With the initial phase of TARGET2-Securities (T2S) due to launch in 2015, Europe is on the cusp of transformational changes to its settlement process. Alex Dockx, T2S program director at J.P. Morgan, gives his insights.
What would you say are the main benefits of T2S?
First is the reduction of complexity in settling transactions across different national markets, as everything will be settled on a single platform. In addition, T2S will create a harmonization of market settlement processes, deadlines and functionalities. Users will find increased efficiencies due to standardized interfaces, message formats, streamlined processes and further harmonization of services, rules and market practices.
Equally important is the reduction of payment risk resulting from the processing of T2S settlements in central bank money and the ability to collateralize intraday credit needs with assets in T2S. As cash and collateral can be pooled across T2S markets, there are substantial netting and collateral efficiency benefits as well.
What possible future settlement landscapes might emerge post-T2S?
The European post-trade landscape is currently characterized by high fragmentation and complexity as single markets have different practices and infrastructures. Today, banks and custodians typically need to go through a complex network of intermediaries that offer full-service access to local markets. T2S will provide an opportunity for market participants to reassess their existing access model into European markets. By harmonizing and centralizing securities settlements, T2S will allow market participants to optimize their operations and decide which business functions are best insourced versus serviced by agents.
We also believe that T2S will lead to some fundamental business model changes impacting market participants and market infrastructures in the settlement value chain. We see competition increasing among providers on two fronts. First, as sub-custodians find their local market niches coming under pressure, they will have to compete on a European scale against each other and against regional custodians. Secondly, CSDs—especially the large ones—will increasingly compete with regional and global custodians for investor business by leveraging their existing business and by offering value-added services. The reverse may happen as well— global custodians and broker-dealers will be able to centralize their activity into T2S, thus by-passing local agents for settlement and cash clearing.
What other key drivers will impact post-trade activity in Europe?
I think it is also important to look at the wider regulatory context, as that will also drive the future of settlement and custody in Europe. One of the most important milestones is the recent adoption of the CSD Regulation by the European Parliament, which provides a uniform regulatory framework for CSDs and outsourcing of services to T2S. It also allows greater flexibility on where issuers can deposit their securities and allows CSDs to operate on a pan-European basis. Last but not least, in addition to harmonization of settlement cycles to T+2, CSDR also provides a set of detailed rules to promote settlement efficiency and penalize fails, including mandatory buy-ins.
The combination of T2S, CSDR and other regulations such as AIFMD and UCITS V, as well as general bank liquidity rules, will, we believe, fundamentally alter the role of different service providers in the post-trade landscape. Not all is defined yet, but a few key trends are clear. As I stated, there will be greater competition, not only among banks themselves but also with market infrastructures. Cost pressure will continue to erode margins but also will lead to a greater unbundling of services. Settlement efficiency will be key to minimizing penalties as a result of settlement fails. There will be a much greater focus on intermediary risk and the quality of providers. The ability to optimize liquidity and collateral will also be important.
Please tell us more about the impacts that T2S will have on liquidity.
Currently, agent banks and sub-custodians provide cash and liquidity services as an integral part of their service offering. This is required, as the cash leg of settlements in local CSDs usually takes place in different domestic central banks.
One of the main benefits of T2S is that it allows the consolidation of liquidity management across markets, leveraging the existing TARGET2 payment infrastructure— hence the name. In the future, banks with a European presence will be able to settle their entire T2S activity in central bank money using a single, dedicated cash account at a central bank of their choice and use the T2S auto-collateralization functionality to fund their intraday needs. This will reduce the need for intraday credit facilities from agent banks and allow to net activities across markets.
Should T2S be extended beyond its current scope to other territories, to other currencies or even to new market segments such as funds or asset servicing?
Once the transition phase is over, it would be a good idea to consider which other activities would benefit from a single, highly automated settlement system such as T2S. The T2S platform has been designed from the outset to accommodate many types of securities and multi-currency transactions. Besides adding more markets and currencies, one potential avenue is in the area of further harmonization of asset servicing practices across markets.
What will be the effect of T2S on investment and trading flows into Europe?
The implementation of T2S will create greater harmonization whereby the possibilities for straight-through processing are maximized. A single processing platform allows more efficient trading and investment and should make Europe more attractive to issuers and investors. Additionally, issuers from non-T2S markets may look closer at opportunities provided by T2S to reach all markets in Europe at the same time.
And what about the impact on collateral management?
Currently, banks usually hold significant collateral portfolios in different markets, making it difficult to reuse and pool holdings. T2S will make it possible for banks and intermediaries to manage their collateral much more efficiently and to optimize funding costs because of the ability to net long and short positions in various markets.
As a result, we should see more opportunities for consolidation and optimization of collateral holdings for settlement, securities financing and other tri-party activities, reducing buffers needed across different markets and locations.
What else needs to happen to reap the benefits of harmonization?
T2S will trigger harmonization particularly in technical and operational areas, for example, common messaging formats or protocols, harmonized daily timetable and calendar. Nevertheless, there will still be differences among practices of different markets, which shall need to be addressed. The biggest opportunities are to be identified in the areas of asset servicing and tax.
What is J.P. Morgan’s position on T2S?
We believe T2S will further strengthen the European post-trade environment and reduce risk for our firm and for our clients. J.P. Morgan has been a supporter of T2S since inception and an active contributor to the industry dialogue via steering groups, user groups and industry associations. In addition to our internal preparations, J.P. Morgan is working alongside clients to ensure a seamless transition to the T2S environment.
How would you describe the firm’s overall T2S strategy, and how will J.P. Morgan’s operating model change as a result of T2S implementation?
Given the scope of T2S, and also considering the requirements of EMIR, J.P. Morgan intends to offer its clients a choice of access into T2S, suited to the types of activity and servicing needs. For our custody, securities clearing and trading services, J.P. Morgan intends to have direct accounts in the key T2S CSDs, and insource settlement and liquidity management from agents following a phased implementation. For our collateral management services, J.P. Morgan will offer clients a single, consolidated CSD hub, which will access both T2S and non-T2S markets, offering clients the benefits of a single collateral pool across markets.
As of Wave 2, March 2016, and for subsequent waves, J.P. Morgan intends to insource settlement, clearing and liquidity management in key markets, while using an agent for asset servicing and communication. This will allow clients to benefit from direct T2S access for key markets.
Our firm is also becoming a securities general clearing member of additional CCPs to ensure complete regional coverage for banks and brokers. For smaller T2S markets, J.P. Morgan intends to consolidate with fewer best-in-class agent banks using a full service model.
Our intention is to work with clients as much as possible to adapt to T2S-related changes while encouraging them to benefit from the new functionalities and harmonization of market practices.