Hopes of a final resolution of the long-running dispute between Euroclear and Clearstream over the alleged difficulty that some clients of Clearstream Banking Frankfurt (CBF) have in delivering securities to Euroclear account-holders during the daylight settlement cycle look misplaced. Initial reports suggested that, as expected, the solution proposed by Euroclear at a meeting in Frankfurt in April had been endorsed by the European Repo Council (ERC) at its meeting in Vienna a month later and that the issue was now history. But it seems that daylight deliveries between Frankfurt and Brussels have become like the Irish question: the problem is insoluble because, as soon as one aspect of it is cleared up, another appears.
What Euroclear proposed at Frankfurt is to introduce real-time reimbursement of securities loans by the end of the first quarter of 2003, as a temporary solution pending the introduction of the ultimate solution – mandatory real-time settlement – at some point within the next eighteen months. This would solve immediately the nagging problem that late deliveries of German securities from CBF is discouraging Euroclear participants from transacting repo business with CBF participants. The nub of the issue is this: some CBF clients struggle to deliver securities to Euroclear in the overnight cycle (as demanded by RepoClear). As a result, Euroclear clients expecting deliveries from CBF are forced either to borrow the securities from Euroclear lenders or (if the securities are unavailable) to finance the position through Euroclear Bank. Mandatory, real-time settlement would certainly solve this problem, by replacing both the overnight and day-time cycles by a continuous settlement cycle.
But even a mandatory real-time settlement cycle has to cater for the possibility that a market participant will fail to deliver cash or securities. So an option to borrow in the last few minutes before the final cut-off time is built into the Euroclear plan. What is puzzling some participants, however, is the decision by Euroclear to introduce intra-day borrowing and lending alongside mandatory real-time settlement. They believe that Euroclear is introducing this facility because there is no real-time link between the Brussels-based ICSD and Clearstream Banking Luxembourg, so any securities delivered by a CBF participant to a Euroclear participant for onward delivery to a CBL participant will almost certainly have to be borrowed from Euroclear. Nobody knows when a real-time Bridge between Euroclear and Clearstream will be introduced
Euroclear concedes that a real-time link with CBL would make it possible for Euroclear participants to deliver (and receive) securities to (and from) CBL later in the day than at present, but points out that it is introducing intra-day borrowing and lending only to complement the current overnight lending and borrowing facility and in order too minimise the risk of trade failure. The cost of any borrowings via the service, adds Euroclear, will depend on the duration of the loan and whether it is intra-day or overnight. However, it is true that the provision of an intra-day borrowing and lending service means borrowing costs will be incurred intra-day as well as overnight for the first time but, as Euroclear rightly points out, lenders do have to be compensated somehow. Euroclear adds that an intra-day lending and borrowing facility is also likely to increase the willingness of Euroclear clients to transact business with CBF clients.
So even the supposed ultimate solution to this problem – mandatory real-time settlement – has thrown up further issues already. And since even the temporary solution of real-time reimbursement will not be introduced until the Spring of next year, the delay in delivering any kind of solution has in itself become a source of complaint. Initial indications were that Euroclear would introduce real-time reimbursement of loans by the end of this year, not the first quarter of next year, so German banking clients of CBF now face a delay of a further three months. This may be sufficiently expensive to persuade more to move their business to the Brussels-based ICSD, but Euroclear denies any skulduggery. It says the three-month delay was caused by the need to examine interim solutions for the period before mandatory real-time settlement is introduced next year. These include a free intra-day loan of securities by Euroclear on the basis of “advices” from CBF clients that securities are on their way. This is in addition to the current practice at Euroclear of advancing free intra-day loans on the basis of both matched and unmatched instructions, where the ICSD is in possession of instructions from both side of a trade rather than just one.
Euroclear has long allowed its members to reimburse loans of securities or cash free of charge as soon as missing securities arrive from CBF during the daylight cycle. Extending the facility on the basis of these “advices” in theory eliminates the problem. No costs are incurred; no trading opportunities are lost; nobody gets fined by RepoClear for late delivery of collateral; and no German bank feels the pressure to switch business to Euroclear rather than incur these risks and costs. And nobody is complaining that if the securities still do not arrive by the settlement deadline – when CBF makes its final delivery of securities for the day to Euroclear Bank – the free loan becomes an automatic overnight borrowing for which the Euroclear participant must pay a fee. Everybody accepts that overnight loans taken out to cover non-deliveries must be paid for.
