Last week, I attended a European Parliamentary Financial Services Forum (EPFSF) event on Europe’s settlement landscape. Like most, I thought of “settlement” as being a little bit dull — its core function is the safe exchange of cash and securities rather than the more interesting front-end business of making investment decisions. However, settlement — carried out by so-called Central Securities Depositories (CSDs) — is no less important. To understand just how important settlement is, consider this: more than 920 trillion euros of securities transactions were settled through CSDs in 2010, leading them to be classified as systemically important by the Financial Stability Board and the Basel Committee on Payment and Settlement Systems (CPSS).
CSDs and their international equivalent, ICSDs, are an essential piece of the market infrastructure jigsaw supporting the global financial system. They are the final link in the chain that spans trading, clearing, and settlement. Although the settlement process held up well during the financial crisis, the systemic importance of the industry means that it cannot be overlooked as part of the wider package of regulatory reforms. Moreover, there remain areas for improvement. Just look at the facts: cross-border settlement in Europe is approximately four times more expensive than domestic settlement, and it carries a failure rate of approximately 10 per cent compared to just 1-2 per cent for domestic settlement. Furthermore, total post-trading costs, taking into account clearing and settlement, are thought to be a multiple of the equivalent costs in the United States. All of which leaves European investors worse off.
So what is to be done? There are two key initiatives under development, namely the CPSS-IOSCO standards on financial market infrastructures — a set of global but non-binding principles — and the Eurosystem’s “Target 2 Securities” (T2S) initiative, the future IT platform for the settlement of almost all bonds and equities that are traded in Europe (more on this below). However, there is currently no legally enforceable regulatory framework for CSDs at the European level and hence no real single market. Instead, the settlement landscape is fragmented along jurisdictional lines which keep costs for investors unnecessarily high and efficiency low. Accordingly, it is no surprise that the European Commission is looking to regulate; earlier this week it published its proposals. As I learnt at the EPFSF event, the legislation must strike the right balance between achieving safety and stability (“boring is good”, as one participant remarked) and the need to support competition and the provision of a level playing field.
“Banking” and Systemic Risk
On the subject of competition, CSDs have been developing and expanding their ancillary services to clients, such as the provision of electronic proxy voting services, collateral management services, and limited banking. The banking function provided by CSDs relates solely to the financing of cross-border settlement timing differences. It is provided only on an intra-day basis and is fully collateralised. As such, the banking service offering is very narrow and very safe, in keeping with CSDs’ low risk profiles. Euroclear (along with Clearstream, one of the two ICSDs in the EU), for example, has a Tier 1 ratio of 40 per cent — significantly higher than most “banks”.
But one of the more interesting aspects of settlement is its interplay with the banking system and the eurosystem — the collective term for the European Central Bank (ECB) and its supporting network of national central banks — via Target 2. This is because CSDs settle in central bank money: the domestic commercial bank serving the counterparty to the transaction has an amount credited or debited at the national central bank, which in turn creates the money for the transaction to be settled in the CSD. Sounds complicated? One participant at the EPFSF event essentially referred to T2S as “nationalisation” of the settlement business.
Intriguingly, a new working paper by the German CESIfo Institute, commented on in the Financial Times, reveals how a central bank’s Target 2 balance — essentially its net claim against the Eurosystem — mirrors the current account imbalances of the countries within the eurozone since the start of the crisis. In particular, the Bundesbank has built up a large claim against the Eurosystem as it has financed the current account deficits of the periphery, an exposure that presents a potential source of systemic risk and has implications for domestic refinancing operations. But that in itself merits a separate blog post altogether.
Whoever said settlement was boring?