Settlement & clearing feature: Under pressure to change

The European securities settlement and clearing space faces enough pressures from within, without Lehmans' collapse last year highlighting problems and the lack of a central CDS clearing mechanism, says Duncan Jefferies. The EU's Code of Conduct, right through to T2S and the drive for interoperability, mean that there is enough transformative energy in the sector already. A period of intense competition and rival visions for this changing marketplace can be expected to transform it in the years ahead, mirroring the pre-trade revolution. The battle for the future is underway

The chaos of the financial meltdown last year led to panic and uncertainty in many quarters. But one section of the industry, the European securities settlement arena, kept their head quite well when all about them were losing theirs. Trades with sometimes uncertain providences were sorted out and positions unwound without total collapse. Although the demise of Lehman Brothers had a catastrophic effect on the financial sector generally; clearing and settlement acquitted itself adequately. "They were presented with issues that they haven't had to address before, such as was a trade that had been done, but not processed, really a trade," says Bob McDowell, European research director at the Tower Group consultancy, "but there have been no losses arising from malfunctioning clearing and settlement processes. They've withstood the pressure well."

The infrastructure is still standing and an orderly deleveraging process is now underway, although the lack of centralised credit default swap (CDS) clearing mechanisms on the exotic side of the business did create problems and a solution to this is now being sought by regulatory bodies. The Intercontinental Exchange (ICE), following its acquisition of the Clearing Corporation, was the first to receive approval from the US Federal Reserve in March 2009 to serve as a clearing house and central counterparty for CDS transactions. Its US rival the Chicago Mercantile Exchange (CME) is also expected to launch a platform, while in Europe there will be competition from LCH.Clearnet, Liffe and Eurex.

A consortium of nine global banks, including Credit Suisse, HSBC, JP Morgan, Deutsche Bank and Goldman Sachs, have committed to the use of central counterparty clearing for CDSs in the EU after signing a letter of intent with Commissioner Charlie McCreevy. UBS, Barclays Capital, Morgan Stanley and Citi also signed up to the agreement, which the EC wants to see in place by year-end. The letter commits these leading dealers in the sector to work closely with infrastructure providers, regulators and the EC to resolve any outstanding technical, legal or practical obstacles in the way of building a more globally cohesive framework for CDS clearing, thereby reducing systemic risk.

Uncertain future
Away from the CDS issue, an indication of the transformative pressures affecting the European securities settlement industry for general 'vanilla' trades, is evident from the recent battle for control over London-based LCH.Clearnet. The American Depository Trust & Clearing Corporation (DTCC) eventually withdrew its offer for the firm in the spring, leaving the way clear for a consortium of 11 banks, led by the inter-dealer broker ICAP, to move ahead with its contested EUR830 million bid.

Consolidation battles such as this are expected to multiply as the EU seeks greater harmonisation and cross-border competition in the post-trade area, although there may initially be a rash of new entrants. The fight between DTCC and the ICAP consortium over the London-based clearer is simply a harbinger of what's to come. It shows how market and regulatory pressures - such as the EU Code of Conduct; eurozone TARGET2 Securities (T2S) system; and Giovannini Protocols with its support for ISO 15022 and 20022 standards to support messaging and settlement interoperability - is already changing the marketplace, as the EU's Markets in Financial Instruments Directive (MiFID) previously did to the pre-trade space.

As for the DTCC, which owns EuroCCP, TowerGroup's McDowell believes it will face challenges in Europe. "Its model is essentially that of a not-for-profit mutual, which is what it is in the US, whereas embedded clearing models in Europe are either shareholder owned or of a utility design," he says. "Unless it can adapt its subsidiary to reflect one of the other models, then I think it's going to struggle." He does not believe there is any appetite in Europe for US-style regulatory oversight of clearing and settlement systems either. "LCH.Clearnet is expanding the asset classes that it clears and it has ambitions in other geographies as well; it believes its technology can be parachuted into local markets."

