A European bank with an on-the-ground presence in all the major euro-zone markets is expected to rise to the challenge of T2S, and BNP Paribas Securities Services has developed a strategy that aims to insulate its clients from as many of the risks and complexities of the new settlement system as it can. The as yet unanswered question is whether the bank can develop an approach to T2S which actually saves those clients substantial amounts of money.
BNP Paribas Securities Services will connect to TARGET2-Securities (T2S) directly. For a provider of its size, the decision was unavoidable. Making a success of it, however, requires attention to detail. BNP Paribas Securities Services staff has had to work closely with the European Central Bank (ECB), the central securities depositories (CSDs) and the National User Groups (NUGs) in each of the 11 euro-zone markets where it is providing direct custody and clearing services.
This reflects a curiosity of the ECB-led post-trade harmonisation project that has become increasingly apparent as the 22 June 2015 deadline for the first markets to adopt the system draws near. "Most of the work we have been doing is to ensure that what has been devised centrally works well in each locality," explains Alan Cameron, head of relationship management for international banks and broker-dealers at BNP Paribas Securities Services in London. "There are a lot of local market specificities that have to be accommodated. Once T2S is up and running we will connect directly for scale. However, we will still need connectivity with the local CSDs for on-exchange transactions, instructing external cross-border movements and processing some less traded securities such as strips. "
The need to accommodate local market specificities is an ironic outcome. After all, one of the attractions of T2S to a provider of direct custody and clearing services such as BNP Paribas Securities Services ought to be that a single settlement system for Europe enables it to skip the costs of having to adapt or upgrade its own systems every time a CSD makes a change to its technology, services or requirements. This cost is unavoidable for the best providers, since they know that the ability of a local custodian to accommodate and exploit CSD system and service upgrades has become a key performance indicator for bank and investment bank network managers. "If we just have to connect once to a single European system, we can save a lot of money on upgrades, even before we collect the benefits of standardised processing," says Cameron.
Cameron says it is important to BNP Paribas Securities Services that they shield their clients from any disruption that the introduction of T2S might cause. An obvious way in which the bank is doing this is its willingness to enable clients to continue to use ISO 15022 messages despite the fact that T2S is insisting on the use of ISO 20022 messages. The bank will simply translate into ISO 20022 all messages going in to and coming out of T2S.
But clients will still have to adapt their processing for multiple jurisdictions to the T2S settlement cycles (two overnight net settlement batch cycles between 7.30 p. m. and 3.00 a.m., and continuous real-time settlement from 5.00 a.m. to 6.00 p.m.) T2S has also added fields that are new to settlement instruction messages, of which the most important is the need to select the CSDs of the delivering and the receiving party. After all, the choice of CSDs will be wide. By the time the third wave of markets joins T2S on 6 February 2017, no less than 24 CSDs and two international CSDs (ICSDs) will be offering access to the new settlement platform.
In fact, although Cameron thinks the relatively robust matching and settlement process imposed by T2S means more trades will settle on time, he believes the real savings from T2S will accrue to clients indirectly. If more trades settle on time, they will have a lower appetite for (costly) credit. Clients will also benefit from auto-collateralisation within T2S, because it enables them to collateralise payments in central bank money with assets held in any portfolio in any market serviced by T2S.
"At the moment, perhaps 30 per cent of Europe is auto-collateralised," explains Cameron. "By being able to use one pool of bonds to collateralise transactions across the whole of Europe, theory and practice dictate that settlement will become much more robust in times of crisis. If we went through another credit crunch, the auto-collateralisation feature will make a big difference to us all. But because it is also pan-European, it means we can make more efficient use of our collateral and, if our clients sign up for it, their collateral."
In other words, auto-collateralisation will eliminate the costs of moving collateral between CSDs, and reduce the overall level of risk within the system. Cameron argues that agent banks are well placed to realise the potential benefits – such as greater liquidity and reduced use of credit – afforded by automatic collateralization. “Equally important is that agent banks gain economies of scale from the process simplification that harmonisation will bring to settlements,” he adds. Any client in danger of missing the point should note that BNP Paribas Securities Services has already centralised its European settlement processing in Lisbon, where it has almost 1,000 people working on it.
Cameron predicts that most of his clients will look to make cost savings by consolidating their agent bank network across the T2S markets. Many have multiple agents that they have inherited from past mergers and historical business relationships, so it made sense to consolidate these even without the spur of T2S. Only a handful of large financial institutions are considering more radical action. They are generally seeking to take control of their own settlements whilst seeking the help of agent banks to provide the asset servicing. Cameron says it is not yet clear whether such models will result in cost savings, because CSD pricing is not yet known.
What is clear is that splitting settlement from asset servicing creates a problem. Asset servicing cannot naturally be divorced from settlement, since the asset servicer has to know who owns which assets, and when they took ownership of them. "The question T2S poses to the global custodians is how they can take charge of their own settlements, yet still have a sub-custodian bank providing the asset-servicing," says Cameron. "The complication is that, to provide asset-servicing, you have got to have a completely up-to-date picture of all the settlements."
This dilemma gave birth to what BNP Paribas Securities Services is calling "sponsored access." Cameron explains how it works. "In our opinion, the best way of meeting the need for an up- to-date picture of settlements is for clients to flow all their settlement instructions into T2S through ourselves," he says. "We can then record the cash or securities in the T2S account of the client at the local CSD, without touching the instructions at all from a credit or liquidity or collateral point of view. We simply pass the information on to the system without doing anything to it. However, because we see the settlement flows, we can update our asset holding records at the same time. That is what we call “sponsored access”.
