Northern Trust surprised its competitors by announcing how it would manage the transition to T2S a good nine months before the first markets joined the new settlement platform on 22 June 2015. Its solution was a practical one, which recognizes the fact T2S is essentially a settlement platform. It combines direct access to T2S settlement services, with a single asset-servicing agent. To access central bank money at the ECB, Northern Trust is using its full bank branch in Luxembourg to enter the euro-system via the Banque Centrale du Luxembourg.

"We are happy to be leading from the front on this," says Andy Osborne, senior vice president, global head of network management at Northern Trust in London. "T2S changes the dynamics of how settlement business is done in Europe, and we wanted to ensure we protected our clients from the risks of that, while ensuring they would enjoy the benefits as well. Other banks are now adopting similar models to ours, so it seems to be the way the business is moving."

Northern Trust is certainly in the vanguard of the banks that planned for the coming of T2S. On 25 September 2014 Northern Trust announced its strategy for T2S long before most other custodian banks had even decided what theirs was. It consists of an investor central securities depository (CSD), in the shape of Euroclear France, supported by Deutsche Bank as a single, pan-European asset-servicing agent.

The early announcement was the fruit of a planning process which had begun five years earlier. The ambition of the planners was to work out how the bank could turn the impending change in the European settlement infrastructure to the advantage of itself and its clients. "Regulatory change always creates a lot of work, but it also always creates a lot of new business opportunities," says Justin Chapman, the senior vice president who heads the market advocacy and research group at Northern Trust.

Back in 2009, the obvious opportunity was to change how the bank connected to markets in the euro-zone. At the time, Northern Trust had a conventional sub-custody network, supplemented by accounts at Clearstream and Euroclear to settle and hold Eurobonds bought and sold by its buy-side clients. The challenge was to predict what needed to change once T2S was in place.

"We conducted a lengthy study that aimed to predict what a post-T2S Europe would look like," recalls Andy Osborne. "Once we had worked out what we thought it would look like, we had to decide how we would operate in that environment." The result of all of this cogitation was an outline of the model Northern Trust announced in September 2014. The next step was to choose the partners needed to implement it: an investor CSD and an asset-servicing agent.

Choosing the investor CSD was a straightforward contest between the three institutions widely expected to survive the inevitable consolidation of CSDs: Clearstream, Euroclear and Monte Titoli, the Italian CSD owned by the London Stock Exchange. The apparent oddity of working through Euroclear France as the investor CSD is easily explained: Euroclear has built its CSD infrastructure around its operation in France.

"Euroclear is providing the technical connection to T2S, and allowing us to open accounts at their depository," explains Justin Chapman. "We are managing our own accounts, and doing all our own settlement activity, so they are not acting as a settlement agent for us in any way.Thanks to the historic consolidation of sub-custodian banks in Europe, finding the right asset servicing agent also reduced to a choice of three: BNP Paribas Securities Services, Citi Direct Custody and Clearing, and Deutsche Bank.

Northern Trust is alive to suggestions that it eventually chose Deutsche Bank chiefly because the German sub-custodian does not compete with it for global custody mandates, unlike Citi and BNP Paribas, but Chapman dismisses the idea. "The decision point was on the narrowest of margins," he says. "We had very strict criteria on the operating model that we felt we could work with, and all of the organisations that tendered could meet them. We could have got comfortable with any of the three organisations, but in the end we had to make a decision, and it was finely balanced."

The key considerations were which asset-servicing agent would work best with a global custodian such as Northern Trust (as opposed to, say, a global investment bank) and which would work best with Euroclear.The German bank could also support Northern Trust in the six euro-zone markets that account for the bulk of its European volumes: Belgium, France, Germany, Italy, Netherlands and Spain. In fact, Northern Trust had already divided the six markets between BNP Paribas and Deutsche Bank well ahead of its final choice of Deutsche Bank as its T2S asset servicing agent in September 2014.

Andy Osborne, who is responsible for selecting the sub-custodians Northern Trust works with around the world, adds that the choice of Deutsche Bank is a strategic partnership. “One of the challenges you face as an early adopter is that you have to choose from what is available at the time," he says. "We are confident what we have chosen has longevity. But once we get beyond the initial phases of the transition to T2S, Euroclear as well as Deutsche Bank are going to have to prove themselves, and they will be judged by the same criteria we use to manage any other sub-custodian. In five years' time we will be reviewing them in the usual way. Once T2S has settled down, we will drop back into a business-as-usual perspective on T2S, as a market in which we need a service provider."

