Roland Berger Strategy Consultants. content. Fresh thinking for decision makers

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1 Roland Berger Strategy Consultants content Fresh thinking for decision makers Post-trade services are at a crossroads New regu lation and dwindling margins make it more difficult to earn money Competition is mounting Providers have to address the question: grow or specialize With compliments januar november Financial Services CC

2 Heterogeneous market VP Lux VP Securities Six Sis In post-trade services, a handful of big providers are surrounded by a number of players that operate mostly in their home markets. The common settlement platform Target 2 Securities (T2S) is going to transform this market fundamentally. BOGS Malta Stock Exchange Monte Titoli Clearstream Banking Luxembourg (CBL) CSD of Lithuania Estonian CSD NASDAQ OMX Group BNY Mellon LuxCSD (50%) Latvian Central Depository BNY Mellon CSD Iberclear Clearstream Euroclear Finland Euroclear Netherlands Interbolsa Clearstream Banking Frankfurt (CBF) Euroclear CDCP Depozitarul Central Österreichische Kontrollbank (OEKB) KDD Slovenia Keler NBB SSS Euroclear Belgium Euroclear France Assets under custody Source: ECSDA, 2012 > 6 trillion Euros > 4 trillion Euros > 700 billion Euros > 100 billion Euros < 100 billion Euros

3 content Post-trade Services Enjoying the regulator's blessing is not everything: The equation "more regulation = more business" doesn't always hold true at least not for providers of services related to stock trading. The need to invest, dwindling margins and ever greater competition are forcing providers of post-trade services to address one serious question: Grow or specialize? The financial markets have been inundated by a veritable flood of regulation. The EU Commission and the European Central Bank are striving to integrate the continent's financial markets as closely as possible. Their focus is on safeguarding financial stability in the euro area for example through the Central Securities Depository Regulation (CSDR), which is still being finalized, and the European Market Infrastructure Regulation (EMIR), which largely prohibits over-the-counter trading of standardized derivatives. Yet competition between financial centers also plays a role: The harmonized Target 2 Securities (T2S) settlement platform pushed by the European Central Bank should vastly reduce transaction costs, thereby helping to guarantee a smooth flow of global capital through Europe's trading exchanges. And then there are the many interventions at a national level, such as taxes on financial transactions and limits on high-frequency trading. Turning point in post-trade Services T2s The implementation of the Target 2 Securities settlement platform requires a validation of the existing business models in Europe. All these actions have one thing in common: They are expensive to realize which makes it increasingly difficult to earn money on the settlement, billing and custody of securities transactions. Providers of these services thus face three major challenges. First, the opening of national markets in the next three to five years will force providers into competition with completely new rivals. Second, more and more questions are likely to be asked about ownership and management structures, not least in light of the governance stipulations envisaged in the CSDR. Third, providers must seek to play an active part in the regulation debate to ensure that they can operate on a level playing field. Regulation gets things moving in a fragmented market How providers should best position themselves depends largely on where they are coming from. The market for post-trade services is extremely fragmented. A handful of large players are surrounded by a flock of small central securities depositories (CSDs) that operate mainly on their home markets. Worldwide, a total of around 140 custody service providers and 84 central counterparties (CCPs) exist in a wide variety of sizes, legal forms and scope. The spectrum includes commercial providers such as universal or custodian banks, broker-dealers and fund managers; public-law infrastructure providers with integrated payment systems; and infrastructure entities that position themselves as a mix of for- and non-profit organizations. Additionally, numerous regulatory projects are blurring the lines between commercial providers and public infrastructures and causing traditional business models to converge. In the new regulatory environment, collateral is a scarce resource. Basel III tightened capital adequacy requirements, and Europe's EMIR directive requires that standardized derivative transactions be cleared via a central counterparty (where collateral must also be deposited). In this context, collateral management assumes a key role in optimizing those aspects of banks' capital relevant to supervisory regulations. Given that this is a relatively new client

