After three years of silence, custodians settlement internalization has moved back onto the European regulatory agenda. It is understood that in the last month, the European Commission has received proposals for data collection obligations for custodians settlement internalization as part of the upcoming CSD Regulations (CSD-R), but other European Union parliamentarians are said to be siding with an outright ban on the activity.
The development has moved into sharp focus in the European Parliament, it is believed, as the securities industry moves toward a T+2 settlement time frame, CSD-R is finalized and TARGET2-Securities, the harmonized settlement platform for securities settlement, targets a 2015 implementation deadline.
The last proposals for CSD-R, delivered by Kay Swinburne, MEP, Rapporteur, on the matter in mid-September, seek to amend CSD regulation by providing a reporting obligation by settlement internalizers to competent authorities on the aggregate volume and value of all transactions settled outside a securities settlement system on an annual basis. While Swinburnes latest report calls for a data collection exercise in CSD-R, it is understood that other MEPs may be seeking an outright ban on custodians settlement internalization.
Settlement internalization allows trading firms to net the delivery and receipt of securities on the custodians books within an omnibus account, with no entry being passed across the CSD for the netted part. Almost all custodians use nominee holdings of client assets, and are likely to use settlement internalization in one or more markets. In the U.K., settlement via CREST is mandatory.
Regulatory action for settlement internalization was first mooted at a European level in 2009. The banking regulator, then called the Committee of European Banking Supervisors (CEBS), now called the European Banking Authority (EBA), decided there was no need for action at the EU level on custodians settlement internalization. It is understood that the work carried out by the CEBS is material to systemic risk, the desire to maximize the use of market infrastructure and to improve regulatory transparency.
Its decision followed a meeting with several custodians in October 2008, before which it sent a note commenting that custodians were excluded from the scope of the ESCB/CESR recommendations for securities clearing and settlement in the EU, under the assumption that all relevant risks incurred by custodians are sufficiently addressed under the capital requirements directive.
On settlement internalization by custodians, the message these organizations gave to CEBS during the 2008 meeting was that the risk posed by settlement internalization was negligible in scope but that no concrete data regarding the volume or frequency of internal settlement transactions is gathered regularly. Concerns expressed by custodians at the meeting over settlement internalization included: determining the moment that an internalized settlement takes place; the finality or reversibility of settlement; the existence of delivery versus payment; and the effect of insolvency of a trading party.
Two months later, CEBS issued a report responding, most of which mapped out ESCB/CESR recommendations for securities clearing and settlement in the EU, under the assumption that that all relevant risks incurred by custodians are sufficiently addressed under the Capital Requirements Directive (CRD). The note also remarked that the European Council had invited CEBS (with CESR) to review the coverage of risks borne by custodians. CEBS considered it appropriate to focus its work on the credit institutions that are subject to the CRD and that perform activities similar to those performed by CSDs/ICSDs and CCPs, i.e., those credit institutions that internalize settlement operations and/or act as clearing counterparties.
In April 2009, CEBS published the outcome of its call for evidence for Ecofin, in which the regulator made the following observations:
– For those that did internalize, the percentage of trades was within the range of 1-3%, and in only few cases reached 30%
– Internalized trades are not always recorded separately, hindering analysis
– One CSD (unnamed by the respondent) would not execute DvP on trades within the same accounts, thus making internalization inevitable
– Settlement internalization is not viewed as a major risk by CEBS members
– There is little evidence that settlement internalization requires intervention at a European level, but supervisors may continue to monitor the issue; it would be overly burdensome to impose or issue guidance applicable to the industry as a whole regarding this activity
– CEBS would be ready to revisit the issue if there is evidence that internalization of settlement has become significant.
In March this year, proposals to regulate CSDs in Europe were adopted by the European Commission (EC) to bring more safety and efficiency to Europes settlement system. The CSD-R proposal will introduce, in line with the ECs international partners, common standards across the European Union for securities settlement and CSDs to ensure a single market for the services provided by national CSDs.
Added data reporting requirements, let alone an outright ban on settlement internalization, would have cost implications for custodians and may likely alter the path for market infrastructures, which are already at the forefront of considerable change. Overall, it would be an inconvenience as custodians would need to change their systems and therefore impose on an activity that has worked well and that has meant cost benefits for custodians and their clients, say industry sources.
Also proposed in the CSD-R are regulations to bring the European market to a T+2 settlement framework instead of the current fragmentation of T+2 and T+3 in some markets.
The draft proposes that the settlement period be harmonized and set at a maximum of two days after the trading day for the securities traded on stock exchanges or other regulated markets (currently two to three days are necessary for most securities transactions in Europe).
In further setting out the benefits of the regulation, the EC said a harmonized settlement period T+2 as opposed to a combination of T+2 or T+3 in various markets across Europe will reduce operational inefficiencies and risks for cross-border transactions, while reducing funding costs for investors (for instance, for those that have to deliver cash or securities at T+3 but can only receive them at T+2). A shorter settlement period would have an important advantage of reducing counterparty risk, added the proposals.
T+2 settlement is also gathering momentum in the U.S., where the DTCC commissioned research looking at the costs versus benefits of moving to T+2. The research examined the risk, capital and cost repercussions of reducing the cycle. After an 18-week business case analysis, Boston Consulting Group concluded that shortening the settlement cycle for equities, corporate and municipal bonds could reduce risks in the securities industry but also costs by hundreds of millions of dollars. The settlement cycle in the U.S. currently is T+3, or three days after the trade is executed. BCG examined a potential switch to T+2, T+1 or T+0.
Crossing back to Europe, the securities industry is also gearing up for TARGET2-Securities (T2S), with CSDs focusing heavily on getting their infrastructures ready. About 23 CSDs have signed the framework agreement so far, and they are now focusing on the 2015 implementation deadline.
Berthold Kracke, who was appointed to Clearstreams executive board last month, comments on the milestones reached thus far: Twenty-three CSDs have committed to join T2S, so T2S is no longer a vision it’s reality. With T2S, one of the major challenges is to now demonstrate to the external world and to our customers that we can create the right value proposition for them, but also, internally, that we have a clear direction and take the right decisions to meet the new settlement landscape, a world with T2S as of 2015. To get there, it is important we are in constant dialogue with the clients while having the ability to translate their requests into operational reality. Hence the new setup of the CBF board.”
At this years Sibos, SWIFT will be announcing the take up of its T2S connectivity solution, which, according to Arun Aggarwal, managing director for SWIFT U.K., is progressing well.
Its fair to say T2S awareness is in general still something we need to work on, Argawwal said in a pre-Sibos video interview with GCTV. If you take into account the phases in which it is implemented, it stretches out beyond 2015. People think thats a long way off, but it isnt. In general theres a requirement for people to budget for changes to systems by 2013. In terms of awareness for the industry as a whole, the CSDs are advanced, but theres a large part of the world that is not up to speed on T2S, and in terms of them making their key decisions the major players are starting to evaluate that now. Its definitely still early days.
Continue here by watching the video with Aggarwal.
Janet Du Chenne