By Peter Norman
In July 2006, Europe’s providers of post-trade services suddenly learned what it was like to wait for the proverbial London bus. After being on tenterhooks for months for news of Commissioner McCreevy’s ideas for the sector’s future, the industry had to cope with two plans coming along at the same time.
On 11 July, McCreevy outlined an industry ‘code of conduct’ to enhance the efficiency and lower the cost of cross-border clearing and settlement of securities in the European Union as a whole. Just a few days before his long awaited statement, the European Central Bank surprised financial infrastructure providers by announcing plans for a securities settlement service of its own for the eurozone.
Although officials in Brussels and Frankfurt insisted that the two plans would complement each other, they differed fundamentally in content, philosophy and origin.
After months of keeping his counsel amid furious lobbying from backers and opponents of EU legislation, McCreevy gave infrastructure providers the option of producing an industry-led solution. He gave them until 31 October to agree a timetable to the end of 2007 for behavioural changes to overcome the barriers to cross-border clearing and settlement of equities.
McCreevy’s plan was all about creating the conditions for the industry to change itself. Drawing lessons from consultations with the industry in the Cesame group and the May 2006 report from DG Competition, the Commissioner set out a road map to achieve greater efficiency in EU capital markets through price transparency and increased competition.
The approach of the ECB, by contrast, was interventionist, radical and technically unprecedented. Although the ECB was further back along the decision chain than the Commission – the ECB press release on 7 July said it was ‘evaluating opportunities’ with the aim of a final decision in early 2007 – it proposed to get into the business of settling securities. Its ideas promised to change completely the way the securities settlement business is structured in the eurozone.
The ECB’s goal was to create a new service to be named ‘Target2-Securities.’ This would be fully owned and operated by the Eurosystem, comprised of the ECB and the eurozone national central banks. The idea was to attach a securities settlement facility to the Target2 system for cross-border payments being developed by the Eurosystem. The outcome would be ‘the processing of both securities and cash settlements on a single platform through common procedures’ with the objective of allowing ‘the harmonised settlement of securities transactions in euro which are settled in central bank money.’
To achieve this, the ECB proposed to take over the core securities settlement function from the CSDs of the eurozone member states, leaving them with the less pivotal but more complex jobs of issuing securities and providing custody and corporate actions services, such as paying interest and dividends to the owners of securities held in the CSD.
Both the code of conduct and T2S – as the central bank’s plan became known – would require the support of Europe’s infrastructure providers. Both initiatives raised many questions. Details of the ECB’s plans were particularly sparse in the early days after the initial announcement. But it was clear that if implemented in anything like their draft form, the two plans - taken together and with other EU initiatives - would fundamentally change Europe’s post-trade sector.
The ECB’s plan – backed by its governing council on 6 July 2006 – came out of the blue.
Whereas McCreevy’s code worked with the grain of the market, the ECB plan for a system owned and operated by the Eurosystem appeared to be a reversal of historical trends towards demutualised, for-profit infrastructures that had built up over nearly a decade.
Unlike McCreevy, the ECB was not proposing a solution for fragmentation throughout the post-trade sector. Its idea was limited to settlement services in the eurozone where it proposed to handle equities and bonds.
With the benefit of hindsight, it is possible to see how the protracted inability of Europe’s post-trade providers to successfully consolidate and integrate the sector stoked frustration at the ECB.
When Tommaso Padoa-Schioppa expatiated on the importance of securities settlement at the Sibos conference in Munich in September 1999, he had every reason to believe that consolidation of Europe’s settlement infrastructure lay around the corner. Cedel, Deutsche Börse and Sicovam still appeared on track for a trilateral merger. He therefore outlined a non-interventionist approach for the ECB as the central bank’s preferred position.
Padoa-Schioppa noted that the Maastricht Treaty made no explicit mention of securities settlement because ‘central banks’ involvement in securities settlement systems has only developed after the adoption of the Treaty’. But central banks needed to be increasingly concerned about the smooth functioning of securities settlement systems because of their statutory duties in the fields of payments systems and monetary policy.
Although the ECB would not be an exception to this rule, it was obliged by the terms of the EU Treaty to act in accordance with the principle of an open market economy. This meant ‘as long as market forces do not lead to unsound or inefficient solutions, the Eurosystem will not influence the trend towards consolidation of the central securities depositories in Europe’.