4 Roland Berger Strategy Consultants need, and one that will gain importance in the future, CSDs need to think carefully about adding exactly the right services to their portfolios. Examples can already be found in banking practice. One involves creating and networking collateral pools providers' response to their clients' interest in keeping costs down by moving collateral around as little as possible. Collateral transformation services for buy- and sell-side companies in need of eligible collateral could be another useful addition to CSDs' portfolios. Prices are declining substantially 80% The intended standard transaction price of 15 to 25 euro cents on the settlement platform T2S is about 80 percent lower than the average price today. Common settlement platform forces the market to open up The ECB-driven introduction of the common settlement platform T2S will also structurally change the industry, as settlement margins can be expected to decline on a massive scale. According to an ECB survey, transaction costs on domestic markets average around 73 euro cents, while cross-border transactions can cost up to ten times as much. The ECB, however, wants a standard price of 15 to 25 euro cents per transaction. In consequence, the settlement business will be worthwhile only for those players that can attract large volumes. At the same time, the "commoditization" of settlement will drive more and more competition toward asset servicing. The best response to this development is to specialize in value-added services, which promise higher margins. At any rate, it is questionable whether providers of post-trade services will still be facing their current competitors in the years ahead. Why? Because European harmonization is triggering a far-reaching structural transition. The abolition of national monopolies expected over the next three to five years will initially lead to further market fragmentation: Working on their own or with partners, the 24 national CSDs that have signed up for T2S will seek to expand into their neighboring markets in order to secure a pan-european positioning. The cooperation of the London Stock Exchange and its Italian CSD Monte Titoli with the US bank JP Morgan, one of the biggest global collateral managers, is but a taste of things to come. In the medium term, however, this line of business too must brace itself for consolidation, as there can be no justification for today's multiplicity of providers in a harmonized European market. To cut costs and reduce administrative overhead, many clients will try to reduce the number of parties they work with. For CSDs, the major challenge is thus to position themselves now for the wave of consolidation that will probably begin four to five years from today. International central depositories (ICSDs) will have a clear advantage over isolated national players because they already operate as depositories on behalf of national CSDs. Moreover, their cross-border networks give them the potential to draw liquidity off national markets. Providers who cannot themselves play an active role in consolidation should make themselves attractive as future partners or acquisition targets. As they do so, it is important to remember that the process will not be the same everywhere. In the mid-office and backoffice, heavy cost pressure coupled with a shortage of skills means that consolidation will be faster here than in the front-office.

5 content Post-trade Services Post-trade services poised for substantial investment Be that as it may, not all the national CSDs that have put their name to the framework agreement for T2S may have the expertise and the financial resources needed to carve out a pan-european positioning. Connection to the common platform is expensive: Roland Berger's project experience suggests costs of at least EUR 30 million to EUR 50 million. National implementation of European directives including the European Market Infrastructure Regulation (EMIR), the Markets in Financial Instruments Directive (MiFID) and the Alternative Investment Fund Managers' Directive (AIMFD) is likewise confronting providers with new technological challenges, some of which again require considerable investments. On top of these directives come new bodies of law such as the US Foreign Account Tax Compliance Act (FATCA), which obligates foreign companies to make their tax affairs more transparent, and the financial transaction taxes that are now in force in a number of national markets. Existing providers must therefore ask themselves what their future business model has to look like if the necessary investment is to pay off. In the present situation, they must also be aware that new competitors could emerge, seeking to conquer the market with new technology. Such newcomers could be business process outsourcing providers or other global sourcing companies, for example. Declining volumes driving consolidation Another point that must be considered regarding investment decisions is the declining revenue from securities trading. There are three reasons for this trend: First, the re-regulation of the financial markets. Individual countries have already imposed a financial transaction tax (FTT) on securities trading. Volumes will decline at the latest when the initiative for a common FTT put forward by Germany, France and other core EU countries comes into effect. Second, many banks are currently reorganizing their business models, especially regarding capital market activities. This partly involves internalizing their custody activities. And third, securities activities are increasingly being farmed out to alternative trading platforms that are much less expensive for market players, such as multilateral trading facilities (MTFs). These platforms collect trades during the whole day and do not clear them until the evening. As a result, the volume relevant to providers of post-trade services is significantly lower than on conventional trading platforms. Forward-looking technologies such as cloud trading and new interfaces that allow OTC trades to be placed via trading information systems are likely to add further momentum to this trend. Declining revenue potential FTT MiFID internalization cloud trading New technologies, business trends and mounting regulation will reinforce the trend to declining volumes in stock trading. To fund the investments required by these developments and to establish robust business models that can stay the course, the market for post-trade services has to fundamentally transform itself. In industrialized countries, the sector is experiencing both horizontal and vertical consolidation. Horizontal consolidation is a good way to reduce overcapacity and make better use of existing infrastructure, especially in the clearing business. Volume