For now, however, Deutsche Bank is gradually absorbing all of the euro-zone business of Northern Trust. Since that choice was first announced, Northern Trust has worked to consolidate its sub-custody business with the German bank. Italy and Spain were switched from BNP Paribas to Deutsche Bank immediately after the September 2014 announcement, and France will follow in November this year. Italy was the most important market to transition, not just because it is large, but because the country was in the first wave of markets scheduled to move on to the T2S platform on 22 June 2015.

Uncertainty about the stability of the platform that Monte Titoli - the London Stock Exchange-owned Italian CSD – has built meant doubts about whether the country would join on 22 June or later were impossible to dispel. "Uncertainty about the transition timetable persisted until very late in the process," says Osborne. "That was unfortunate, because we needed practical, pragmatic decision-making by the European Central Bank (ECB) to minimise the impact on the downstream conversions."

How will those “conversions” work in practice? In a classic sub-custody arrangement, the sub-custodian would act as the gatekeeper to the CSD, settling trades and servicing the assets of the clients of global custodians such as Northern Trust through their own omnibus accounts. By controlling the accounts at Euroclear France directly, Northern Trust will exert a greater degree of control.

Importantly, in the light of the promise from Andy Osborne to return to a business-as-usual management of service providers once T2S has bedded down, controlling the accounts at Euroclear France also makes it much easier for Northern Trust to change their asset-servicing provider. "Asset-servicing is a sub-set of a sub-custody service," as Osborne explains. "Separating it from settlement, which we will now control ourselves, changes the nature of the relationship.”

It certainly does. The ability to service assets hinges on access to accurate settlement information. Since T2S forces banks to divide settlement from asset servicing, Northern Trust has had to build what Justin Chapman calls a “single pipe” to share settlement information with Deutsche Bank simultaneously. "Deutsche Bank has to work with the issuer CSD at the local level in each market where it is servicing assets, so they have to mirror what is held at the investor CSD level, which could be different from what is happening at the issuer level," says Chapman. "They have the ability to consolidate the assets of an investor in the euro-zone as a whole, but need to remain granular at the issuer CSD level."

The fact that T2S is a settlement platform only has made it difficult for Northern Trust to promise clients early reductions in transaction costs. "Asset-servicing costs are higher than transaction costs, and they have not changed at all," says Andy Osborne. "In fact, we had some very interesting discussions with our potential asset–servicing partners, as we and they tried to work out how to unbundle asset-servicing from settlement as a sub-custody service.” Shareholder registers and corporate actions data, for example, continue for now to be controlled by local issuer CSDs.

This bifurcation of settlement and asset servicing will persist until T2S assumes the asset-servicing functions as well. Justin Chapman is sceptical that this will happen soon. Despite the efforts of the Giovannini Group at the turn of the century, and of working groups of the ECB and the issuer CSDs in the run-up to the launch of T2S, corporate actions information alone is still too country-specific to be processed successfully at a supra-national level. "What you may see is the erosion of the ability of domestic CSDs to maintain these services at the domestic level," predicts Chapman. "So they may start to share platforms, or adopt standards, or consolidate."

He agrees that consolidation is likely to be triggered by the portability of issuer activity under the Regulation on Settlement and Central Securities Depositories (CSDR). "If large corporate issuers do start to shift, it will throw the entire European CSD space up into the air," says Chapman. "The biggest corporate brands in any country might choose to stay with their national CSD but, equally, it could become a competitive segment if they decide that returns to shareholders are more important than national loyalty." He adds that, if issuers do start to shift their business to a new class of emergent pan-European CSD, it sets a challenge for the asset-servicing agent to keep up.

