How has T2S evolved since its launch in 2015?
Let’s revisit the initial aims of TARGET2-Securities (T2S) and key usage figures from today. Nearly eight years have passed since T2S initially went live with the first set of central securities depositories (CSDs) being onboarded.
The overall vision of T2S was nothing less than to revolutionise securities settlement in Europe. It was aimed to bring an end specially to complex cross-border settlement procedures and the problems caused by different settlement practices and standards among the EU countries.
The main objectives were: facilitation for investors buying securities in other Euro-area countries, reduction of cross-border securities settlement costs, increase in competition among providers of post-trade services (i.e. clearing and settlement services) in Europe, streamlining of the use of liquidity through single settlement accounts, a reduction of settlement risk and increase of financial stability by using central bank money for transactions on the platform.
Before its launch, it was widely considered a critical initiative for lowering costs and increasing cross-border settlement efficiency within Europe. A couple of years later, reality shows that some expectations were partially too optimistic and not all goals have been fully achieved. The settlement market remains – at least in parts – ineffective and fractured. This complexity leads to duplication of solutions, fragmented processes and, at the bottom line, risk and cost inefficiencies for market participants. The introduction of settlement fail penalties by the Central Securities Depositories Regulation’s (CSDR) Settlement Discipline Regime (SDR) in 2022 has so far not shown a notable impact on settlement efficiency, although a definitive statement regarding SDR can probably be only made when data is available for a longer period. The largest attributor of settlement fails remains lack of securities. We anticipate that the CSDR Refit will address some inconsistencies in the methodology. In the meantime, we are heavily engaged with our clients and community on both a bilateral and multilateral basis to support improvements in the settlement efficiency rates.
More significantly, when one recalls the objectives of T2S, is that the level of cross-CSD settlements compared to total settlements by volume has remained low between 2018 and 2022, increasing from 0.67% of all transactions in 2018 to 1.25% in 2022. Since the inception of T2S, Clearstream has invested in providing an extensive cross-market settlement product to our clients. Even so, within T2S today, systemic and operational barriers remain, which deter market participants from fully realising the significant cross-market potential of T2S. We have identified several and are working with stakeholders to address these.
Thus, so far, we paint a picture of a heterogenous settlement landscape at the start of its harmonisation journey, to ultimately improve trade lifecycles and profitability.
What has changed in the macro environment?
We see an increasingly pressuring monetary policy environment being met by a more prepared than expected banking sector. The Basel Committee on Banking Supervision (BCBS) reports major improvements in bank liquidity risk profiles and capital reserves since 2008 as a milestone in building the resilience of the global banking system. Reflecting on recent stress events in Switzerland with the Credit Suisse takeover and in the US and UK with the collapse of Silicon Valley Bank, BCBS points at the risks of high inflation, low growth, and geopolitical tension. Specifically, a long period of low interest rates allowed debt to build across household and corporate sectors and, in a now higher interest rate environment, borrowers are facing significant increases in their debt service obligations. Widespread repricing of assets may also create risks for the banking sector.
Regulation in the post-trade environment has also been geared towards risk reduction with initiatives such as ECMS, T+1 and settlement efficiency regimes, and we see these taking front and centre when it comes to network priorities. What we would also like to bring to the table, which is not a regulatory requirement, but rather derived from the launch of T2S, is the more widespread use of central bank money and efficiently reduced credit requirements, as the result of an optimised post-trade set-up for market participants.
Is there still potential for further efficiencies?
We see the main sources of post-trade inefficiencies can be categorised across three areas: operations, funding, but also capital. In an everchanging macro environment and the apparent entry into a new monetary era, these areas are increasingly challenged by a high interest rate environment, collateral scarcity and ever-increasing regulatory scrutiny of capital and risk management. In 2021, the T2S average daily value of unsettled transactions was at €26 billion. The interest rates for ECB overnight credit rose from 0.25% to 3.75% between March 2022 and March 2023. The interest rate increase leads to an increase in T2S market-wide borrowing costs from €65 million to €910 million. This corresponds to an aggregate cost rise of ~€300 million per 1% increase in interest rate, solely for end-of-day activity.
T2S had quite a rocky start with lower volumes and longer implementation than originally projected which meant fees had to be increased in 2019. Since then, we’ve seen a significant increase in volume driven largely by market activity (44% increase from 2017 to 2022) but unfortunately, we do not yet see a corresponding fee reduction that T2S is able to pass this back to customers. We see T2S as a platform at the centre of market efficiency, which consequently needs to be aware and proactive in providing cost-efficient settlement.