6 Roland Berger Strategy Consultants growth in the wake of takeovers will enable economies of scale to offset growing pressure on margins. At the same time, extending the value chain and broadening their portfolios gives providers greater leeway on pricing. Great market potential Today, the European market for exchange-traded derivatives already adds up to four billion contracts per year Explore the possibility of entering new asset classes One way of achieving economies of scale is to penetrate additional asset classes. The market potential is immense: The European market for exchange-traded derivatives (ETDs), for example, added up to four billion contracts in 2012, while the global market for OTC derivatives topped EUR 473 trillion. Bond trading on the secondary market generates EUR 80 trillion to EUR 100 trillion annually, despite the fact that only an estimated 3,000 fixed-income securities are traded per day. At the close of 2012, the European repo (repurchase) market had a total volume of EUR 5.6 trillion, of which only 30% have so far been settled via central counterparties. And that's not to mention the potential of the foreign exchange market, where around EUR 3 trillion changes hands on average every day. The biggest market in the world is still largely unregulated: The two leading trading platforms, ICAP and Reuters, together have a market share of less than 10%. The biggest hurdle to successfully breaking into new asset classes is liquidity. Due to derivatives' lack of fungibility, it is hard for newcomers to draw off liquidity from incumbent players. In practice, this limits organic growth of existing and new market players. For example, fast-growing market segments such as ETD trading are in the hands of just three large providers: Eurex, Liffe/ICE and MICEX/RTS together occupy 95% of the market. Discussions with various providers have revealed that their strategic challenge is to identify which markets and products are worth penetrating and, of course, to determine whether they possess the necessary expertise to do so. The overdue process of vertical consolidation will most likely be triggered by rising cost pressure and clients' growing tendency to concentrate on just a small number of providers. Despite the heavily fragmented nature of the European market, the trend toward a very heavy concentration of custody volumes is already apparent: Four out of five dollars held in custody are already placed with one of the four major providers. National interests obscure sound economic reasoning Providers must factor the trend toward consolidation into their decisions regarding necessary investments, some of which will be very substantial. Certain smaller market players might do better to make themselves attractive as cooperation partners by choosing the right area of specialization. In isolated instances, however, this decision will be based on more than purely economic considerations. National stakeholders are often only too willing to subsidize CSD business in the hope that they themselves can retain their sovereignty over the domestic financial market infrastructure. Providers who decide to take an active role in the market transformation and who are sufficiently large should consider expanding abroad. Many growth markets in Asia and the Middle East lack the infrastructure needed to guide the growing influx of capital from around

7 content Post-trade Services the world into the intended channels. Development potential in post-trade services is enormous especially as the regulatory changes currently being implemented in the West are now also taking effect (or at least serving as blueprints) in these parts of the world. Western providers who can deliver the required expertise up to and including turnkey IT systems will find the door open to all kinds of cooperation, as the example of LSE technology subsidiary MillenniumIT shows. Given the right expansion strategy, the necessary investment is not only easier to justify but can also be funded more quickly. Identifying and exploiting sweet spots Roland Berger Strategy Consultants recommends five specific actions that can help providers of post-trade services position themselves in the T2S environment: See change as an opportunity: T2S gives pan-european providers a suitable platform on which to consolidate client assets and, by leveraging their function as investor CSD, to gradually draw liquidity off their national rivals. With the right partners, client-oriented settlement and collateral management solutions can be developed that can also be marketed in growth markets such as Asia and South America. Improve your margins: Systematically industrializing operations creates lasting efficiency gains. The aim must be to gradually increase margins and align back-office capacity with the new market conditions under the T2S regime. Extend your value chain: Add-on services can help offset the loss of revenue associated with T2S. To develop client-oriented solutions, CSDs can add or extent collateral management services, expand into banking services and/or establish themselves as sourcing providers for banks with end-to-end solutions. Use your home advantage: National providers who lack the resources, infrastructure and expertise needed for acquisition-driven growth strategies can engage in asset collecting. Where the given market structure permits, they should strive for exclusive agreements with the foremost financial institutions on their home markets. This will strengthen their position and make them attractive as partners for global or pan-european competitors. Develop specialization: National providers should consciously establish a position with regard to local and global concerns. Tax issues, databases of trading information (trade data warehousing) and the peculiarities of national regulations give CSDs a wide array of options for positioning themselves in the T2S environment. By offering high-quality processing of corporate action data for securities admitted for trading, CSDs can set themselves apart and improve their margins: Clients should be willing to pay more for extensive guarantees of data accuracy. This strategy too can help providers consolidate their market position and makes them attractive to global players who lack their specific market knowledge. PLEASE CONTACT US AT ANY TIME WITH further questions Dr. Peppi Schnieper, Principal peppi.schnieper@rolandberger.com Bruno Colmant, Partner bruno.colmant@rolandberger.com Adrian Pfammatter, Senior Consultant adrian.pfammatter@rolandberger.com think:act CONTENT ditor: Charles- douard Bouée, Prof. Dr. Burkhard Schwenker Overall responsibility: Dr. Torsten Oltmanns Project management: Dr. Katherine Nölling Roland Berger Strategy Consultants GmbH Am Sandtorkai Hamburg news@rolandberger.com

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