Securities clearing and settlement in Europe by qov12652


									           Securities clearing and settlement in Europe

Executive summary

Converting the European securities market infrastructure from its current
configuration where each member state has its own trading, clearing and settlement
arrangements to, at least, an EU-wide integration of the clearing and settlement
platform is a prerequisite to making European financial markets more efficient and

Traditional exchanges are already losing their former role as national monopolies
with the advent of cross-border listings, Alternative Trading Systems (ATS) and new
execution venues offered to a broader range of customers by investment banks,
brokers and private initiatives. We would encourage competition among trading
platforms to improve customer service, and we recognise that for-profit public
ownership of the traditionally mutually-owned exchanges helps to achieve this. Once
executed, trades should be cleared via a Central Counterparty (CCP), where
novation occurs. This reduces counterparty risk, makes netting possible, decreases
regulatory capital and reduces the number of settlement instructions. Reductions in
settlement volumes will help this infrastructure accommodate the expected large
increases in equity and bond trading volumes in Europe, considering that, in equities,
evolution is driven, in particular, by the necessity for capital-backed pensions, despite
the current downturn. The more trades pass through a CCP, the greater the
efficiency achievable via netting. In the final analysis, one CCP for all transactions in
debt securities, equity and their derivatives in Europe would be the most efficient.
Such a CCP would itself be a source of systemic risks and the question therefore
arises, how such risks can be managed effectively. The same applies to Central
Securities Depositories (CSD), which provide deposit, custody and Securities
Settlement Systems (SSS), i.e. essential market facilities. Settlement is a business
subject to the economies of scale and this has led each market to consolidate at the
level of the national CSD's. Moving on from their initial focus on fixed income
products, the two International Central Securities Depositories (ICSD) (Euroclear and
Clearstream) have launched equity clearing services in recent years. Consolidation
of Europe's many settlement platforms is necessary to reduce per unit costs and
thereby make Europe's markets more competitive. Trading should be unfettered from
designated clearing and settlement processing models. No trading platform should
have an undue influence on any single settlement system. Free and open access for
all intermediaries to the infrastructure is required, including financial intermediaries
and other CSD's. Users must have adequate influence on the governance of the
settlement systems. As consolidation takes place, settlement systems should
gradually move into the role of a public utility, whereby the focus for these services is
                                Clearing and Settlement in Europe

on delivery at the lowest cost and competition is limited considering that
consolidating transaction flows is necessary to deliver efficiency. This is already
apparent in that the European market is already largely polarised between the
Euronext/Euroclear and Deutsche Börse camps.

We believe the objective of integrating the European financial services markets is a
fair one and we suggest 3 conditions should be met if we want to best serve
European investors and issuers:
- a consolidation of European market infrastructures,
- the fostering of competition to ensure choice for market participants and to keep
    pressure on prices, and
- the harmonisation of the legal, fiscal and regulatory frameworks to reduce the
    costs of cross-border activity for market participants and, in general, for issuers
    and investors.

Current arrangements

Market infrastructures for clearing and settlement services interact in a vertical chain
organisation with stock exchanges and National Central Banks (NCB) serving as
market participants. Clearing and settlement infrastructures benefit from a natural
monopoly – granted de facto, if not by law. Thus, central counterparties and central
securities depositories benefit from dominant positions on the European domestic
markets. As a result, access to these infrastructures is compulsory for financial
intermediaries, who serve retail and institutional investors. Their roles can partly be
compared to that of railway, airport or telecommunication infrastructures. As such,
they must be adequately regulated and supervised as long as the barriers to

                            Trading                             Execution           Competition    Choice
                                                             venues, such as
                                                               ECNs, etc.

                                                                                 Pan-European CCP through
                                                                  Clearing       competition where the best
                            Clearing                             House with      providers can flourish and
                                                                                 extend their service into new
                                                                   CCP           national jurisdictions

                                                                                             Creation of an
                                                                                             open, competitive
                                                      CSD                     NCB            framework will lead
                           Settlement                                                        to consolidation
                                                                                             and possibly a
                                                                                             European DTCC
                                                     Notary                Cash
                                                    Securities           Settlement

competition in this field are not removed.

