One of the main aims of the European Union’s Markets in Financial Instruments Directive is to foster competition among execution venues for the trading of pan-European stocks. But the thorn embedded deep in MiFID’s side is Europe’s fragmented system of post-trade service infrastructures. By and large, these infrastructures are segregated by country, making cross-border trading far costlier than domestic trading.
Many predict that without competition in clearing and settlement-which are together known as post-trade services-significant competition in cross-border trading cannot occur.
“You can’t talk about competition in European trading without talking about clearing and settlement,” says Ruben Lee, managing director of Oxford Finance Group, a financial-services research and consulting firm in the U.K. “And clearing and settlement is where controversy has been at its peak in Europe for the last year and a half.”
For the first time, serious industry efforts are now under way to pry open this opaque world in which many post-trade securities-processing entities run what are effectively monopolies. The industry’s voluntary Code of Conduct for Clearing and Settlement, adopted last November, aims to allow competition for post-trade services. But it’s unclear how effective these efforts will be.
Currently, every European country has a central securities depository (CSD) for settling trades. And most have their own central counterparty (CCP) or clearinghouse to clear domestic trades. Within a country, these organizations are often tied-by rules, regulatory fiat or habit-to that country’s dominant exchange. That tight relationship prevents other firms from providing competitive post-trade processing services.
“The real inefficiency in the trading world in Europe is post-trade. When trading a stock in its home market, you must clear and settle in that country and form relationships with the clearing and settlement organizations and local intermediaries,” says Ian Peacock, CEO of North American operations for Cheuvreux, the European brokerage subsidiary of French banking giant Calyon. “And if you trade the same stock across two venues, as increasingly will be the case post-MiFID, you’ll have multiple tickets to process.”
The code of conduct encompasses a phased plan to provide more pricing transparency in post-trade services, access and interoperability between organizations, and-by the beginning of 2008-an unbundling of offerings that will enable users to mix and match services from different providers. The inspiration for the Code of Conduct was forced on the industry by two powerful European Commission policy groups-those for Europe’s Internal Market and Services and for Competition-which threatened regulatory action if the industry didn’t address its inefficiencies.
The code of conduct faces an industry undergoing tremendous regulatory upheaval, in which most interested parties are scrambling for position as the landscape shifts. “It will take a long time to assess whether [the guidelines] will result in real competition,” says Patrick Cirier, global head of professional trading group solutions for Fimat, the brokerage arm of French bank Societe Generale.
In Europe, cross-border trading costs are significantly higher than domestic trading costs. According to EU reports, the high costs resulting from fragmentation jeopardize the growth of an efficient European single financial market. An analysis by the EC’s Competition department in May 2006 estimated that the removal of restrictive tax, legal and other barriers to cross-border trading could lead to a 7 to 18 percent reduction in total trading costs for cross-border transactions. Decreased trading costs, the report suggested, would lead to a surge in trading by making executions more efficient and new investment strategies profitable.
There are also secondary, knock-on costs resulting from fragmented post-trade services. For banks and broker-dealers, these include the costs for connectivity to multiple service providers, monitoring staff, reconciliation services, legal advice in different jurisdictions and so on, notes Cirier.
The code of conduct follows years of infrastructure consolidation within European countries and across asset classes. From 1999 through 2004, the number of CCPs in the initial 12 countries to adopt the euro dropped to eight from 14, while the number of CSDs decreased to 18 from 23, according to a 2005 European Central Bank paper on post-trade services.
Post-trade services in Europe currently come in two flavors: vertical and horizontal. In a vertical setup, the exchange owns and controls the clearing and settlement organizations. Deutsche Brse, Borsa Italiana and Bolsas y Mercados Espaoles (the Spanish exchanges group) have vertical structures. The London Stock Exchange and Euronext, on the other hand, have horizontal structures, with clearing and settlement provided by independent organizations.
Banks and broker-dealers would typically rather control a clearinghouse themselves than rely on a clearinghouse controlled directly or indirectly by an exchange. The premise is that user-owned clearing infrastructures are more responsive to the cost and technology needs of their members and are likelier to operate more like a utility, lowering prices when possible and seeking benefits through economies of scale.
