The Dutch specialist in European securities services adopted a pragmatic approach to the coming of T2S, with the aim of maximising the obtainable savings on post-trade processing, while minimising its costs, especially in terms of investment in systems. KAS Bank strategists also think the full benefits of T2S will take many years to disclose themselves, further militating against a costly and over-ambitious approach that might turn out to be mistaken.
When T2S starts, Hans Koek T2S Program Manager at KAS Bank in Amsterdam, thinks little will change at first for banks such as his own. Transactions will continue to settle in local central securities depositories (CSDs), and most banks will continue to access those depositories via their local sub-custodian banks as well. Koek thinks this is especially true of the stock markets with a vertically integrated central counterparty clearing house (CCP), since its role as mandatory counterparty and netting agent to all trades provides an ideal protectionist device for local markets until such time as Europe gains a single clearing platform as well as a single settlement platform.
This is a characteristically down-to-earth assessment of the T2S project by people who have actually to settle trades as well as talk about it. Yet its logic is far from obvious. It suggests the principal driver of the consolidation and centralisation of settlement in Europe will be not the custodians or CSDs but the CCPs independent or ambitious enough to be willing and able to disintermediate their domestic equivalents. Of course, the attachment of KAS Bank to this line of reasoning can be seen as specifically Dutch. European Multilateral Clearing Facility (EMCF), the Dutch CCP created by Fortis in 2006, was in December 2013 purchased by EuroCCP, the European clearing house owned by the Depository Trust and Clearing Corporation (DTCC), which will certainly be looking to win from domestic incumbents cross-border business going into European markets.
Its ambition is matched by LCH.Clearnet. And the success of CCPs such as EuroCCP and LCH.Clearnet in diverting transactions into equally ambitious CSDs - most obviously, the international CSDs (ICSDs) that are widely predicted to be the principal beneficiaries of T2S - will be as important as the activities of stock exchanges in driving the consolidation of the European post-trade infrastructure. They will achieve this by determining the destination of settlement flows in the same way as exchanges will determine the destination of execution flows. "The pressure to move the settlement of share transactions around will come from stock exchanges and CCPs such as EuroCCP and LCH.Clearnet that are trying to attract the business of exchanges and MTFs," explains Henk Brink, head of Client Service Clearing and Settlement at KAS Bank. "It is why interoperability matters to them, and why it matters to us. It is not good for the development of the market in Europe that we have all these politically protected silos."
Of course, not every market in Europe has a CCP, and the logic of this argument dictates that they are the most vulnerable markets in the early stages of the transition to T2S. Even in markets which do have an incumbent CSD, Brink adds that T2S gives challenger CCPs an opportunity to compete for business on equal terms for the first time. "T2S levels the playing field for them" he says. "EuroCCP, for example, presently has an instruction-based matching process, where trades have to be matched separately before they can be settled. With the introduction of T2S they will be on the same level as the incumbent CCPs, which settle trades which have already matched automatically. With the coming of T2S, EuroCCP will be able to issue settlement instructions for matched trades in exactly the same way as the incumbent CCPs."
In the long term, the importance of guessing successfully at the outcome of such a complex set of interactions between independent actors is far more important than the operational technicalities. "T2S is 20 per cent technology, and 80 per cent strategy," says Brink. "Obviously we have to build the necessary functionality so we have a working system when T2S starts in June, but the significant benefits will accrue over the next three or four years if we get our initial strategy right."
That strategy consists of being a direct participant for cash and an indirect participant in securities. As a direct cash participant, KAS Bank can operate a single cash account for all the member-states of the euro-zone, and so dispense with its network of cash correspondent banks. A major benefit of this is to release liquidity tied up in settlement activity in various markets throughout Europe. On the securities side, by contrast, the bank will connect indirectly through its existing network of CSDs (where KAS is a direct member of the CSD) and sub-custodians (mainly in the smaller markets, where the bank does not participate directly in the CSD).
This bifurcated strategy reflects the fact that T2S is nothing but a securities settlement platform, so KAS Bank will continue to need asset servicing support - income collection, corporate actions, proxy voting and tax reclaims - in local markets and for the assets it holds on behalf of clients in the ICSDs. The bank cannot ditch its sub-custodians until a single securities account is supported by a multi-jurisdictional asset servicing service. This is the ultimate goal of the most ambitious "investor" CSDs - eurojargon for the CSDs that want to hold and service assets irrespective of their place of issue, to distinguish them from the "issuer" CSDs that want to stick to holding and servicing the securities issued into them - such as the ICSDs.
At this stage, KAS Bank can simply wait to see what asset servicing capabilities the investor CSDs develop, and capitalise on the investments they make. After all, every CSD has to "move up the value chain," as the phrase has it, because T2S is going to eat a third or more of their core settlement revenues. Even the mighty ICSDs are not exempt from this revenue shrinkage. But Brink nevertheless expects the two ICSDs to be among the certain winners of the T2S-induced shake-out of custody networks and market infrastructures in Europe. Each ICSD has already invested around €100 million in their T2S platform, albeit by fee adjustments to existing clients as well investing their own resources. This has raised the opportunity cost for rivals that wish to match them. Once the ICSDs add local asset-servicing to their repertoire, they could well be unbeatable.
"This is the expected end-game of T2S," says Brink. "Given the amount of investment the investor CSDs have to make and the limited amount of their existing settlement systems that they can decommission - maybe 15 or 20 per cent of them, if they are to continue to provide asset servicing and collateral management services - consolidation is the only possible outcome. But consolidation might take another five or ten years to happen." One reason for the slow pace of development is that the behaviour of the indirect end-users of the market infrastructure - institutional investors, fund managers, issuers and private wealth managers - is unlikely to change quickly. “For the smaller incumbent CSDs not able to become investor CSDs because of the required investments, the future looks gloomy,” says Brink.
