guidelines Q&A TARGET2-Securities for Funds

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1 guidelines Q&A TARGET2-Securities for Funds

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3 Introduction p.4 I. Issuance Do we need to change something to our current model due to T2S? p.5 Should we change our current processes? p.5 What are the possible issuance models? p.5 What are the advantages and disadvantages of each issuance model? p.8 What criteria should I consider in making a choice regarding the issuance model? p.10 Who makes the choice of the Technical Issuer CSD? p.10 What criteria should funds consider to select a Technical Issuer CSD? p.10 How does the choice of a Technical Issuer CSD impact distributors? p.11 What are the financial impact of the target operating model on stakeholders? p.11 Key takeaways p.11 II. Share & Cash Settlement III. Transparency What is the difference between commercial and central bank money? p.13 What are the costs of using central bank money today? Will this change with T2S? p.14 Do you use central bank money today and how will the process change in 2016? p.14 Do asset managers need to change their settlement times to participate in T2S? p.16 What does CSD Link mean and how does that benefit fund transactions? p.16 How can share trading efficiencies be gained in T2S? p.16 What is the impact on share reconciliation? p.17 Will share settlement change in 2016 with migration to T2S? p.17 Are there transactions which are not impacted by T2S? p.17 Who can own an account with the central bank? p.17 How does the cash reconciliation and cash management process work? p.18 Key takeaways p.18 What are the challenges of T2S for the funds distribution? p.19 Why is transparency important? p.19 Did these challenges already exist pre T2S? p.19 Why are these challenges more important with T2S? p.20 What CSD models are currently used for Luxembourg funds? p.20 How is transparency managed in existing CSD models? p.20 What are the operating models of each option? p.21 What order-marking practices could be used? p.22 What is required to make these solutions work? p.22 Is there a need to review distribution agreements? p.23 Key takeaways p,24 Glossary p.26 3

4 introduction Dear Reader, TARGET2 Securities (T2S) will have a significant impact on the European securities industry and will also change the way the fund industry operates. We hope this Q&A will assist you in understanding the implications of T2S for funds and how you can capitalise on the infrastructure in your organisation. T2S for funds can be an additional burden, or a driver of operational efficiency within your organisation, depending on your approach. T2S was designed primarily for bonds and equities. The specific needs of investment funds are not fully catered for. Over time T2S for funds will most likely enable investors, distributors, asset managers and service providers alike to benefit from secure and efficient way of cross border settlement by using highly scalable and automated processes. But where did T2S come from? It all began with the interbank payment system for the real-time processing of cross-border money transfers throughout the European Union called TARGET. Eventually TARGET was replaced by TARGET2 to support the Euro real-time gross settlement payment system. In the latest iteration securities are included and thus leads us finally to TARGET 2 Securities. The migration to T2S, for fund investor transactions, is foreseen in several stages. The predominate players for Luxembourg domiciled funds will migrate in The first being Euroclear France as the national Central Security Depository (CSD) of France in March 2016, followed by Clearstream Frankfurt (CSD of Germany) and LuxCSD in September In scope of T2S are securities denominated in Euro. Still, non-euro denominated securities will be eligible in T2S, however based on propitiatory solutions. And why should it concern you? When you as an asset manager have shares eligible via one of the above mentioned national CSDs by default you will be in scope of T2S. In this instance you need to take actions now. When your funds are not eligible within a national CSD in the Euro zone you still need to address the question what your position will be when investors or distributors will request T2S settlement from your funds. Within the ALFI T2S Working Group we focused on three main areas of T2S for funds, being: The process of issuance of shares within T2S and how corporate actions will be processed The processes around cash and share settlement; and The challenge to overcome transparency dilemma of omnibus positions and transfers in a CSD environment. The Q&A document will continue to be updated and you will find the latest version on the ALFI webpage Notably chapters on corporate actions and order routing will be added later on. We wish you good and fruitful reading. 4