All the big bourses in Europe are also for-profit, publicly traded companies. They can therefore use their ownership interests in post-trade services to boost their profits or protect their markets by limiting access. “If an exchange has power over the clearing side, it can stop others from competing with the exchange, and it can do that in complicated ways,” says Oxford Finance Group’s Lee.
LCH.Clearnet, for example, was formed in 2003 through a merger of the London Clearing House, which cleared trades in various asset classes, and Clearnet, which Euronext had created. The aim was to make clearing for the new group’s users more efficient through synergies in technology and economies of scale. Three years later, industry participants note, that hasn’t happened.
LCH.Clearnet still has different clearing platforms for the LSE and Euronext–the LSE’s trades are cleared through London-based LCH.Clearnet Ltd., while Euronext’s trades go through Paris-based LCH.Clearnet SA. Equity trades cleared for investment firms transacting in both markets are neither cross-margined nor netted.
Investment firms also pay higher fees for clearing trades on Euronext than on the LSE. LCH.Clearnet’s Alberto Pravettoni, managing director for corporate strategy, says this reflects different clearing processes and business requirements in the two markets. However, he adds that the CCP has reduced fees substantially, with more cuts to come, and is working toward a “harmonization” of fees across markets.
Some of these changes will come on the back of a new ownership structure. Euronext owned 41.5 percent of LCH.Clearnet before it merged with NYSE Group earlier this year. The clearinghouse is in the process of a share buyback that will reduce that stake to 5 percent by next April. “To deliver the lower fee levels required in a highly competitive environment, we needed to reduce both the influence and economic interest of Euronext,” says Michael March, director of corporate communications at LCH.Clearnet.
Competition in clearing, spurred by the code of conduct, is expected to reduce costs by giving customers choice. The LSE says competition has already lowered clearing costs for its members. The LSE has used London Clearing House (subsequently LCH.Clearnet) to clear its trades since introducing a CCP in 2001. In May 2006, the exchange said it would also allow SIS x-clear, the Swiss CCP, to clear its trades. According to Nic Stuchfield, the LSE’s director of corporate development, LCH.Clearnet has since dropped its clearing fees for LSE trades by about 40 percent. “And the competitive environment is not yet live,” he says.
Stuchfield stresses that the LSE has long advocated a horizontal model to benefit its customers. “We don’t earn money from clearing,” he says. “We have a strong interest in being pro-competitive.”
Vertically organized markets have also responded to users’ pricing demands in anticipation of a more competitive environment. Deutsche Brse’s Eurex Clearing cut its clearing fees for trades on Xetra and the Frankfurt floor in mid-summer. That followed a halving of connectivity fees in the spring.
Ironically, the London exchange, which is merging with Borsa Italiana, will soon own a vertical post-trade services structure, since the Italian exchange owns its clearing and settlement organizations-Cassa di Compensazione e Garanzia for clearing and Monte Titoli for the settlement of Italian securities. Stuchfield, who says the LSE remains committed to competition, notes that the exchange will add CC&G to its slate of CCPs and will enable other CCPs to access CC&G to clear Italian equities.
Although the code of conduct is pushing the industry toward integration, many broker-dealers and banks favor the U.S. model of a single clearinghouse and a single settlement entity for all European securities. But few say that’s likely in the near term-not without regulatory intervention, which the industry would rather avoid. Internal Market commissioner Charlie McCreevy last year acknowledged users’ interest in single-infrastructure models, but said that “it is not [the EC’s] role to impose a particular model on the market.”
Still, the hope for a single solution remains. Merrill Lynch, like many big investment firms, would prefer to ultimately have one clearinghouse. In the meantime, “any exchange that owns a clearinghouse should separate it out or at least have separate accounting,” says Niki Beattie, European head of market structure for Merrill. “Right now there’s a lot of cross-subsidization between all domestic exchanges, clearinghouses and CSDs. It’s hard to get transparency around what each leg of the trade actually costs.”