The bank argues that this is less clumsy than having clients deal with T2S directly, and copying their T2S settlement messages to BNP Paribas, since it avoids duplication of settlement instructions. For clients, however, the process does add cost. They have to reproduce internally the settlement capabilities previously entrusted to their sub-custodian, and continue to pay the sub-custodian to provide the asset servicing, without the leverage of the revenue it previously paid the bank to settle its trades.
Unsurprisingly, meaningful T2S economies are proving elusive for clients. One global custodian has announced it will settle all of its euro-zone business in a single national CSD connected to T2S, and appoint a single custodian bank to service its assets at the local level in the underlying markets. Inevitably, this adds cost, in the shape of the settlement CSD that routes transactions into T2S.
Cameron says sponsored access is a less complicated alternative. "There are various flavours, ranging from us only passing the settlement flows on to us doing everything that we do today, but it is not that much cheaper whatever you do," he says. "Compared to a traditional service, the only thing we are not doing is providing the liquidity, credit, and collateralisation. Clients are surprised that there are not substantial costs savings to be gained from splitting the processing of settlements and asset servicing. But it does give them a level of control over their settlements that they seem to require. It is more to do with the business model that they want rather than cost saving."
However, asset-servicing is an area in which the CSDs are positioning themselves. Faced with the loss of their core settlement revenues, the CSDs aim to compete with the custodian banks to service assets. As Alan Cameron points out, even their domestic clients do not find this idea convincing. With Monte Titoli among the first CSDs to enter T2S in June this year, a number of Italian banks which use BNP Paribas Securities Services as their global custodian have now invited the French bank to do their Italian domestic custody as well.
"They have told us, 'We do not want to go through this journey, of connecting through the CSD to T2S, and go through all the testing,'" explains Cameron. "Since Italy is going to end up looking pretty much the same from their point of view as any non-domestic market where they already use us, such as France or Germany, they reckon they might as well use it to do the whole lot. That has been a big surprise to the CSDs, who thought they would be taking clients off the banks."
The predictable consequence - and many industry participants are predicting exactly this - is the consolidation of the CSDs of Europe. "We do expect to see consolidation of CSDs in Europe," agrees Cameron. But he is not convinced it will happen quickly. "In actuality, we see new CSDs popping up all over the place," he jokes.
The likeliest trigger of consolidation, in his estimation, is the coming into effect of the right granted to issuers under the Central Securities Depositories Regulation (CSDR) to issue securities into any CSD in any European market they choose. Not yet in effect, this measure has the potential to break the domestic monopolies of the CSDs, forcing them to compete with each other to host securities. "They have still got this franchise on the issuer side, which is relatively well protected," says Cameron. "CSDR has the potential to change that, if and when it really happens."
In the short term, Cameron thinks the flat pricing structure devised for T2S by the European Central Bank (ECB) will help the CSDs survive the early stages of the transition to a single European settlement system. It will postpone an inevitable process of consolidation, simply because flat pricing is so obviously to the disadvantage of the biggest markets that can trade price for volume. They are of course the natural leaders of any consolidation process.
Cameron expects the CSDs to use the reprieve to attempt to reinvent themselves, but he warns them against trying the obvious. "The worst possible thing would be for all these CSDs to reinvent themselves as global custodians," says Cameron. "Global custody is a game of scale. The global custodians themselves are building up local franchises, and have the balance sheets to offer them a full range of services. CSDs turning themselves into mini-global custodians is a waste of the time and resources of the industry. Only those with scale can survive."
Global custodians of scale – and BNP Paribas Securities Services is one of them, in its alternative guise as a global rather than local custodian - can be expected to take that view. But the CSDs, at least until they consolidate into groups with greater scale, are not in fact an immediate competitive threat to BNP Paribas Securities Services. The more worrying competitor in a post-T2S marketplace is the ICSDs. They have the necessary scale that Alan Cameron sees as the hallmark of the T2S survivor, including in the domestic markets where they control the CSDs.
In a widely read paper published last year, Clearstream argued that a broker-dealer with trading assets and liabilities of €100 billion across the major T2S markets could save €70 million a year by consolidating its European settlement activity with the ICSD. "The investment banks can achieve savings through the consolidation of their networks,” counters Cameron. “As long as CSD pricing is unknown, and liquidity needs are unknown, there is not a lot else that can be predicted with any degree of certainty, which is why a lot of network managers are content to wait and see what happens next.”
What happens next will play out over several years. Alan Cameron thinks irreversible structural change, in the shape of settlement business shifting to a smaller class of providers, or CSDs merging with each other, is unlikely to begin before the third wave of CSDs have joined T2S in February 2017. At that point, Clearstream, Euroclear, Iberclear and Monte Titoli – which are widely predicted to be among the winners – will be competing head-to-head.
The end-state Cameron expects is a T2S that has aggrandised most of the settlement activity in multiple asset classes across Europe. He expects the Euromarkets to succumb first, followed by UCITS funds. "The billion euro question is what happens to the United Kingdom markets," he says. "The ECB has never resolved the flat pricing or the governance issues in ways that would tempt the United Kingdom to be part of T2S."
Whether T2S will develop asset-servicing capabilities as well is a speculation too far for Cameron. But then he sees T2S not as an end in itself, but as part of a wider, steadier and longer running integration of European securities markets. "T2S is just one step among many towards the harmonisation of the European post-trade environment," he says.