I was recently passed an intriguing booklet on the €300 billion question and the benefits of T2S. I have to say the guys at PwC and Clearstream, who co-produced it, know how to create mind-blowing tag lines. When I got over the shock and saw it did not relate to a new cost estimate for the market of the T2S development, I established that the €300 billion referred to the estimated shrinkage required out of Euro bank Tier 1 capital if the market is to hit the 2019 current Basel III standards.
And the argument in the booklet is that T2S could contribute around 11% of that shrinkage or approximately €33 billion. Now we have to recognize that this saving is a function of an assumption. The assumption is that Basel III will bring all intraday credit facilities into the new net stable funding ratios. Essentially this means that intraday credit would have to be transformed from unsecured at bank option lines to secured committed lines. I do stress that no decision has yet been made and that this issue impacts the payment and foreign exchange markets rather than just the securities markets.
The assumptions behind the saving, if the markets were to adopt Basel III strict rules, are based on a Clearstream study. This claims one can shrink daily cash or credit usage by 15% using a single pooled Euro cash account. In reality, T2S is not needed for such a structure for the single currency has been around for many years! The shrinkage factor appears realistic at 15% of the aggregate. If, however, the 15% shrinkage in demand equates to €33 billion of capital savings, gross demand for capital support within the Eurozone for securities liquidity needs would appear to amount to around €220 billion. And my experience indicates that clean cash payments need at least the same quantum of liquidity as securities markets. Thus, surely adopting the mooted approach would lead to incremental capital support demand from current intraday facilities within the Eurozone alone of more than €400 billion. That implies global demand would be well in excess of €1 trillion. And today there is no direct capital support needed for such facilities. That adds €100 billion+ annually to someone’s bills based on a 10% cost of capital!
The study should surely take into account the structure of intraday exposures by market segment, essentially principal or agency counterpart. The bulk of demand is from the principal segment of the market. Currently there is adequate intraday liquidity to enable efficient demand driven settlement in this key segment as, when properly structured, the facility is a low-cost, low-risk product repayable from the completion of the transaction lifecycle and backed by an underlying value. If there is a new cost associated with liquidity provision then the market will demand a change in process to reduce that demand. Again, if the Eurozone will need to allocate €200 billion plus of capital to securities transaction processing, the cost of that capital will be around €20 billion a year. That is an added annual cost and out of all proportion to current day costs.
The study also needs to pay greater attention to the risk management process, especially in respect of some of the major custodian banks. The internal rating based approach to risk will recognize their unique characteristics. The reality is that specialised banks such as Northern Trust, Brown Brothers Harriman or State Street are fundamentally lower risk than the major money center based ones.
The study also needs to take account of two major changes in securities settlement. Firstly there is the auto-collateralization process adopted by CREST in its early days and incorporated into T2S design. Secondly, there is the fact that settlement risk will be reduced by the harmonization of the settlement period to two days with, rather than directly as a cause of, T2S. And the study does not refer to the ability of CCPs to eliminate settlement flows, although that also is not a risk or cost-free transformation.
The study also does not talk of reducing settlement demand for liquidity. From experience at the time of the launch of the CREST system, there are many tools available from managing the settlement algorithm, structuring the batch process or enhancing flow management that allow meaningful reductions in liquidity. Markets will need to consider these, if a dramatic added cost is incurred for liquidity in Basel III. In theory, the liquidity demand can be reduced to close to zero. But that creates two operational risks. First, there will be adverse impacts on the timing of finality. Second, there will inevitably be a move to multi batch overnight and intraday processes with end batch settlement, which from every perspective, is a move into a riskier operating environment.
And finally, we need to think carefully of the implications for other markets. The international securities markets, essentially Eurobonds, are based on intraday liquidity provision using collateral backing. If the ICSDs need to provide capital to support peak liquidity demand, they will have to demand pre-funding as they do not have the capital to support such an environment. And we need also to be wary of regional adoptions of tough rules. The EU capital markets are already looking less and less attractive from a regulatory and financial perspective. The PwC/Clearstream study quite rightly notes the AIFMD/EMIR challenge or the FTT threat. Let us hope that the ECB is not too macho in their approach to the new rulebooks or at least no more than their peers elsewhere.
The study is well worth reading, although the mathematics behind some of the capital saving assumptions goes beyond my arithmetic abilities. The study, when looking at AIFMD sees that as encouragement for a direct CSD link to eliminate sub-custodian liability. It looks at EMIR and finds the CSD linkage model compelling to maximize collateral usage. Perhaps it is a bit biased and there are many ways to tackle these issues; or perhaps we all are just going to have to become CSDs!