Conversely, McDowell expects to see a rise in regulatory tension within Europe - what he calls Anglo-Saxon capitalism vs mainline European corporatism, which could create additional barriers for the intended pan-European clearing and settlement environment. "If you look at the way Europe has attacked the banking crisis, each country has done its own thing, in its own way. It's stabilised its banking system, re-capitalised domestic banks at different times and in different ways, with the objective of stabilising the national economy. Those sort of things, although not directly related to clearing and settlement, don't argur well for the acceleration of pan-European clearing and settlement as originally intended. Politics may yet bar the way.

Interoperability
The concept of interoperability between clearing and settlement systems, such an important idea since MiFID, took a step forward when the EMCF, the Dutch Central Counterparty (CCP) and SIX x-clear, the CCP and licenced Swiss bank, signed a memorandum of understanding earlier this year to share protocols and offer a dual CCP. The move will provide a competitive clearing environment for equity trade flows in those shared exchanges or platforms that wish to adopt the dual CCP model, allowing customers around Europe, particularly in the 'home' markets of Holland and Switzerland, to select the clearer of their choice. The interoperable link will go live this summer.

The co-operation between SIX x-clear and EMCF is in-line with the Access and Interoperability Guidelines in the European Code of Conduct, which is designed to encourage more openness in the post-trade area. You can expect many more similar link-ups as the traditionally nationally-based settlement engines in Europe seek to win cross-border business. The economies-of-scale available to large volume processors will also drive the cross-border consolidation trend, in a similar manner to that which has already happened in the payments industry with the introduction of the Single Euro Payments Area (SEPA).

Transformative pressures: T2S
The Bank of England has already expressed reservations about adopting the European Central Bank's TARGET2 Securities (T2S) integrated settlement system, which would connect all clearing networks in the eurozone into a single platform. The ECB claims this could cut settlement costs by 90 per cent, but Andrew Bailey, Bank of England executive director and chief cashier, has raised concerns over the governance and costs involved. As a global centre for trade, London, also feels that it should be consulted on this initiative even though it is outside the eurozone. The ECB wants sterling-denominated securities to settle on T2S when it launches in 2013, so that's understandable. A multilateral agreement, involving 16 eurozone central banks and 27 European Central Security Depositories (CSDs) was also signed in July, clearing the way for the next building stage of the project. One thing's for sure, it is yet another thing that will change European settlement procedures.

MiFID
Since the introduction of MiFID, which has enhanced competition and encouraged cross-border trading and execution, major changes have slowly been creeping across the clearing and settlement landscape. "Significant liquidity has been successfully moved from the traditional exchanges into new trading avenues, such as Turquoise and the other Multilateral Trading Facilities (MTFs)," explains Diana Dijmarescu, managing director, treasury and securities services, JPMorgan. Over the last couple of weeks Chi-X, one of the more successful of these new entrants, has had more trading volume on its execution platform than Deutsche Börse, according to some measurements, so the changing nature of trading venues is clear. The question is what affect will this have later down the line?

"It was inconceivable for Chi-X to have such a lead over an incumbent exchange only a year ago," explains Dijmarescu. "As a result of this, and because the new MTF entrants came in with their own solutions for clearing and settlement, we have more competition today in the clearing space ...instead of having consolidation, what we've actually seen initially is really fragmentation and new CCPs being created." She feels that in the long-term not all these new players will survive. "One would expect there to be a wave of consolidation, but right now the pie is big enough for all of them."

More competition but is it 'risky'?
Marco Strimer, CEO of SIX x-clear, the central counterparty (CCP) and licensed Swiss bank, believes that although lower prices are important, and will be a consequence of the changing settlement environment, efficient and effective risk management is actually much more important. He believes risk is an area that should never be competed on. "What you don't want is another Lehman's case with systems that are not capable of providing the security and sustainability needed because of a price war. You have to be very careful as it's a thin line ...you can start to save money on the wrong elements, although I'm not suggesting that anybody does that at the moment. It's just a danger to be aware of."

