As we approach the final quarter of the pre-T2S age, the salesmen in the impacted countries are all geared up to defend the role of the agent bank and prove the value added of the local service provider. In reality, if there were a cut and dry case for direct participation in T2S, with or without the support of an agent bank, it would definitely have been made. Some players have adopted new solutions, with the Northern Trust dual settlement and servicing hub being the most imaginative and, at first sight, cost and quality effective. Many have opted for status quo, perhaps out of lethargy, other development priorities or considered choice in the face of the hard to determine value advantage of direct over indirect T2S participation.
T2S has created some real discussion around access routes, collateral, liquidity and agent bank roles. None of this is surprising as T2S forces all direct members, and also direct participants in CSDs, to re-engineer their market gateways and, in many cases, their network structures. It also changes the collateral and liquidity dynamics of markets, creating extra demand for scarce resources. And finally, although not a direct consequence, it raises the question of the need for local agents and indeed for local CSDs.
Market gateways need to be re-engineered by all direct participants, whether CSDs or financial firms. At a simplistic level there is a need to change from ISO15022 to ISO 20022 for the appropriate message suite. There is a need to accommodate some functionality, new in several markets, to allow for the concept of record dates, partials, prioritisation, pooling, auto-collateralisation and central bank money cash accounts. Most direct participants will have to adopt translation applications to enable use of legacy messaging at client level. And there is still work to be done on maximising the value of the different reports that will occur in T2S, with some challenges, perhaps still to be uncovered, in adapting information in the richer world of ISO20022 in an automated fashion for delivery to the lesser mortals marooned on ISO15022 and earlier standards.
The collateral dynamics of the market will be less affected by T2S than many assume. T2S, or the ECB, will only accept limited collateral, mainly government bonds. I still struggle with the idea of collateralising my Siemens trade with Greek paper, should the current ECB policy be reversed from the February 2015 status. The main value of T2S is from the auto collateralisation functionality. It may well be that, depending on the settlement mix of markets between equities and bonds, the current number of batches will need to be increased to ensure that the bulk of settlement can take place in the overnight batch. The custodian market will make little use of auto-collateralisation as they cannot pledge client stock unless they run client level accounts within T2S. Broker dealers, on their principal account, can benefit but a recent study by BNPSS appeared to indicate that the value was less than many supposed at under a quarter of transaction flow.
The liquidity dynamics are similarly interesting. The logic of settling multiple markets against a single cash pool is evident, although the option has been around since the launch of the single currency. There will be a technical challenge for markets. Essentially liquidity will be supplied in markets by Target account holders making collateral available for the batch securities overnight settlement. The idea is that the batches end before cash payments begin and the net surplus collateral will be released to support the Target cash market. That means that no extension or outage can be contemplated that would cause the two to overlap and that the net demand from securities markets, which will mainly settle overnight, must not impair the smooth flowing on the cash side during the active morning sessions. When markets settle in commercial bank money, there is a commercial decision, with some latitude on collateral, made by the settlement bank. T2S is unlikely to be able to offer any flexibility and, for those who doubt the risks, it would be appropriate to review the occasional, and potentially cataclysmic, near misses that have occurred in the quite similar CREST platform over the years.
T2S has raised the question of the value of an agent bank. Agent banks are sighing with relief as they have not seen the feared outflow of clients. At least not yet. The agent bank has three fundamental values. They provide liquidity. They provide insurance. And they cover clients in all off market or non- standard processes through tax, governance or data flow. The reality is, if T2S is really to be a catalyst for change, that it should promote harmonisation in these areas. It does not need to become a full service CSD. It does need to be the catalyst to remove the inefficiency of the T2S landscape looking like a single market for settlement and a cacophony of divergent processes in most other areas of the securities transaction life cycle.
Agent banks have realised that they do not necessarily need a presence in each location they cover. Citibank, for example, have run, for many years, a very effective hub out of Tampa covering a major part of Latin America with its plethora of small countries and micro financial markets. RZB are planning the same thing for several CEE markets. The concept that a competent hub can manage multi markets will work as long as the cost of their operation reduces from the current almost usurious heights of many individual smaller centres.
Longer term, major clients will question, if markets harmonise more, whether they could operate those hubs and strip out the middle-man. Depending on the risks involved, mainly for operational error, they will need to decide if they want the sub custodian insurance policy. And, depending on their footprint, they will need to decide whether their wallet across their business or their own business model, allows them to ensure the liquidity they need in each market.
T2S solves perhaps a few percent of the EU’s problems. A financial market, which is around the size of the USA, is fragmented, diverse, high cost and high risk. In twenty years’ time, or around three quarters of the gestation period of T2S, if economic forecast have any credence, it will account for around 20% of global custody assets. In a global market, it is high risk for it to account then for perhaps 30% plus of global costs.