Chapman thinks the emergence of pan-European CSDs will increase once swap clearing, which is mandatory under the European Market Infrastructure Regulation (EMIR), starts. This is because clearing is at present a largely broker-to-broker business, whereas EMIR will draw asset managers (and eventually end-investors) into centralised clearing. "If we get more asset management flows into CCPs, it could be a catalyst for change," he says. "Under EMIR, CCPs have to hold their collateral at a CSD, so the logic for a CCP holding T2S-eligible collateral is to appoint a pan-European CSD to hold all of its assets, so they can be posted to all sorts of purposes across the euro-zone."

In fact, one reason Chapman welcomes T2S is its contribution - through the auto-collateralisation service that allows users to pledge eligible collateral in one market against exposures in another - to more efficient collateral management. He adds that T2S creates a safer as well as a more efficient environment, not only through auto-collateralisation, but by reducing the settlement timetable, speeding up reporting of settled trades, and reducing the consumption of credit as well as collateral by making settlement more reliable. "If you get more reliable settlement, clients can use their own funds, so there is less credit required, and a consequently reduced impact on the capital ratios of the custodians," explains Chapman. "From the point of view of the market, that probably amounts to a higher return than a reduction in the cost of settlement."

That is just as well, since Northern Trust not only downplays the prospect of immediate cost savings. The banks also believes material savings in cross-border settlement costs from T2S will not emerge for quite some time. The celebrated 15 cents advertised by the ECB does represent a decline in cross-border settlement costs that run up to 400 basis points under current conditions, says Chapman, but it is merely the starting point. Further charges are levied for functions too essential to successful settlement to escape, such as matching and allocation.

“The designers of T2S were originally trying to compete with the United States, and get total costs of settlement down to 50 cents a trade, or less. There is some way to go before it gets to that, but once the cost of the investment in the infrastructure is recouped, T2S should in the end create efficiencies. There will definitely be a lag before the benefits come through, though. They should be visible by 2018 at the earliest."

One reason the benefits will take so long to materialise is that the custody industry as a whole is thought to have invested at least the same amount in T2S as the ECB, which adds up to €1 billion apiece. Northern Trust spent its share of that sum on a variety of adjustments necessary to support its clients through the transition to T2S. Although the bank is ISO 20022-compliant, many of its clients are not, so it has had to retain the capability to translate messages into ISO 15022. “We service over 2,000 fund managers, and the level of technological sophistication varies widely,” explains Andy Osborne. “We have positioned ourselves to support all of them.”

Insulating clients from ISO 20022 included investing in the T2S-specific messages and testing the reliability of connections to the new system. The bank also chose to invest in insulating itself from any slippage in the T2S transition timetable in particular markets by forging connections to every market in the first wave anyway.

Further investment has gone into assessing the strength of the potential settlement connections and asset-servicing capabilities in the 13 euro-zone markets where Northern Trust transaction volumes are less material. "We have to protect our clients' interests, wherever they are active," says Chapman. "Through waves one, two and three we have conducted full assessments of our agents to check their level of readiness, and what investments they need to make in new technology, because we did see a number of agents withdraw from the market."

Oddly, for a platform designed to harmonise market practices, T2S implementation still comes in particular flavours in each market. “Each market that comes on to T2S has a different nuance, in terms of matching, affirming, confirming, holding, processing and reporting messages to and from the global custodian, the broker and the sub-custodian,” says Chapman. “So we have to test functionality and bandwidth thoroughly as each wave comes onto T2S from 2015 through to 2017, including Euroclear and our agent bank in each market. In any cross-border trade, we have to ensure that T2S and the CSD as the settlement location are always aligned on which CSD will actually hold the asset, because it is our buy-side client, and not the broker, that determines the destination. T2S means delivering safely four or five new markets a year, including avoiding the cost of buy-ins for failure to deliver under the CSDR. It is a big investment of time and money.”

That investment needs to be recouped before prices can fall. Chapman is confident they eventually will, and does not shrink from the implications of that reduction, when it does arrive. "T2S is good for the market," he says. "It is underpinning the evolution of the European marketplace into a much more competitive and open landscape. We are very supportive of the ECB initiative and what it is trying to deliver, which is a reduction in the cost of one segment of the transaction chain - namely, settlement." This, coupled with the operating model opportunities T2S provides Global Custodians when overlaid with the CSDR, will ultimately foster an environment with increased asset safety, transparency and liquidity, making the T2S investment worthwhile.”

Dominic Hobson