The Code of Conduct, which was adopted as a voluntary measure in November 2006 in the EU by stock exchanges, CCPs and Central Securities Depository (CSDs) has led to significant progress being made on the improvement of price transparency - another driver for change. "One thing we've seen in the last couple of months is this fantastic competition in pricing," says Dijamarescu. "The CCPs have had to reduce their tariffs significantly just to be able to compete."

Mark Kirby, head of Euroclear's business model and strategic alliances division, says that progressively, the CSDs have come to have a better understanding of how clearing fragmentation has an affect on their own business. "Clearly, if a CCP comes into a market where there hasn't been one before, such as is happening in the Nordic area, where we have two CSDs, then that introduces - purely from a business point of view - the prospect of netting and reducing the transaction flows that comes into a CSD, and consequently the revenue flow that the CSD earns. However, it has been the experience in most markets that overall trading and settlement activity increases as a result of trade netting efficiency."

Referring to the London Stock Exchange's purchase of Borsa Italiana, Kirby says: "As with the Deutsche Börse Group, this means they now have their own CCP and their own CSD. Each time there is a merger within Europe's infrastructure, we will all have to reassess the implications of the changes in the overall landscape and deal with new areas of uncertainty and opportunity."

Giovannini
There are still however Giovannini barriers to harmonisation that need to be addressed. These are, in the main, public ones - legal definitions, taxation issues and political differences between European countries. The market pressures will only really kick in once these public issues are addressed. Kirby says the remaining public Giovannini barriers have hampered Euroclear's own programme to develop a new Single Platform that will cover all seven of its European markets, plus the cross-border business of Euroclear Bank. The platform is accessed only through a CCI-compliant gateway, which will consolidate and harmonise all settlement, custody (corporate-action processing and meeting announcement functionality) and related services. "We've had a fairly long-held criticism that the public sector really hasn't been making sufficient progress in removing the legal barriers, while the private sector has been making very good progress on removing those barriers assigned to us."

Kirby is optimistic about the future though. "There is now a serious discussion about a securities directive, the explicit objective of which is to remove the legal barriers identified by the Giovannini Group. That gives us the first real bit of encouragement that the public sector is dealing with the legal problems."

Universal standards
Good progress has been made on the adoption of ISO standards across the clearing and settlement industry since FST last covered this issue prior to Sibos 2008. "You would be hard pressed to find anybody now who does not regard the migration of message standards from whatever legacies are still around to ISO standards as inevitable," says Kirby. "It's purely a question of when this is included within development budgets. The fact that the ECB intends for T2S messages to be ISO 20022 compliant will have a significant impact on driving that move."

SIX x-clear's Strimer claims that although the road to interoperability has been far from smooth, the industry is certainly moving in the right direction. "Interoperability has actually been around since 2003 when SIX Swiss Exchange invested in implementing the 'user-choice' clearing model. This model has worked successfully even in these turbulent times - contradicting comments put forward by a few commentators who believe that interoperability actually increases risk."

When the LSE allowed its clients a choice of CCP provider and SIX x-clear joined LCH.Clearnet, UBS, the largest single provider of trading liquidity on the LSE, moved all UK equities to SIX x-clear, allowing the bank to combine its UK flow at one clearer and thereby drive down the unit cost of clearing. There were considerable arguments before access was allowed however and understandable demands for reciprocity.

Strimer believes the UBS implementation highlights the worth of the dual CCP model - namely the ability to pass cost and operational benefits on to clients. "We have established that interoperability is not a dirty word anymore. People have seen this can work and are taking advantage of interoperability, because they now have a choice of CCPs. That is a clear demonstration of how the pieces have moved and how services have improved over the last couple of years."

There will be many more arguments yet, however, about what countries are 'open' to real competition and what aren't. There is a long way to go yet in the transformation of the clearing and settlement landscape in Europe, but the pressure for change is on and the tectonic plates are beginning to shift.

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