Which is also why Euroclear clients are reluctant to trade with CBF clients who cannot commit to deliver securities by settlement deadlines, because it is then too late for Euroclear clients to deliver the securities onwards. The main reason why this problem occurs at all is the fact that in many cases Euroclear clients are borrowing securities from CBF clients for onward lending to another Euroclear client. So if and when securities fail to arrive from CBF in the overnight cycle, the Euroclear participant borrowing from a CBF client has three options. The first is to borrow the securities from Euroclear, deliver them, and hope that the securities arrive from CBF soon enough during the daylight cycle for the loan from Euroclear to be free. The second, if he is unable to borrow, is to take in the CBF securities whenever they arrive and fund them himself because his Euroclear counter-party will invariably satisfy his demand elsewhere. The third is to persuade his Euroclear counter-party to take delivery of the CBF securities later on, provided it is still within the optional real-time daylight cycle. It is in the case of the second option that the Euroclear participant incurs a cost, which he may or may not be able to pin on his CBF counterpart. Only mandatory real-time settlement can eliminate this cost, by allowing securities to be delivered from CBF much later in the day.
There is a second – but more speculative – reason why Euroclear participants might be willing to pass costs on to CBF counter-parties in this way. It is that the Euroclear participant has a financial incentive to do so. Provided the cost of borrowing securities from Euroclear is below the rate which cash can earn in the money markets, a Euroclear participant can profit from borrowing securities from Euroclear to meet his commitment. For example, a Euroclear participant borrowing securities for use as collateral in a repo transaction with another Euroclear participant can profit by borrowing securities from Euroclear, collecting cash from the repo transaction, reinvesting it in the money markets and charging the CBF participant the repo rate for failing to deliver securities on time. This transaction is not free of charge. The Euroclear participant who borrows securities has to pay the overnight charge, but provided this is below what the cash can earn for a day in the money market the charge is worth incurring.
It can be seen that in either case – and the extent to which either of these events actually happens is unknowable, though both clearly happen often enough to irritate both Clearstream and its clients – the transaction results in the payment of a borrowing fee to Euroclear by the Euroclear participant. It can also be seen that the proposed interim solution out forward by Euroclear – real-time reimbursement of loans of securities or cash free of charge as soon as missing securities arrive from CBF during the daylight cycle – will in many cases be less than useful. It would work only if Euroclear was prepared to extend the free reimbursement facility beyond late deliveries from CBF to encompass the members of the transaction chain within its own system. In other words, if Euroclear participants could borrow securities free of charge to cover late deliveries from other Euroclear participants as well, in at least some cases the costs which result from late deliveries by CBF participants would not be incurred. The ERC is now exploring with Euroclear whether free reimbursement can be extended to all deliveries of securities, and not just those from CBF. Understandably, Euroclear contends that borrowing cannot be free at all times: if it was, there would be no lenders, and settlement efficiency would decline dramatically.
Euroclear has a further complaint. At the ERC meeting in Vienna it was also suggested that the onus of solving this problem should not fall on Euroclear alone. In particular, it was suggested that if CBF was willing to invest in improvements to the German infrastructure (or alterations to German settlement timetables) which enabled CBF clients to obtain securities from German institutional lenders more rapidly it would go someway towards solving the problem. It was also proposed that CBF introduce an intra-day borrowing facility to enable clients making deliveries to Euroclear to obtain the necessary securities that way. Euroclear is miffed that these proposals were not taken seriously.
All of which means that, although mandatory real-time settlement is clearly the ultimate solution to this problem – and therefore far from unwelcome to market participants – a number of short-term issues have arisen. If they are not resolved quickly, it never takes long for trust between Euroclear and Clearstream to break down. Even observers unsympathetic to Euroclear baulk at this idea, alluding to the open spirit of the discussions which have taken place between Euroclear, Clearstream, the European Repo Council and the central banks and national regulators. But there must be a risk – as market participants explore the details of the initial solution and, fairly or unfairly, find new causes of complaint – that relations between the two ICSDs will become strained once again, and perhaps even break down. At bottom, however technical it appears now, this is a business dispute. The key question is whether Clearstream either faces or is prepared to risk a further migration of German business to Euroclear.