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                                     Clearing and Settlement in Europe

Future options

The European financial system is undergoing rapid changes, thanks to continuing
technological innovation and closer integration. For investors, investment strategies
are increasingly based on pan-European, sectoral considerations. However, markets
remain fragmented on a national basis. To facilitate integration and efficiency, the
misuse of existing monopolies must be counteracted and restricted access to trading
and post-trading services must be abolished. For post-trading, we support horizontal
integration. In the long run, establishment of a consolidated system with the
character of public utility, at least at the clearing level (as in the United States where
the Depository Trust and Clearing Corporation (DTCC) is owned by market
participants), is an option. The principal alternative is vertical integration, with
exclusive relationships between trading on one side and clearing and settlement
systems on the other, as is currently the case in many EU countries (silo systems).
The compromise solution, in which it will be left to market forces to decide which
model will prevail, lies in removing the barriers identified by the Giovannini Group,
such as restrictions on the location of securities or differences in market practices.
This nevertheless requires adequate oversight from the Giovannini Group to make
sure that the strategy for removing such barriers is implemented accordingly.

Thanks to technology, we have the ability to process huge quantities of information in
(near) real time and to link multiple information providers and recipients anywhere
around the world. Multiple market participants (traditional exchanges, alternative
trading systems, investment banks, etc.) are able to better satisfy customers'
demands, while at the same time, providing the usual benefits of a competitive
environment: greater incentives to innovate, lower costs and greater efficiency. For
financial exchanges, this means evolving towards a decentralised structure, where
trading takes place on different platforms - a system formed by a multitude of
participants, in which national exchanges lose many of their features as public
utilities and behave like regulated companies. In such a system, trading platforms are
supplied by a new breed of exchanges that are run for profit and compete against
each other. This requires national governments to eliminate all rules imposing
obligations that shares in listed companies be traded on a particular exchange. The
supervisory roles currently assigned to some European exchanges ought to be

The growing number of participants interacting in financial markets has multiplied the
number of potential trading counterparties enormously. Establishing counterparty
relations with each one is difficult and inefficient. In this sense, a central counterparty
- which interposes itself in every trade – would enormously simplify trading
relationships. This process called novation allows for multilateral netting. It has “the
potential to reduce liquidity risks more than any other institutional form” and “the
credit risks of this institutional form are generally less than in other forms”1. In the
United States, through netting, the CCP cuts the counter value of the transactions
settled by an average of 95%. This has allowed the system to successfully
accommodate the huge growth in trading volumes.

    BIS, Report on Netting Schemes, February 1989.

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                                   Clearing and Settlement in Europe

Given the strong doubts as to whether a competitive market place is feasible for
CCP's and their related strong systemic importance, it made sense in the past that
clearing and settlement governance arrangements were aimed at fulfilling public
interest requirements (CPSS/IOSCO Recommendation 13)2. But other aspects
nowadays deserve strong attention. Particular importance must be placed on the
CCP's risk profile. The CCP is a tool for risk reduction (it reduces bilateral settlement
exposure and, by matching positions in assets, it minimises the need for collateral).
But by assuming risk, the CCP also concentrates it. This requires strict prudential
regulation - its failure would have huge systemic consequences. (See CPSS/lOSCO
Recommendation 4 regarding prudential regulation, collateralisation of risk, margin
requirements, etc.)

To maximise its benefits, the CCP ought to represent a single entry point across
securities (equities and bonds) and across markets (cash and derivatives, regulated
markets, ECN’s, OTC, etc.). In Europe, it ought to operate across currencies,
including, besides the euro, at least the British pound, Swedish krona and Swiss
franc. Clearly, the existence of vertically integrated exchanges (that have exclusive
arrangements with their own clearing and settlement institutions) represents a major
obstacle to the formation of a single CCP.