Fast forward 30 months and Sirkka Hämäläinen, another ECB board member, was sounding rather less sanguine. Commenting in April 2002 on the euro at the launch of a capital markets research network in Frankfurt, she noted how ‘no other currency area has ever had to cope with such a highly fragmented securities infrastructure’. Looking back at developments in the US, Italy, France and Britain over the 20 years to the mid-1990s, she first noted how there had been ‘some form of public intervention either by the legislator, the securities regulator, or the central bank in order to effect changes in the national securities infrastructure. Second, the interventions all sought to improve the efficiency and competitiveness of the domestic securities industries.’ She added: ‘Given the current degree of fragmentation of the securities infrastructure for the euro, it is natural to study whether similar action might be useful or necessary today at the euro-area level.’
Move the clock forwards another four years to June 2006 and Gertrude Tumpel-Gugerell, the ECB board member in charge of financial infrastructure, seems close to the end of her tether. Tumpel-Gugerell succeeded Hämäläinen on the ECB executive board in 2003 after a career in the Austrian central bank in which she rose to be vice-governor.
After stating that integration of securities settlement providers should be market driven, she told a conference organised by the Spanish central bank: ‘However, this does not mean that authorities should just stand back and wait and see. Action by authorities is warranted in the event of market failures. Some markets can be reluctant to change (the first step is always the hardest and old habits die hard) and the different time horizon of costs (today) and revenues (tomorrow) relating to the necessary investments may increase this reluctance. Moreover, market forces may not be able to take all the necessary steps to ensure effective competition as well as the stability of the infrastructure. It is not a coincidence that, to date, the most successful example of integrated infrastructure has been the TARGET system for settlement of large-value payments. It should be noted that TARGET was created not by the market, but by the central banks.’
Tumpel-Gugerell’s comments reflected more than pride in the technical capabilities of TARGET. Among her officials, there was also a belief that the ECB could be a successful catalyst, bringing greater efficiency to the post-trade sector.
They looked back to the nine standards devised by the [European Monetary Insittute] in the late 1990s and concluded that these had fostered consolidation by forcing some settlement systems – in Spain and Italy, for example - to choose between investing to meet the standards or merging with others which were already compliant. But that process had run its course. In the eurozone, the national CSDs were usually local monopolies and disinclined to consolidate. Their number had dropped only modestly from 23 in 1999 to 18 in 2004. The settlement sector needed a new catalyst to spur consolidation.
By the time Tumpel-Gugerell gave her speech in Madrid, the idea of T2S had already been discussed between the ECB and national central banks. It is possible that by July 2006 the ECB felt it had little choice but to take on the catalytic role. The ESCB-CESR standards, which might have been expected to foster change, were stalled. The possibility of a framework directive from the Commission – a measure which Tumpel-Gugerell explicitly backed in her Madrid speech – looked less likely as the end-July deadline for McCreevy to make up his mind drew nearer.
By putting forward its own solution for securities settlement in the eurozone, the central bank would be seen to take a decisive lead after years of only limited progress by the private sector towards a more efficient post-trade infrastructure in Europe. The history of clearing and settlement in the US provided a precedent of sorts. Intervention by Congress and the Securities and Exchange Commission in 1976 led, by the end of the 1990s, to a cheap and efficient, utility-model US clearing and settlement infrastructure with The Depository Trust and Clearing Corp (DTCC) at its centre.
But there was another compelling reason for the ECB to act, which its officials chose at first not to advertise, and yet which determined the specifications of T2S.
For roughly a year, serious differences had persisted among some of the eurozone’s leading national central banks over how to handle the cash leg of securities settlement using central bank money. The unprecedented technical design of T2S reflected an urgent need for the ECB leadership to overcome a split among the national central banks in its governing council.
In setting up T2S, the ECB proposed to follow what was accepted as best practice in the industry: the so-called ‘integrated’ model of cash and securities settlements on one platform, using for the cash-leg central bank money, which is the most secure of all cash settlement methods.
Soon after announcing the project, ECB officials let it be known that T2S came with three non-negotiable elements. One was the use of the integrated model. The second was that T2S should have monopoly use of eurozone central bank money for securities settlement and there should be no ‘outsourcing’ of central bank money to other post-trade service providers. The third was that all the eurozone would be brought into the scheme.
The ECB’s proposal to take control of the cash leg of settlement of eurozone securities using central bank money in an integrated system meant it would have to ‘insource’ securities settlement on a single platform of its own. This reversed the practice, approved in pre-euro days by the Banque de France when it outsourced the cash leg of the integrated settlement function to Sicovam, the French CSD that became Euroclear France in 2001.