“Some people want a Europe-wide clearinghouse,” observes Alastair Laurie-Walker, principal of Synthetic Capital Advisers, a U.K. firm that helps arrange clearing capital for CCPs. “But others are saying, Let’s have a spaghetti Bolognese scenario with little cores of meat around Europe that are all linked together.'” With three or four major clearing groups emerging, he expects Europe “to get nearer to more efficient spaghetti.”
On the settlement side, consolidation appears even less likely than it does among CCPs. The settlement process is complicated because issuers’ relationships with CSDs vary by country and because national tax and fiscal laws are different. Consequently, consolidation of securities depositories is not necessarily a spur to efficiency.
But the problem of fragmentation remains: “Why do we need 27 CSDs in Europe? Every time we do a trade, we are paying for 27 sets of overhead,” notes Merrill’s Beattie.
In July 2006 the European Central Bank joined the fight to deliver more efficiency to the settlement world. It proposed a settlement services platform in the Eurozone based on its payment platform for central bank activities, called Target. The settlement platform has been dubbed Target2-Securities, or T2S.
Industry response, which has been voluminous, has run from polite approval to sharp criticism. Euroclear, a CSD provider that settles trades in a number of countries and that is working on a single platform for its markets, has described T2S as a “major public-sector intervention in the post-trade industry.”
It’s potentially an added layer of complexity that could deflect resources from other efforts,” says Fimat’s Cirier. In his view, the immediate focus should be on eliminating national differences around settlement. Each country, he points out, has vastly different rules and tax regimes for corporate actions, the collateralization of accounts and so on.
Bob Giffords, an independent banking and technology consultant in the U.K., notes that despite early worries, the industry “might just buy in if the ECB can be sufficiently flexible.” He points out that the ECB has a long horizon-its goal for the platform is 2013-which gives it enough time to build an advanced technology platform and surmount existing obstacles.
Currently, a broker or custodian must fund each of its CSD accounts in order to settle in those countries, Giffords explains. In the future, CSDs could hold their cash and securities accounts on the same Target2 platform, with sub-accounts for their customers that allow instant transfers between accounts. “This means a bank would need less cash overall and, importantly, less collateral,” Giffords says. He adds that other services currently provided by CSDs would, under the code of conduct, be unbundled and could be paid for separately.
In June, European exchanges, CCPs and CSDs-under the auspices of their industry groups-produced “access and interoperability guidelines” for establishing links between their organizations. This opens the door for competition in post-trade services.
LCH.Clearnet wasted no time testing the guidelines. The firm in August asked Deutsche Brse and Borsa Italiana for “full interoperability” to their respective clearing entities, Eurex Clearing and Cassa di Compensazione e Garanzia.
For interoperability between CCPs, a clearinghouse must first get access to the exchange-controlled trade feeds from each market, says LCH.Clearnet’s Alberto Pravettoni. Once that happens, he explains, if two customers execute a trade on, for example, Borsa Italiana and one wants to clear with LCH.Clearnet, while the other is using Cassa, “we will be the counterpart for our client, Cassa will be the counterpart of the trade for their client, and we will have arrangements between us and Cassa, where we manage the risk among our two CCPs.”
The process of access and interoperability is complex. It involves, Pravettoni says, building connections between the clearinghouses and satisfying various access criteria and legal requirements in the home country of the exchange. Interoperability, he notes, also involves an extra leg in the transaction, adding to operating costs in the market.
Indeed, some say interoperability is not an ideal solution for clearing, since it doesn’t by itself reap the benefits of economies of scale. “I don’t think interoperability will be the answer. It’s costly and complex,” says Fimat’s Patrick Cirier. He speculates that another round of mergers among CCPs-especially if there’s further consolidation among Europe’s exchanges-would be a quicker and better path to a more efficient clearing environment.
Although interoperability is expected to spur consolidation, there are many hurdles, including financial ones. Merrill Lynch’s Niki Beattie points out that the obvious way to achieve a single clearinghouse is to do a deal. “But how do you price the deal when many of the clearinghouses have an unsustainable clearing profit?” she says. “How do you value Eurex Clearing or Italy’s Cassa, where there is little transparency into those vertically owned structures?”