5 I. issuance Investment fund shares are already settled today through CSDs depending on the distribution policy of the funds and the investors they target. A given fund may settle through one or several CSDs but the issuance process agent is straight forward and every CSD concerned acts as a Technical Issuer CSD, in accordance with their own processes and rules. The asset manager therefore does not need to make a particular decision regarding the issuance itself. Markets are working in silos and fund shares are generally not transferred from one market to the other or if they are, this transfer takes place through the fund register. Fund shares can be issued directly in the register or indirectly in a CSD. ICSDs also maintain fund positions on behalf of their clients. While ICSDs are not in scope of T2S, some of these assets may be transferred to T2S upon the decision of investors and distributors who want to hold those securities in T2S, as they do for other types of instruments. Do we need to change something to our current model due to T2S? Where the fund is distributed in at least one domestic market and wishes to use the CSD infrastructure for cross-border settlement, a review will need to take place. The fund will have several options, as explained below and may decide to continue their current processes or open the model to issue through additional Technical Issuer CSDs. Asset managers may also take the opportunity of the implementation of T2S to start distributing their funds in new markets, capitalising on the cross border settlement opportunities offered by T2S. What are the possible issuance models? Several issuance models can be considered. The details are provided below. In the interim period, until such time the major CSDs have migrated to T2S, no change is probably required. Euroclear France and Clearstream Banking Frankfurt are currently the two most important CSDs in terms of settlement of funds distributed on a corss-border basis. This means concretely that for funds distributed in both CSDs, a hybrid model will remain until Wave 3 of T2S in September 2016, when Clearstream Banking Frankfurt migrates to T2S. The approach asset managers will adopt may be different for existing funds and for funds that are launched post T2S. For current fund distribution, the impact on investors, distributors and processes needs to be assessed with a migration plan in case of change in the issuance and the settlement of the funds. For new funds however, these aspects are less relevant. Model 1 Status Quo (Interim period until Wave 2) Current situation is maintained; Every domestic market continues to function in a silo with no cross border links opened between the CSDs. Should we change our current processes? If funds are currently distributed in several T2S domestic markets and settled through the local CSDs, they will need to carefully assess the impact of T2S and decide on their target operating model. A decision on how and where issuance will take place and what will be required from the CSDs involved, whether the CSD is a Technical Issuer or Investor CSD, is needed. 5

6 I. issuance Model Luxembourg Domiciled Funds Euroclear France No Link Clearstream Frankfurt T2S Issuer CSD Issuer CSD Settlement Instructions Settlement Instructions TA Account TA Account Model 2A All Investor CSDs are also Technical Issuer CSDs (between Wave 2 and Wave 3) All investor CSDs are also Technical Issuer CSDs; Bi-lateral links may be open between CSDs; STP realignment procedures and reconciliation will need to be defined and agreed between Technical Issuer CSDs and Transfer Agents to ensure alignment of positions. Model 2B More than one Technical Issuer CSD many Investor CSDs some of which are not Technical Issuer CSDs Not all Investor CSDs are also Technical Issuer CSDs; Bi-lateral links may be open between CSDs; STP realignment and reconciliation procedures will need to be defined and agreed between Technical Issuer CSDs and Transfer Agents to ensure alignment of positions. 6

7 Model /17 Model 2b Luxembourg Domiciled Funds Euroclear France Investor CSD No Link Investor CSD Clearstream Frankfurt T2S Issuer CSD Bilateral Links Issuer CSD Settlement Instructions Settlement Instructions TA Account TA Account Model 3 One single Technical Issuer CSD many Investor CSDs (Post Wave 3) One single Technical Issuer CSD; Model /18 Luxembourg Domiciled Fund Many Investor CSDs can offer the funds for settlement and safekeeping to their clients; Investor CSDs will hold their positions with the Technical Issuer CSD. Investor CSD Investor CSD Investor CSD T2S Issuer CSD Settlement Instructions TA Account 7