The Lamfalussy report states that, at least at an early stage, it should be up to the
private sector to promote the consolidation of the post-trading infrastructure3. To a
large extent, we agree with this. Nevertheless, authorities need to monitor conduct
that may be in contradiction with competition policy. For instance, vertical trading
system arrangements allow access to be restricted to the post-trading infrastructure.
Given the public utility nature of post-trading, which entails insufficient competition,
this practice ought to be assessed carefully. It is widely believed that access to the
clearing and settlement infrastructure must be based on clear rules to avoid
discrimination of the front-end exchanges' potential competitors. These rules should
ensure that participation is based on public criteria and that access is 'fair and open'
(as stated in the CPSS-IOSCO Recommendation 14).

With the advent of ICSD’s the clear distinction between different types of service
providers was put into question. The two European ICSD’s were set-up4 in 1968 and
1972 to serve the homeless and unregulated Eurobond market. Thus, both of these
ICSD’s act as CSD’s to secure the deposits of the same securities. For the past 30
years, these two entities have operated as a "duopoly", connected through an
electronic link, which has proven to be a constant source of concern for both ICSD’s
and market participants. Furthermore, the ICSD’s have also developed intermediary
services based on their banking licenses in addition to their core market
infrastructure role for Eurobonds. The standards proposed by CESR-ESCB for the
securities clearing and settlement systems in the European Union highlight the need
for adequate regulatory guidance.

  Committee in Payment and Settlement Systems (CPSS) / Technical Committee of the International
Organisation of Securities Commissions (IOSCO), Recommendations for Securities Settlement
Systems, BIS; January 2001.
  Final Report of the Committee of Wise Men on the Regulation of European Securities Markets,
February 2001, p. 16.
  Euroclear was founded by JP Morgan in Brussels in 1968 and Cedel, now Clearstream, was founded
by European banks in Luxembourg in 1972.

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Infrastructure providers that have developed banking functions must make sure
adequate risk control measures are in place to avoid possible spill over risks. Also,
because infrastructure providers have special relationships with market regulators,
market authorities and other market infrastructures which are not available to
commercial enterprises, they must make sure they do not exploit their monopoly
remits for their core functions to reduce competition in their intermediary business.
This would not mean a corporate break-up or cancellation of banking licences for any
of the existing groups. But it would involve managing the intermediary business at an
arm’s length from the CSD, on a level playing field with other intermediaries.

The blurring of functions must not lead to new regulatory burdens by regulating
banks as infrastructures and by adding new layers of regulation to the existing
prudential banking and securities regulations that already cover the credit and
operational risks they assume. Doing so would generate additional costs for banks as
intermediaries but it would also reduce the amount of cash liquidity intermediaries are
able to provide to the market. Furthermore, despite the quality of their balance
sheets, intermediaries would need to mobilise additional collateral, resulting in costs
passed on to investors. We recommend that the CESR/ESCB standards be applied
to CSD’s and that financial intermediaries be put under BASEL II prudential
regulation rules.

We support the recommendations of the Giovannini Group in favour of government
intervention in the field of clearing and settlement, if necessary:
- The integration and consolidation of European settlement infrastructures is a
    prerequisite to delivering an integrated EU financial services market;
- European authorities should promptly intervene to enforce the general interest
    criteria, that is cost efficiency, avoidance of systemic risk and allowance for fair

