As we all await a decision from ESMA about a possible further delay its worth reflecting on the origins of the regulation. Settlement isn’t glamorous. Nobody pretends that settlement is the most stimulating issue extant in the market today. But it is important. In fact, it’s vital – because it’s truly systemic. Without settlement the capital markets would seize up. This was identified by the novelist Tom Clancy in his 1999 book “Debt of Honor” where he suggested that destroying the HQ of the monopoly US settlement provider would bring the market to a halt. Unhelpfully he actually specified the street address. Tom’s prescience was genuine and operational resilience – thanks to events like 9/11 and Superstorm Sandy – is now vastly improved. Things we now take for granted, such as duplicate live production sites with geographical separation, were not the norm at the turn of the century. It’s easy to forget.
The systemic nature of settlement is why the European Union decided to legislate the sector after the financial crisis. The most common question raised at the time of early development of CSDR was, “Why is it needed? What problem are they trying to solve?”. This was a genuine issue – CSD’s sailed through the financial crisis without missing a beat. Even the collapse of Lehman Brothers, with its huge number of open unconfirmed trades, did not raise any process issues. Back-offices may have been in full crisis mode but CSD’s themselves functioned very well.
So why did the EU decide to legislate? As politicians would say “never let a crisis go to waste”. The financial crisis gave the EU the justification for a complete renewal of Europe’s regulatory structure. To support the single market the EU had long wanted to create a more unified regulatory structure in the EU’s 28 member-states. New institutions, such as ESMA, were created and a raft of new legislation was produced. The CSD Regulation was a component of this post crisis response. From a policy-maker perspective it would have been quite illogical to not have new legislation covering the settlement segment. Although nobody can point to a failure caused by CSD’s being locally regulated by national supervisors the centralisation agenda would prevail. It fitted the “more Europe” model.
Additionally, other new legislation, principally MiFID II/MIFIR, had significant downstream impacts. The EMIR legislation made sweeping changes to the clearing segment. Without a complimentary piece of legislation covering CSD’s and settlement the process of re-architecting the regulatory structure would be incomplete and incoherent. The panoply of post-crisis EU legislation may look somewhat discordant, but the genuine intention was to be joined-up and inclusive.
The other, very significant, background issue was the view of the policy makers that Europe has too many CSD’s. Alongside the legal framework that underpins all EU legislation the viewpoint is often driven by economic theory. This is reflected in the focus the EU puts on competition policy. The Competition unit (known as DG COMP) is hugely powerful and very effective. It’s the beating heart of the Commission. Their view is that national silos inhibit true competition.
The logical response to the ongoing proliferation of CSD’s, especially if you’re an economist, is that a harmonised regulatory framework and pan-European standardisation will encourage competition. The expected outcome is a process of consolidation.
This viewpoint was also a big factor in the launch of the ECB’s T2S system. The approach can be summed up as “if you won’t do it yourselves, we’ll have to do it for you”. A senior ESMA official told an audience of post-trade managers at a conference in 2018 that T2S and CSDR were the only really successful post-trade initiatives in the market for many years. However surprising and controversial this claim might be it clearly shows the policy viewpoint that the market should consolidate is driving the policy.
The longed-for consolidation hasn’t happened and there’s no sign of it happening in the future. So, the objective remains wholly unfulfilled. More of this in the next post.