What Hath T2S Wrought?

As European central securities depositories (CSDs) go through the testing phase of TARGET2-Securities (T2S) and the first migration wave in June 2015 quickly approaches, the financial industry on the continent is likely to change dramatically, for better or worse.

On the positive side, T2S will help harmonize Europe’s securities markets, something that was left fragmented following the creation of the euro. With the efficiencies gained from T2S, the platform could even expand further in the EU.

“What I hear from sources in the ECB is that given the prospects of T2S that it will be a very efficient settlement layer, they are quite confident that a lot of other currencies in the European Union will join T2S as a settlement platform, even if they don’t use the euro. I think it’s in the back of a lot of people’s minds that, if T2S is as efficient as I have been given to understand, it would make a lot of sense for other countries in the European Union to join this from an efficiency point of view; the politics will be different,” says Godfried De Vidts, director of European affairs, ICAP and chairman of ICMA’s (International Capital Market Association) European Repo Council.

But for some of the CSDs themselves, the platform could spell trouble, as it will likely commoditize settlement, and not all CSDs will survive.

“While we’re going through more fragmentation at the moment, sometime in the future there will be more consolidation because we are in a critical mass business,” says Edwin De Pauw, director, head of product management Europe at Euroclear. “Who will survive, how many will survive? It’s difficult to predict, but with our neutral, open-market infrastructure strategy, we’re convinced that Euroclear will be one of those survivors.”

While ICSDs such as Euroclear stand to benefit from T2S, the smaller, national CSDs will likely suffer.

“The small CSDs who are not able to adopt the T2S system or to be very flexible on the client side, they will disappear as CSDs. The question is will they merge or will they be bought by bigger players,” says Christian Pinetz, head of relationship and network management at OeKB, the CSD of Austria.

Specifically, CSDs in countries with smaller capital markets such as Romania, Bulgaria and Slovenia, will not be able to carry on as they did before T2S.

“The problem I think, from our analysis of the Romanian, Bulgarian and Slovenian CSDs, is there’s low volumes and few turnovers,” says Pinetz. “With T2S, they will lose most likely issuers, and for Bulgaria, for example, they will lose turnovers coming from the stock exchange. So I don’t know if there’s huge appetite to buy them. So from my point of view, I think they have to merge. Maybe we will see a merger between the Romanian and Bulgarian CSDs to increase the volume, reduce IT costs and have some synergies between the two CSDs.”

For OeKB, the CSD has put forward a plan to reduce costs by leveraging T2S.

“We try to get the utmost benefits of T2S,” says Pinetz. “First, we will provide to our clients all functionality of T2S. The second step is we will get rid of our current IT environment—our accounting system and settlement system—and will replace it with T2S. Thus we can reduce our IT costs. The third point is to be flexible for the clients to give them as easy access to the market as possible, for example, having a standard SWIFT interface so they do not have to fill in any huge forms, fulfill different requirements, etc. In order for global players to enter the market, we try to be efficient and as flexible as we can be. That’s an advantage for us because as a smaller player we are adaptable and unbureaucratic.”

For KELER, the CSD of Hungary, the market infrastructure is taking a slightly different route but is also trying to benefit from the changes.

“We know we have to develop to stay successful, need to grow out of our traditional scope of business, change our attitude and image,” says Peter Csiszer, director, strategy and client relations, KELER. “In 2012 we decided to join T2S and right after we initiated our greatest ever IT investment to implement a new state-of-the-art CSD platform, the BaNCS system from TATA Consultancy Services. The system—going live in 2015—will be interfaced with T2S and will bring a series of service enhancements to our clients.”

Csiszer also sees regional potential post T2S.

“Central Eastern Europe, our home market, is lacking standardization and is not completely lined up for T2S,” he says. “On that basis, we will offer regional investor CSD services including standardized T2S settlements, safekeeping and optional ancillary services. Our safekeeping in Central Eastern Europe will be intimated by direct CSD links, while our asset and local currency services will be supported by professional partners. We will also rely on our banking licence to offer euro payment bank and local currency services and liquidity solutions complementing the features of T2S. Such a single, centralized CSD access maximizing the T2S functionalities coupled with strong client focus and intense marketing will make a difference in the region.”

David Field, managing principal at consultancy GFT, agrees that CSDs need to think beyond their borders to survive.

“The CSDs that can provide settlement agents, such as custodians, with access to multiple European markets will inevitably be preferred by users seeking to reduce the costs and complexity of cross-border settlement,” he says. “CSDs that are not geared up to provide multi-market access will not benefit from this opportunity, and moreover are likely to fare badly as users seek to streamline their settlement networks. According to a recent survey we undertook with the International Capital Markets Association, over half of market participants expect to reduce the number of agents they use, as a result of T2S.”

And to put it simply, “Smaller CSDs must adapt or die,” says Field. These CSDs have four options going forward, he says. One, they can build cross-border capability; two, sell themselves to a bigger player to leverage their domestic market expertise; three, partner with other small CSDs to create an alternative cross-border venue, and the fourth option is to do nothing and just cut costs until the business becomes unviable.

The industry agrees that some CSDs will not be able to adapt sufficiently.

“I firmly believe not all CSDs are going to survive,” says Rob Scott, head of custody at Commerzbank. “I believe it’s somewhat implausible to think that all of the CSDs can offer the full range of services on a competitive basis. In the longer term, I expect volume to concentrate towards the major European centers.”