Blueprint for a European clearing & settlement infrastructure

A harmonised legal and regulatory framework of European capital markets is leading
to a standardised clearing and settlement model that will challenge the need for
intermediaries, encourage competition and thus foster consolidation among providers
of post-trade infrastructures. Uniformity of clearing and settlement processing will
allow providers to leverage their technology platforms resulting in significant
reductions in both domestic and cross-border settlement costs for the users.
The logical conclusion is the elimination of ‘cross-border’ settlement within the Euro
zone such that all European securities clear and settle ‘euro domestically’
irrespective of home market. This should be possible at an even lower cost than
‘national domestic’ clearing and settlement already in practice in light of the vastly
increased economies of scale. The main characteristics of such a desired
infrastructure include unrestricted access and egress along the value chain of a
securities transaction. Service offerings should be voluntary and transparent so that
users are free to pay only for the services received. This is the necessary answer
especially for those exchanges and clearing and settlement operators under
suspicion of possible cross-subsidisation between trading and clearing or across their
CSD activities and banking services - a practice which might be in contradiction with
a sound competitive environment. The final state of the European securities
 These general interest criteria were also identified by the European Parliament and the Group of
Thirty in reports published on 15 and 26 January 2003.

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                                      Clearing and Settlement in Europe

landscape cannot be foreseen yet but there is no reason why competition and
consolidation should not eventually lead to a single European central securities
depository. In this context, national central banks should consider achieving a level
playing field by stipulating unrestricted access to central bank money both for foreign
and domestic market participants.

While this utopian vision is undoubtedly some way off, we believe the foundations
need to be laid and the route plotted now to ensure correct positioning and to avoid
unnecessary investments by the industry.

Clearing and settlement in the European Union - Main policy issues and future

The regulation of clearing (CCP's) and settlement (CSD's) infrastructures is essential
to protect individual investors, to protect them against systemic risks, and to enforce
competition rules. Hence, we welcome the communication of the European
Commission, dated 28 May 2002, which presents the main policy issues and future
challenges for clearing and settlement in the European Union.

The consolidation of the European clearing and settlement infrastructures
must respect the role of the infrastructures

The changeover to the euro has prompted several mergers across EU
infrastructures. This consolidation process, much awaited by market participants, has
been led by market initiatives: Euroclear Bank Brussels and Clearstream Bank
Luxembourg (ICSDs) have acquired a number of CSDs in Europe.6 In recent years,
they have developed consistent global custody operations focused on the European
markets. Unfortunately, the current domestic legal frameworks are no Ionger suited
to regulate these new pan-European infrastructures emerging from the consolidation
process. This situation generates systemic risks for the financial market and a
distortion of competition for banks by permitting the blurring of roles between the
(I)CSD infrastructures and their banking members without an appropriate regulatory

We believe that market initiatives must be complemented by a political vision at the
EU level; we suggest that the European Commission, with the support of the
European Parliament, promptly implement a European framework for clearing and
settlement infrastructures. The need is all the more urgent in that we are addressing
an existing situation at the EU level and in considering that the lack of a central
depository in the USA led Congress and the SEC to require the creation of DTC back
in 1973.

    Respectively Belgium, France, Holland, Portugal, UK, for Euroclear and Germany for Clearstream

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                                Clearing and Settlement in Europe

Integration of the European financial market is a fair objective

We feel that the current EU debate is largely dominated by market infrastructure
perspectives (exchanges, clearing houses, central securities depositories) and that it
will not be complete until it includes investors' views.

We support the Commission and Parliament's objective of integrating the European
financial services market. In order to reach this goal, we believe we should not limit
our analyses to the international transfer of securities between (I)CSDs.

In fact, the issue at hand is rather the current fragmentation of EU clearing and
settlement infrastructures. This stems from the EU's current diversity of existing legal
and tax regimes from which domestic infrastructures have developed. Hence, we
believe we must set the highest priority on the development of a single legal, fiscal
and regulatory framework in Europe.

This is a long-term goal, because it involves the convergence of company laws, and
of securities regimes. Nevertheless, this is the true key to pass cost reductions on to
investors, as the current diversity is the major source of costs for intermediaries, and
thus ultimately for investors.

We suggest that the regulation of clearing and settlement infrastructures be placed
as a priority within future legislative activity. In the medium term, progressive
convergence of the European legal, fiscal and regulatory regimes for both securities
codes and securities transactions is required.

These are the conditions to ensure that the construction of an integrated financial
services market respects the interests of the general public and actually fosters cost
reductions for the market participants.

Brussels, December 2003

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