We Need Real Change

Many moons ago, I was involved in meetings of the leading global custodians and clearers on the potential to create a pan-European, or even global, CCP. Around the same time, I was also involved in a discussion on the feasibility of merging the two ICSDs.

Many moons ago, I was involved in meetings of the leading global custodians and clearers on the potential to create a pan-European, or even global, CCP. Around the same time, I was also involved in a discussion on the feasibility of merging the two ICSDs.

In both cases the rationale was simple. The broker-dealer community was exasperated at the costs of multiple CCP connectivity, disparate margining practices, inefficiencies in handling multiple collateral pools and pricing opaqueness in the industry silos. The same community, with some custodian support, wanted to gain economies of scale by merging the ICSDs and, above all, creating a pan-European CSD.

Fast-forward a decade or so, the CCP and CSD landscape remains littered with suppliers, pricing stills tends to the opaque, collateral management remains inefficient and the cost of connectivity remains high. A major difference is that the profitability of the buy side has declined and the outlook is far from positive.

A year or so ago, one of the thought leaders at the ECB admitted in conversation that, in hindsight, they had made an error. Rather than go for TARGET2-Securities, they should have focused on CCP consolidation. Unfortunately, with both Dodd Frank and EMIR, markets have once again missed that opportunity. Instead, irrespective of the increased capital adequacy requirements for CCPs, they have loaded the CCPs with more volume, more risk and continuing collateral management challenges.

However, both T2S and EMIR could be catalysts for useful change. Useful change achieves cost reduction and risk reduction by the same process.

T2S will reduce risk by moving settlement into central bank money, and in some cases, both sides of settlement into real time. There may be savings in cash management, although it is dubious whether these have not all been achievable since the launch of the single currency. It is debateable if the risk and marginal cost benefits of T2S justify the more than one billion Euro pan-industry bill. But the clock is not going to turn back, so we need to find ways of leveraging T2S.

It is the same with EMIR and other regulations. They are wedded to the concept of the irreproachability of CCP structures, the fundamental superiority of industry utilities over private sector suppliers and the need to curb short termism across the market. Paradoxically, few would argue with some of these basics concepts. CCP structures offer better risk management tools than bilateral, partly collateralised and, often incestuous, commercial transactions. CSD default experience has been better than that of the private sector. But the private sector is too broad a constituency for comparison. In reality, many private sector suppliers are lower risk than CSDs because they are willing to assume liability whilst employing a control and capital protection culture. Those private sector participants are not to be confused with Lehman, Bear Stearns, Madoff and similar entities. Short-termism is a problem in the trading environment. High frequency trading, short selling, algorithmic trading or other such strategies may help liquidity but they also radically increase the risks of the originators of, and counterparties to, such trades.

So how could EMIR and T2S enhance the risk and cost profile of markets?

We need to leverage one of the key benefits of T2S—its experience in facilitating harmonisation in markets. It is true that some harmonisation in the T2S settlement space has been achieved through smoke and mirrors with location-specific idiosyncrasies being migrated to the outer fringes of the process rather than replaced. But that does not obviate the fact that introducing harmonisation, especially in areas such as record date or the expected T+2 settlement cycles, are great achievements. EMIR has shown that the EU commission itself can move from the fairly passive role it adopted for the Giovannini barriers to a much more influential role. The ECB and the Commission would be a powerful force for change. Key for them would be to ensure that they listen more to the market and less to the latest political flavors.

Harmonisation would have two attributes. One, it would reduce the friction costs of settlement and asset servicing across Europe, and two, due to the cost of harmonisation, it should lead to consolidation of infrastructure across Europe.
Putting forward an agenda for harmonization is dangerous, especially if it has a subtext of enabling infrastructure consolidation. But the key areas of focus could well include:

– Recommended minimum margining structures, in terms of haircuts and instruments, with a capital premium required for those below the standard.

– Mandatory standard communication protocols, based on ISO20022, for all infrastructures.

– Price unbundling for each component of the infrastructure post-trade value chain with mandatory equivalence irrespective of market of trading or infrastructure of settlement.

– Consistent timetables and data content for corporate actions with a requirement to include, in all prospectuses, a standard data sheet of all elements needed for post-trade processing.

– Standard tax reclamation documentation, portable to each country in the EU, and standard timing procedures for reclaims.

– A uniform KYC standard allowing a single document, portable to each country within the EU.

Would that reduce industry cost and risk? I am sure that it would, and the savings could be a substantial percentage of the billions of Euros in back-office costs currently incurred. Would it lead to consolidation? That seems likely as the costs of independence increase, the divergence of market structures decline and the hidden pricing barriers to level playing fields are eroded. Will it be popular? I suspect I may have to close my Twitter account to avoid the hate mail such suggestions may well generate!