How Will T+2 Settlement Change the Landscape of European Central Securities Depositories?

The years of wrangling appear to have paid off. The European Union reached its latest milestone in creating a single capital market union when four European central securities depositories (CSDs) went live on the TARGET2-Securities (T2S) settlement engine in late June.

Originally, Italian CSD Monte Titoli was to go live with its Greek, Maltese, Swiss and Romanian counterparts, but it was set to use the new settlement engine by the end of August, according to EU officials.

“Cross-border settlement of both debt securities and equities is now treated in the same way as domestic settlement, with harmonized conditions, making it easier and more cost-effective for investors and companies to buy and sell shares in other countries,” said Mario Draghi, president of the European Central Bank (ECB) while giving the keynote at the launch celebration.

T2S provides a standard linkage between the participating CSDs and the ECB, whose money will be used in the new centralized delivery-versus-payment settlement model, as well as between the CSDs themselves.

By using the new linkages, CSDs could retire the existing “spaghetti code,” which they use to connect to each other and often hampers CSDs in smaller markets.

“It was basically impossible to the international CSDs to accept our International Securities Identification Number (ISIN) code,” explained, Indars Ascuks, chairman of the Latvian Central Securities Depository’s management board. “In this sense, T2S certainly can help and our investors hopefully could enjoy that and make sure that their investors can transfer the securities to their accounts in other CSDs or international CSDs in about two years’ time.

In the meantime, Ascuks does not view T2S as a panacea that solves all the woes of current cross-border settlement transactions. “To be frank, the volumes that have been in the cross-border links have not been as high to have an IT solution be the bottleneck for services or transfers,” he said.

Ascuks attributes the bottleneck to the lack of pan-European securities market law that forces CSDs to comply with the commercial laws of each cross-border market to which they link. A settlement finality directive could be implemented in various ways in national legislation, he suggests, “All of that would require diligent paperwork to set up safe links.”

As the head of the ECB and the man seen as the savior of the Euro currency, Draghi agrees that the E.U. and its members still need to take legislative and regulatory actions to eliminate these remaining barriers to settlement harmonization.

“This is because financial markets in Europe are subject to a vast network of legal rules, which sometimes conflict on issues such as taxation requirements, insolvency procedures and corporate governance,” Draghi explained. “For full integration, we need to have a single rulebook for capital markets, and all market participants must have equal access to markets.”

No matter how much effort it takes, improving Europe’s cross-border settlement competitiveness is a must for Draghi. “If we consider the fact that settling a cross-border transaction in Europe used to cost up to 10 times as much in Europe as it does in the United States, the importance of our new settlement platform to the deeper integration of capital markets becomes evident,” he said

Harmonization = Consolidation?
Level any playing field and the immediate advantage often goes to the larger players at the expense of the smaller ones.

This lesson has not been lost on the CSDs in the smaller European markets, such as the Baltic markets. “We can see that in many other industries, whether it’s telecommunications or payments,” said Latvian CSD’s Ascuks.

Henri Bergstrom, head of product management for CSD technology at Nasdaq OMX and chairman of the board of NASDAQ OMX Armenia at Exchange and CSD, sees the same effects closer to home. “If we look at the capital market changes in Europe which started from the exchanges with Markets in Financial Instruments Directive (MiFID) and we went into the central counter-parties with the European Market Infrastructure Regulation (EMIR),” he said. “Now we’re on the CSDes and everyone has seen the impact of the other two.”

The smaller CSD operators that operate only domestically may suffer as the EU pursues its common European agenda to be more competitive in cross-border settlements, believes Ascuks. “It could be that domestic fees go up whereas the cross-border transactions go down,” he postulated. “That’s certainly what I expect to happen with T2S over the medium- and long run, but not in the near term.”

The smaller CSDs were not alone in the their concerns that T2S might take a bite out of their domestic business at the beginning of the project, according to Chris Prior-Willeard, a senior advisor at Thomas Murray Advisory and former CEO of Bank of New York Mellon’s Belgian CSD.

“You had some very well formed, well founded, and, in some cases, well-capitalized national markets, he said. “Of course they’re very happy to receive the benefits of cross-border competition, but they are very reluctant to cede any national turf.”

It was the project’s explicit political backing that gave T2S momentum to overcome the participant’s reluctance, Prior-Willeard adds.

Yves Mersche, a member of the ECB’s executive board, firmly stated that no CSD was forced to join the T2S community. “Many securities depositories chose to participate because they saw great potential in T2S in terms of cutting settlement costs, fostering competition and generating new business opportunities.”

Only the large international CSDs, such as Clearstream and Euroclear, as well as global custodian banks like Bank of New York Mellon and J.P. Morgan that offer their own European settlement services likely will reap the rewards, Ascuks believes.

For him, T2S benefits are tied directly to the economies of scale that a CSD can muster to meet the settlement initiative’s “one size fits all” approach. “Whether you are a small or larger CSD, the requirements are pretty much the same,” said Ascuks.

He expects that new compliance costs and the resources needed to connect to the T2S settlement engine will prove to be a greater burden for smaller CSDs and their limited budgets.

CSDs adopting T2S will need to bring up new linkage to the ECB in order to participate in the monetary operations of the Euro System, which could prove difficult for smaller CSDs, according to Ascuks.

The smaller CSDs also are less likely to establish fewer new cross-border linkages than their larger counterparts, he adds.

“It could be the case that some of the CSDs actually prefer to work with some of the larger CSDs and international CSDs to cover the markets that are maybe less active for that CSD,” Ascuks said.

Even after improving its efficiency, the Latvian CSDs will have a hard time lowering its current approximately 30-euro cent settlement fee.

“In this sense, it is challenging for smaller CSDs like we have in the Baltic to justify investment in T2S,” said Ascuks.

One CSD’s Approach
If the smaller CSDs are not competitive with their core securities settlement offerings, industry insiders recommend that the CSDs improve their other core functions, such as notary (issuing) and asset servicing.

“CSDs need to thrive on active participation and they need to take an active role in developing their market and services… and have a future business plan in place for the local market,” suggested Nasdaq OMX’ Bergstrom.

Ascuks believes that developing new ancillary offerings around asset servicing would not provide a potential competitive advantage for smaller CSDs, given the depth international CSDs and custodial bank’s current offerings.

Instead, the Latvian CSD plans to merge the other two Baltic CSDs into a single entity to improve its competitiveness, which is permitted under a provision of the EU’s CSD Regulation.

“Thanks to that provision, it is possible to create one legal CSD and operate branches in other countries,” said Ascuks. “We are planning to operate in this way and that will certainly us to centralize and make more efficient our regulatory compliance.”

The new entity will make strategic IT investments that will increase its level of straight-through processing while shortening its time to market, reducing client response time.

“Serving your issuers will become your bread and butter in the future because the issuing business, especially on the equities side, we expect to be sticky or stickier than other CSD business lines in the future,” Ascuks added.

However, it is still too early to write the biographies of the T2S winners and loser. Only the first of five T2S-migration waves are live on the new settlement engine. The last wave is not slated to be on the system until February 6, 2017.

A lot can happen between now and then, according to industry insiders.

Thomas Murray’s Prior-Willeard also does not discount the power of unintended consequences may have on the European CSD landscape.

At the beginning of Markets in Financial Instruments Directive (MiFID) there was a fear that it would produce a single European exchange due to economies of scale, he explained. “Instead of having fewer exchanges, the same market supports, I believe, 140 trading platforms,” he said. “Either we’re going to end up with a handful of CSDs or we are going to see a great deal more when people start to see access to an authorized CSD as a competitive advantage.”