For nearly 12 months, the German and Italian central banks, backed by the Spanish, led a determined, behind-the-scenes campaign to turn ECB policy against outsourcing the use of central bank money for securities settlement. Securities professionals were aware of the power struggle. Indeed in January 2006, Jean-Francois Théodore, the CEO and chairman of Euronext, wrote to Tumpel-Gugerell expressing concerns that the row could jeopardise investment in the ESES settlement system for Euronext.
In part, the opposition of the national central banks to outsourcing was principled. Historically, the control of central bank money was a core central banking function. No matter how rigorous the rules, they argued, ceding control through outsourcing entailed some risk for financial stability. But there were also suggestions that the national central banks had ulterior motives. They were interested in retaining business in their territories that might otherwise be lost to other providers through outsourcing.
Jean-Michel Godeffroy, the ECB’s director general for payments systems and market infrastructure, later recalled how he and his team came up with the idea of T2S after being sent away ‘to think the unthinkable’. This was when the ECB, initially, had no intention of entering the securities settlement business.
‘We were divided. The Eurosystem was divided,’ he said. ‘There were two schools of thought. And behind that was the market asking for harmonisation because some of them were considering that they were in an unfair situation.’
‘Then my team was asked, after long discussions, to start thinking about something else: to think the unthinkable. We had to think the unthinkable, because for us it was unthinkable that we [the ECB] would get into this business.’
‘But the logic was very simple. If we have to keep the efficiency of the market deriving from the integrated model, but at the same time we cannot outsource the central bank account, then the only solution is to in-source the securities accounts. But don’t believe T2S exists just because of this triggering event. It exists also because there was a lot of frustration in the market and among the political authorities in Europe.’
‘To be very honest, when we presented this project – T2S – to the governors, I believed that they would not accept [it]. I thought the risk would be too big for the governing council: the financial risks and the reputational risks. And I was very surprised - I would say happily surprised - that they took this risk without division within the council. I could not name a governor who is against this project.’
While Godeffroy was ‘happily surprised’ by the T2S initiative, the reverse was true for the Euroclear group. Euroclear was a clear beneficiary of outsourcing of central bank money and seemed set to benefit more in the future. Euroclear France settled transactions using central bank money under outsourcing arrangements originally approved by Jean-Claude Trichet, the ECB president, when governor of the Banque de France. The integrated model of securities settlement, with an outsourced cash-leg, was planned for ESES and the single settlement platform that would complete the group’s €500 million investment in the domestic market for Europe.
T2S, if realised, would fundamentally change the business practices of national CSDs in all the eurozone countries. It would also force Euroclear, Europe’s biggest securities settlement provider, to remodel a business plan that had already cost about €250 million and which promised to cut costs sharply for users.
The announcement of 7 July left many unanswered questions, including issues of cost and timing. The ECB envisaged recouping the cost of investing in T2S from fees paid for its settlement services by national CSDs. But would it also have to compensate Euroclear – and national CSDs – for investments taken over or rendered obsolete by its plans? Or would it wait to introduce T2S after these investments were amortised? If so, how long would that be?
Also unclear were the scope of the project and technical risks involved. ECB officials initially talked of T2S as a small operation, operating in daylight hours, which would leave settlement in commercial bank money to others including existing CSDs and ICSDs such as Euroclear Bank and Clearstream Banking Luxembourg.
But was that what the market wanted? Would a small-scale T2S meet the demands – especially from investment banks - for sophisticated services tailored to fast changing requirements covering a wide range of asset classes? How would a daytime system fit with an industry that conducted many of its operations through the night?
On technology, the ECB could reflect with some satisfaction on past successes, including the TARGET1 payments system. But had it the know-how to deal with the securities infrastructure, where investments had so often gone wrong in the past? In the week the ECB governing council decided to go public with T2S, David Hardy resigned as CEO of LCH.Clearnet because its failed technology programme ran up losses of more than €120 million.
At a more fundamental level, there were questions whether a proper legal base existed for T2S in view of the absence of any mention of securities settlement in the EU treaties.
Nonetheless, the concept of bringing back to the central bank securities settlement with central bank money got the ECB off a difficult hook. It would allow the securities industry to benefit from the state-of-the-art integrated model using central bank money while ensuring peace inside the central bank’s governing council. The central banks of France, the Netherlands and Belgium, which at that time backed outsourcing and which had Euroclear-owned CSDs in their territories, were thought to have acquiesced in the ECB solution rather than be outvoted.
Plumbers and Visionaries - Securities Settlement and Europe's Financial Market is published by John Wiley & Sons, Ltd. (ISBN 978-0-470-72425-5).
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