Areas such as post-trade are not always strategic priorities but can serve as a source of long-term profitability. Given the potential for inter-operability that T2S promises to offer, centralising access to T2S via one CSD can impact the profit and loss of market participants through pooled settlement, reduced intraday liquidity requirements, balance sheet netting, use of central bank money and of course simplified operations. While balance sheet netting solutions have been leveraged previously, there is an opportunity for market participants to use their European network as a strategic leverage for increased profitability.
What are further changes needed for market participants to fully leverage the benefits of T2S?
Our analysis shows a variety of reasons that are keeping market participants from shaping their processes towards adopting the advantages envisioned by T2S, e. g. by adopting the investor CSD model, as Clearstream defines it. They are preventing a sustained improvement of settlement efficiency in T2S markets.
The reasons identified can be broadly categorised into three different areas:
- Unrealised potential on the market participants’ side regarding the benefits of adaptations, or being unsure how to adopt them. If a CSD allows its customers to hold securities of another issuer CSD on its books, the CSD acts as an investor CSD. The investor CSD enables its participants and connected clients to access securities other than those for which it itself performs the notary function (i.e. the issuer CSD). The unrealised potential issue is exacerbated by the fact that in many financial companies, settlement is purely considered an operational activity. And even when well understood by subject matter experts, benefits are not perceived as being easily understandable and tangible by the actual decision-makers.
- Operational issues and cost considerations complicating the implementation by clients into their operating model and IT infrastructure. Costs arising from settlement activities are in many cases simply passed on and charged to the internal or external customers. Hence the need for an analysis or investments to reduce or in some cases even identify cost sources and savings potential is not always seen. The economic pressure arising from various areas is thus mostly not felt as a burden. The cost of adopting new operational setups including technology, processes, people, and data in the settlement process can be high. Therefore, a lack of economic pressure to encourage change also leads to companies only undertaking change projects related to essential transformation. Such essential undertakings can be related to mandatory, regulatory, or industry-driven initiatives as well as necessary changes to operational setups and technical infrastructure due to obsolescence or shifting business environments that would disrupt business operations if not addressed.
- Structural issues of T2S and incomplete adoption of the T2S functionality by CSDs, market participants and service providers which limit the realisation of potential benefits. As mentioned earlier, this is particularly the case in the adoption of T2S functionalities which enable cross-CSD activities via an Investor-CSD scenario. Although the initial T2S migration waves were completed 6 years ago, many market participants have yet to make the adaptions in their systems or processes which would enable the market to realise the cross-market potential of T2S.
From a market participant standpoint, a centralised settlement setup with an investor CSD can provide optimal benefit to a client when all or at least most of the traded securities are available for custody via the investor CSD.
While T2S has standardised much functionality across markets, there is still work to do to achieve harmonisation in settlement, custody and asset servicing practices. In order to solve all these issues, central initiatives driven by the ECB or the European Union could force the market providers to move in the desired direction.
What is Clearstream doing to support the market in this direction?
As the CSD covering over 50% of T2S volumes already, we found our German hub, combined with our extensive link network, to be the natural home for a centralised T2S access and central bank money solution. Since the launch of T2S, Clearstream’s German CSD has established links to 13 T2S CSDs with more links coming up, as well as connections to multiple CCPs and trading venues, to ensure that market participants are provided with a comprehensive coverage model and can gain as much efficiency from their T2S as possible. Throughout our experience rolling out this custody model, we’ve discovered the scope of areas of further harmonisation and interoperability that are needed to fully unlock the benefits of T2S and are active in lobbying together with market participants to achieve them.
Moreover, we see the trend of the market moving in the direction we have been set on since the launch of T2S. With the SEC recently deciding to move to the T+1 standard settlement cycle in the US in 2024, discussions about such a move in European markets have started as well. Such a shortening of settlement cycles could not only reduce the risk and cost associated with the process but also align European markets with other global markets such as the US, India or China. We agree with the market associations that the shortening of settlement cycles would not only put immense pressure on post-trade operations, potentially increasing the risk of settlement fails, but would also require collective industry effort and a broader harmonization across markets. Market harmonisation and interoperability has been at the core of our strategy in the past years, and being linked to the domestic CSDs within T2S, Clearstream’s German and Luxembourg CSDs are well positioned to provide a full service for clients upon the launch of the Eurosystem Collateral Management System (ECMS), where we have partnered with Vermeg for a fully-fledged STP collateral management solution. Lastly, I would add that data is a valuable lever that market infrastructures can use to provide added value to their participants, be it through predictive analytics such as our Settlement Prediction Tool and Insights Dashboard or as the golden source for key efficiency information.
If there was one note you could leave the reader with, what would it be?
Post-trade is quickly becoming a strategic pillar for any market participant, through regulation and an ever-stronger requirement for value creation. We are proud to be at the centre of this innovative process and are looking forward to forming strong partnerships on this journey.