The debate about the future of the European clearing and settlement infrastructure may have stalled temporarily, pending the release of further details of the TARGET 2 for Securities (T2S) project initiated by the European Central Bank (ECB) in the summer of last year. But an ECB paper published last week suggests that the custodian banks are winning the internal debate over whether they or the central securities depositories (CSDs) will ultimately control the activities of T2S.
Much of the 61 page paper, which is co-authored by Diana Chan of Citigroup and Florence Fontan of BNP Paribas – the two banks most closely associated with the `Fair and Clear’ group resistance to the expansive CSD consolidation strategy hatched by Euroclear, which T2S appears to have scuppered – alongside ECB officials Daniela Russo and Simonetta Rosati, can be read as a sober description of the evolution and structure of the securities services industry today.
The principal interest of the ECB in the custody industry lies, of course, in the area of systemic risk. Would a major default or an operational failure by a custodian bank, such as a failure to make cash payments or an expensively missed corporate action or a miscalculated NAV, have serious knock-on effects? On the whole, however, the paper is sanguine that the major credit, operational, legal and financial risk are covered by existing risk mitigation techniques and regulations, though its tone is less certain about the position beyond the European Union.
Which means that the main interest of the paper lies in its discussion of the positions of the three principal parties to the current debate about the future structure of securities clearing and settlement in Europe – custodian banks, CSDs and ICSDs – ahead of the publication by the ECB of further details of T2S.
Despite the apparently neutral tone of the paper, it is clear that the custodian bank contributors have had a substantial influence over the document. On T2S in particular, the paper warns that a single point of entry into multiple European CSDs threatens custodians not only with disintermediation but with the additional threat of competition from national CSDs seeking to make up lost settlement revenues by offering a broader range of banking services. The paper concludes that users are best-advised to avoid duplicating services they can buy already from a custodian, and warns that banking CSDs “raise risk concerns … detrimental to the safety of T2S and the financial market.”
The influence of the custodian bank authors is further evident in the observation on page 22 that “competition between CSDs and custodians has thus far moved in one direction: CSDs with a banking licence are expanding into the commercial market of custodian banks … Custodians cannot compete with CSDs on their infrastructure business.”
On page 38 it is argued that “custodian banks would find it difficult to match the economies of scale of a market infrastructure … and could not match the efficiency level of market infrastructures, especially if the value added services are run on the CSD’s platform …Services such as securities financing and collateral management benefit from the network effects of a CSD.” It goes on to argue that custodians should be freer to compete with CSDs which save banking licences, while the idea of more CSDs getting banking licences would need to be “carefully analysed” as a potential source of moral hazard.
Indeed, since the last thing custodians want as part of the price of being allowed to compete with CSDs is to be regulated as an equally important part of the market infrastructure. Which explains the apparently contradictory statement on page 11 that custodians and CSDs cannot really compete with each other because custodians are obliged to use CSDs to hold securities on behalf of clients. Internalisation, which enables a custodian to avoid settlement via a CSD by settling trades on its own books, is dismissed (page 23) as “incidental and marginal … not a substitute for CSD settlement.” Besides, adds the paper, custodians perform completely different functions from CSDs.
This view is elaborated at length on pages 22 and 23, as part of a clear attempt by custodians to escape the onerous regulatory requirements borne by CSDs – an idea which horrified custodians when first advanced as part of the ESCB-CESR standards a few years ago, and which has re-surfaced in an unwelcome way since the CSDs agreed to sign the European Commission Code of Conduct on Clearing and Settlement in November last year. Interestingly, the paper notes that Daniela Russo will shortly publish a study of the subject which is expected to conclude that all risks incurred by custodians in their daily business are already fully covered by the existing regulatory regime.
Given all this, it is not surprising that the paper is coy on the role of the custodian banks in restricting direct access to CSDs by investors, and in preventing CSDs providing a full range of banking services. Yet it is obvious that custodians have succeeded in most markets in limiting the ability of the CSD to compete with them by ensuring they control its governance, and preventing their clients from opening accounts with CSDs directly. They have something similar in mind for T2S.
Hidden politics apart, the paper serves as a useful summary of the state of play in securities services, and can be used as a primer for anybody new to the industry. And in itemising the difficulties which analysts confront in seeking to estimate the size of the custody industry and its annual revenues, the paper delivers a timely reminder of the continuing – and indefensible – degree of opacity over the value of assets in custody and fees charged to customers. The paper puts the total value of securities in issue at over US$ 128 trillion, but is effectively unable to even guess as to how much of this sum is in custody, or with which types of custodian, or what users of custody services can expect to pay. If custodians succeed in defending this totally non-transparent position, especially in the wake of the obligations laid on CSDs, CCPs and stock exchanges by the European Commission Code of Conduct to publish their prices on the Internet, it will be one of the great lobbying triumphs of our time.
The paper, which is one of the series of Occasional Papers released by the ECB on a wide variety of subjects, can be downloaded free of charge from here.