But while it’s clear that change is coming, it’s not exactly clear how everything will play out, even if we know some of the CSDs’ strategies.

“I think there’s still a lot to work through to see who’s going to be playing and in what capacity,” says Scott. “I believe a lot of the big players are thinking scale, scale, scale, and yes scale is important to reap the benefits. However, it’s not all about scale. There’s a place for service partners who are closely aligned to their clients’ needs and listen to their requirements, as opposed to building a pre-defined service offering akin to a ‘sausage factory’ approach. Certainly in the European markets ‘one size does not fit all.’”

Similar to Pinetz thinking that OeKB could benefit from its flexibility that larger CSDs may not have, Scott sees some smaller CSDs being able to carve out a path for themselves.

“It’ll be very interesting to see how the overall pricing structure plays out,” says Scott. “There are still many unknowns. I think the cost recovery process between the ECB (European Central Bank) and CSDs is a challenge—as is clear definition on how the CSDs are going to operate and interface with one another. It’s very interesting to see CBF (Clearstream Banking Frankfurt) and Euroclear cover their costs of implementation by charging additional fees for the T2S project. I don’t see that with the smaller CSDs. I think one of the things that will be interesting is with some of the smaller CSDs, while they’re going to have major challenges, there could be some very unique service provisions that come from them as they are ultimately in the best position to know their domestic clients and needs best.”

For the time being, the industry seemingly concurs that the focus will be on making the migrations to T2S and trying to create value-added services, but it’s unclear when this will change to a consolidation phase.

“We are all very focused on implementing the changes,” says Jesus Benito, CEO of Iberclear, the CSD of Spain and a Bolsas y Mercados Españoles (BME) subsidiary. “I would say after 2020, maybe, there will be movements, but who knows.”

Plus, free market forces will not necessarily determine who is still running.

“National pride and protectionism might also hold up consolidation,” says KELER’s Csiszer. “Even when a major chunk of core CSD revenues evaporate, a country can decide on keeping the local infrastructure alive and independent, subsidized, or as part of the government budget.”

Still, consolidation appears to be the long-term outcome, but not all players are anxious to make acquisitions.

“We certainly see business opportunities in T2S, yes,” says Thomas Zeeb, CEO of SIX Securities Services (SIX operates both as an ICSD and as the CSD of Switzerland.) Will it be through the acquisition of other CSDs? I doubt it. One of the things that T2S has the potential to do is to suck settlement liquidity out of small markets to the bigger players, because the settlement liquidity will follow where the collateral management is done. And if the collateral management is done in more central locations because it’s more efficient, than you will naturally see a shift of liquidity out of particularly the smaller markets to where that collateral can be more effectively managed and optimized. I don’t, however, think it’s necessarily the case that you have to go and buy other CSDs because the flow will shift anyway. What those national CSDs will look like in the future remains to be seen. My sense is they will look more like registrars in the future than the kind of integrated CSD structures we have today, which means they too will have to look at other areas of providing value to their local market.”

Partnerships are one significant way that smaller CSDs will evolve going forward. For example, Iberclear has partnered with Cleartsream for a 50/50 joint venture trade repository, REGIS-TR, which can bring additional revenue to the firm, and more recently, the two partnered to provide international access to T2S via the “Liquidity Alliance,” a global association of market infrastructures. As a result, the CSDs of Australia, Brazil and South Africa will have access to cross-border collateral.

“It’s changing for everybody, not just CSDs, but for ICSDs, sub-custodians and global custodians as well,” explains Benito. “I see a lot more ‘co-opetition.’ We have already two important businesses at Iberclear, which are collateral management and trade repository services for OTC and exchange-traded derivatives. We are doing this in partnership with Clearstream, and it’s a very successful business. I see the same with Clearstream and BNP Paribas for asset services for foreign securities or Spanish securities with BBVA. So in the end, there is competition, but at the same time, there’s cooperation among the competitors at times.”

But over time, CSDs may start to differentiate themselves, as not all will follow the same path in what services they choose to offer. In Iberclear’s case, the CSD is focusing more on its core offerings than trying to expand too much.

“What we are trying to do is not compete with our clients,” explains Benito. “There are other CSDs who wish to be ICSDs by themselves, to be banks for banking services. We prefer to maintain the neutrality, to continue to be a market infrastructure because we believe we are good at market infrastructure services. We are layman in relation to banking services. In the end, as the world is changing, if our clients demand both a market infrastructure provider and value-added services, we are keen to find a partner who is an expert in banking services, in a way to protect our core business.”

But partnering is not a must for CSDs such as Iberclear. “We are open to everything,” says Benito. “What we want is to offer the best possible service for our clients. If we can do it alone, perfect. If they demand new services which we are not able to offer them or we are not the experts to offer to them, then we will have to partner with anyone else.”

Euroclear’s De Pauw agrees that there can be many smaller players who can offer services they excel in that fit a market need.

“I don’t think the question though is ‘Is there going to be consolidation,’” he says. “I think there will be a few pools that will attract the critical mass of business activity, and I think you will have a growing number of niche firms that will focus on market-specific needs either from an asset servicing perspective, a settlement perspective or a collateral management perspective, etc. I think that’s more how we will evolve than consolidate.”

“It’s a business in competition,” adds Benito. “Clients will decide how many providers they want, as it is in any other industry. There are going to be different models and we have to be able to adapt to the client’s request. In the end, I fully agree that in the longer term, there will be consolidation around CSDs, but clients will decide which CSDs and which models will continue to exist in the long term.”