for customers as minimal as possible. “Merely functional changes, such as the introduction of partial settlement, will necessitate adaptations by customers,” he adds. This is a similar tactic to that being carried out by Euroclear.

Euroclear is going to offer three access points to T2S: global access through Euroclear Bank (the iCSD), a single access point through its platform Eses (which covers Belgium, the Netherlands and France) or Euroclear Finland; and direct CSD access to individual markets.

The first option is aimed at firms looking for a multi-currency post-trade service to access T2S and other global markets. “We’ll shield clients from having to make T2S-related changes. We’ll make the changes on our systems while keeping client access to Euroclear Bank unchanged,” says  Alexandre de Schaetzen, director of product management at Euroclear, about the first option. “There will be minimal changes and no T2S investment costs for clients. Transactions will settle in commercial bank money. Euroclear Bank clients need to do nothing and they’ll be ready for T2S.”

In the second gateway, clients will be able to access all other T2S markets. “They won’t need to open an account in each CSD," says Mr de Schaetzen. "The difference with access to T2S via Euroclear Bank is that Eses settles securities transactions in central bank money. Some clients prefer to settle the cash component of the trade with their central bank whereas others need or prefer the services of a [commercial] bank to extend credit and/or securities loans to complete their settlement obligations, and to settle trades in currencies other than the euro."

Eses already has links with 13 European CSDs and is aiming to cover all 23 T2S markets, in line with the different CSD migration waves. “Because clients can then access all T2S markets through this one Euroclear CSD relationship, they can rationalise their relationships with other CSDs that are also connected to T2S,” adds Mr de Schaetzen.

The third gateway is for clients who want to connect directly to a CSD to use Euroclear’s asset-servicing and collateral management service. “For the big European markets such as France [through Eses], Italy, Germany and Spain, we will offer clients a range of unbundled services if and when they elect to have direct access to the local CSD, as well as operate their account in the CSD for T2S settlement purposes. This is an option for clients who want to remain close to a CSD without involving a long chain of intermediaries,” says Mr de Schaetzen.

Consolidation due

With these changes, Mr Godeffroy says the ECB’s ambitions of creating more competition among CSDs may be realised. But many, including Mr Godeffroy himself, expect consolidation among CSDs in the long run, as technology costs and competition rise and required service levels move beyond their capability. Currently, CSDs are locally restricted. In the era of T2S, they can offer services throughout Europe. This harmonisation will initially lead to a rise in the number of CSDs, Mr Godeffroy expects – as is already evident from BNY Mellon’s and LSE Group’s announcements.

“National CSDs in smaller markets may lose volume to larger market CSDs as the larger CSDs exploit economies of scale to act as an access hub for T2S settlement throughout the eurozone,” says Mr Raschen.

Will this result in one big European CSD? This seems unlikely. Ultimately, local expertise will still be in demand, many believe. “National CSDs will continue to have a function to manage remaining country-specific features of corporate actions [as this is outside the scope of T2S]. There is a lot of behind-the-scenes work going on to come up with some form of corporate action harmonisation,” says Mr Raschen, although concrete examples have yet to emerge.  

“The location of a CSD will not matter, except that in some countries securities laws may still require the CSD to be on home territory. Also, although an investor CSD can be based anywhere, issuing corporates may well still want to issue their securities into a local CSD. Non-local CSDs [new to a market] may therefore have to spend time building their issuer customer base,” he adds.

Wider impact

These industry changes also impact custodians, brokers and others in the value chain. “Regional custodians will no longer need local custodians to access all European markets. They’ll be able to do this directly through T2S,” says Mr Ray at Deutsche Bank.  However, he adds that for sub-custodians, the local expertise will remain a valuable business, given the variations in regulation and accumulation of upcoming regulatory deadlines. “With T2S, we look at each component of our bundled service and identify the most optimal operating model for [our clients]. That means picking the value-added services that are key to them in a T2S environment,” he says.

The choices will vary for different client segments, says Mr Ray, but one of the primary focuses is around account structures, from both securities and cash perspectives, as T2S and other market regulations drive clients to review account operator models.

For brokers such as RBS, the T2S evolution means two options, according to Rob Mason, head of EMEA securities operations at the bank. These options are either direct connection to T2S or going through agent banks. But direct connection would incur up-front technology spend and a change in the process of the settlement of trades; while the custodian would facilitate the connection to T2S, reducing upfront costs.

"Many firms count on T2S to reduce the complexity of the cross-border environment and bring down cost in the long term – but that may take 10 years," says Ms O’Shea at Aite Group. The overall costs in the short-term may increase for settlement services under T2S, she adds, with no great savings in the next three to five years.

Worth it?

As no central bank or CSD is obliged to participate, there is a certain amount of volume that will not go through T2S. So far, the Danish CSD is the only non-euro CSD that has agreed to participate, even though T2S can support multi-currency settlement. The ECB believes uptake will come naturally as CSDs sign up and differentiate through value-added services. But some do not see the benefit of joining T2S, such as the Bank of England (BoE).

The cost of implementing T2S for the BoE was disproportionate to the benefits T2S brings, according to a BoE spokesperson. The BoE already has a single settlement infrastructure for sterling-denominated securities with an integrated pool for liquidity and delivery versus payment in central bank money. The BoE also sought an equivalent role to that of the Eurosystem for T2S governance.

“[Once] the UK’s vision of Europe has been clarified, positively or negatively, once T2S is working well and the main UK CSD needs to replace its software, the London market will have to choose between two options: building a new expensive system or joining T2S,” said Mr Godeffroy during a speech to the LSE and Monte Titoli in June.  

There is another reason the ECB wants the BoE to participate: the participation of a sterling securities settlement could have added about 30% to T2S transaction volumes and so reduced unit process costs, says Mr Raschen. “Transaction volumes have fallen since 2008. Nevertheless, removing barriers to cross-border settlement within Europe will benefit cross-border investment, and act as a catalyst to harmonising European post-trade activity across the EU's 28 member states,” he adds.

For now, institutions outside T2S can continue working via iCSDs, global custodians, and sub-custodians in commercial bank money, says Mr Somogyi. He believes they may also see a reduction in transaction fees, but there will be some changes, such as CSDs moving from T+3 settlement days to T+2.

Eventually, there is a widespread feeling that a harmonised post-trade market should attract more volumes due to easier access to a wider range of securities. Under T2S, a foreign investor – from, say, Japan – could open one securities account with a T2S CSD and a cash account with a European central bank. “If a US investor wants to invest in a German instrument and in an Italian one [today], they will be faced with two completely different set of rules regarding the settlement. They may have to rely on two distinct service providers to access each market” says Ms Olivier. T2S should smooth these discrepancies.    


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