This is partly because settlement fees will not fall by enough to impress anyone on the buy-side, and not every bank and broker will pass on the savings on to their clients anyway. Jeroen van Walsem, Product Manager Transaction Services, predicts minimal cost savings from the initial transition to T2S. When the European Central Bank (ECB) launched the T2S project in 2006, it argued that any reduction in cross-border settlement costs of less than 90 per cent implied the failure of the project. That is now a pipedream. When the central bank first published its tariff structure, settlement was going to cost €0.15 for a cross-CSD delivery against payment. That figure has since risen to €0.18, and the ECB talks less about cost savings and more about the other benefits of T2S.
Those ancillary benefits are undoubtedly real, and may well turn out to be far more important than lower settlement tariffs. They include improved settlement efficiency from the operation of single cash and securities accounts, harmonised settlement timetables throughout the euro-zone, easier movement of collateral across borders, and reductions in the commitment of cash to multiple settlement processes in multiple jurisdictions. Despite their reality, the value of these benefits is uncertain in every sense except the fact they will fall some distance short of being transformational. After all, €0.18 is the cost of settlement only. The CSDs will add a charge to cover the costs of building an ISO 20022-compliant interface - compulsory for participation in T2S - and settlement instruction messages and status reports will incur further additional charges.
Nor are the ISO 20022 messages sent and received by CSDs and global custodians connecting to T2S harmonised between the 24 markets of the euro-zone, creating further unwelcome costs. "T2S may be a European platform with only one standard, but every CSD linking to the T2S platform has its own interpretation of the messages, and every custodian bank linking to the local CSD makes its own translation from the SWIFT ISO 20022 messages to the ISO 15022 messages our systems can read," says Hans Koek,. "Once you get into the bits and bytes of a settlement instruction, there remain substantial differences in the local interpretations of the messages. We receive different specifications of the same message from different CSDs and ICSDs. So there is standardisation, but it is always local. The standards are not really standard, and it has nothing to do with market-specific requirements. It is just down to different interpretations of the same message. So we still have to do a lot of work to accommodate all the different specifications of all the providers in the market, one by one and field by field, which we would not have to do if we had a true single market standard."
SWIFT has worked in hand to control the unhelpful proliferation of ISO 20022 interpretations. Until that is complete, KAS BANK is happy to postpone becoming a direct securities account holder in T2S. An indirect connection via the Dutch CSD buys the bank time before switching over to ISO 20022, since a direct connection would add further costs and technological complications to an already crowded agenda, simply because T2S insists on communicating via the ISO 20022 standard only from the outset.
The bank expects to re-visit the issue of ISO 20022 compliance in 2018. Between now and then, however, KAS Bank will look to rationalise its sub-custody network, and move more business to the ICSDs as they start to service more assets in a larger number of markets. "In the end, we will probably need no more than three or four connections to investor CSDs," says Brink. "But it is not an easy job, even for organisations such as the ICSDs, to get the asset servicing part 100 per cent correct for all the underlying markets in a short period of time. In the meantime, we still need our existing network."
Once the costs of these various lingering inefficiencies are taken into account, Brink thinks the true cost of settling a transaction in T2S will probably fall somewhere between €0.30 and €0.40, which is not drastically below the €0.50 charged by the Dutch CSD today. Custody fees charged by CSDs - and custodians, for that matter - can also be expected to rise to compensate for lower settlement revenues. "We have not yet seen a fee proposal from any of the CSDs or sub-custodian banks which gives us the proposed increases or decreases in nominal settlement fees at all," says Brink. "We have seen proposed structures only, which consist of modular build-ups of various charges."
Koek does not expect a substantial reduction in settlement fees, at least in the short term. That means client behaviour is unlikely to be much affected. After all, even if T2S led to a material reduction in settlement fees, post-trade expenses are a small proportion of the total cost of running an investment portfolio. "Settlement in T2S may be a bit cheaper, but we do not think it will make a hell of a lot of difference," says van Walsem. "Fees may go down in the medium term, but it will not be spectacular. Certainly not enough to influence the investment decisions of buy-and-hold institutional investors of the kind we look after. It might make a difference to high frequency or algorthmic traders, but I doubt even they will care that much about nominal settlement costs."
Corporate issuers will care even less. For them, post-trade costs are not trivial by comparison with issuance and listing costs, but irrelevant to what they are trying to do. "Would an issuer issue securities in the United States rather than Germany because the settlement costs are lower?" asks Koek. "I do not think so. The decision is driven by the investors they want to reach. Post-trade costs are not material in the context of what they are doing."
In the end, the only factor that might force KAS Bank to re-write its T2S strategy is T2S is itself. At present, T2S is a securities settlement platform only. However, many custodians fear its leadership has clear ambitions to develop asset-servicing, mutual fund and perhaps even data repository services, as part of a long term plan to become a Depository Trust and Clearing Corporation (DTCC) for Europe.
Brink accepts that T2S has plans to service additional asset classes, including mutual funds, margin calls and repos, but he is not convinced these will be supported beyond settlement. "I do not think T2S will ever become a DTCC for Europe," he says. "It will remain - we hope - a highly efficient platform for the settlement of euro-denominated securities. I know they are interested in exporting the T2S technology to other parts of the world, such as Asia, but I do not think T2S will evolve into a fully fledged CSD. I have not seen any evidence that they have either immediate or long term plans to evolve in that direction."