8 I. issuance What are the advantages and disadvantages of each issuance model? Each of the models of course has pros and cons for the parties involved in the process, i.e.: Asset managers and their agents; Investors and distributors; The CSDs themselves. The pros and cons of the above models are summarised in the tables below. Model 1 - Status Quo Asset managers and their agents Investors and distributor Pros Cons No change in processes and interactions with stakeholders involved in the order routing and settlement process. No impact from a settlement point of view No X-border settlement possible as current silos remain. Multiple issuance is required. No X-border settlement possible as current silos remain T2S/CSD Minimal impact No possibility to competeto attract new assets Model 2A - All Investor CSDs are also Technical Issuer CSDs Model 2B More than one Technical Issuer CSD many Investor CSDs some of which are not Technical Issuer CSDs Pros Cons Asset managers and their agents Asset managers can accommodate the investors and distributors requirements and propose an open model Issuing agents need to establish and manage relationships with the Technical Issuers CSDs, potentially implementing specific interfaces and processes for each Real time position realignment and daily reconciliation process to be implemented to adjust holdings between Technical Issuer CSDs Most complex model to implement and maintain with inherent operational risks As many sources of information (transparency) as Investor CSDs. Some investor CSDs may not provide any transparency 8

9 Investors and distributor T2S/CSD Open model, the Distributor can settle X-border easily and efficiently and benefit from the advantages of T2S CSDs are competing to attract issuance Model 2B: investors and distributors who hold their assets in an Investor CSD that is not a Technical Issuer CSD need to investigate the potential financial consequences of this model. Most complex model to implement and maintain with inherent operational risk Transparency requirements from Fund and reporting on investor CSDs clients Real time realignments Daily reconciliation Most complex model to implement and maintain with inherent operational risk Model 3 One single Technical Issuer CSD Pros Asset managers and their agents One single entry point into T2S, one single settlement process per share class Cons Makes transparency more complex No realignments Investors and distributor N/A For existing funds: investors and distributors who hold their assets in an Investor CSD that is not a Technical Issuer CSD need to investigate the potential financial consequences of this model. T2S/CSD CSDs are competing to attract issuance No realignments In case of change of Technical Issuer CSD, settlement processes will need to be adapted Transparency requirements from fund and reporting on Investor CSDs clients Daily reconciliation 9

10 I. issuance What criteria should I consider in making a choice regarding the issuance model? The main items to be taken into consideration are: Current distribution patterns: Where is the fund currently distributed and settled? In one or several domestic markets? If the fund is distributed in more than one domestic market, is there a predominant one or do they have an equivalent weighting? The distribution strategy of the funds: What types of distributors and which markets are targeted? Is T2S an opportunity to settle funds in new markets and attract new investors/distributors? The share of domestic distribution in the different countries to determine if it makes sense to have one or multiple Technical Issuer CSDs Distributors requirements Who makes the choice of the Technical Issuer CSD? Ideally the asset managers want to have the lead on the choice of the Technical Issuer CSD(s) due to the operational impacts, investor and distributor requirements and the specific relationship that will need to be set up between the asset manager, its agent and the Technical Issuer CSD(s). From an asset manager perspective, we also want to make sure that the CSD(s) that will be fulfilling this role are the most appropriate ones. Specific documentation (legal or other) may need to be established, in certain cases, global certificates will have to be issue; Operational flows will need to be set up for issuance, settlement, reconciliation and handling of corporate actions; Set up of participants positions reporting to ensure transparency For existing share classes, the above is even more true. Indeed a change of model will require a set of migration activities to take place, including communication to CSD participants and a detailed timeline to cover the migration activities. What criteria should funds consider to select a Technical Issuer CSD? The Fund should take the following elements into consideration: Is there a main distribution market where it would make sense to appoint a Technical Issuer CSD? What are the services provided by the different candidates to be designated as Technical Issuer CSD in terms of Transparency and participants reporting; Order routing; Issuance process; Realignments if relevant; Corporate actions process; Reconciliation. The fund and its agent will look for the most efficient and automated way to issue and settle shares into T2S. It is also essential that reconciliations take place on a daily basis between the TA and the Technical Issuer CSD. Last but not least, transparency has to be provided in the form of standard reporting so that the asset manager can fulfill its duties in terms of oversight on investors/distributors as well trailer fees calculations. Before a CSD can start acting as Technical Issuer CSD, some mandatory activities will need to take place: 10

11 How does the choice of a Technical Issuer CSD impact distributors? Operationally from a settlement point of view distributors may have to amend their settlement process if there is a change in Technical Issuer CSD. This will concretely mean that distributors will settle against a new cross-border counterparty, whereas they would have been settling against a counterparty located in the same CSD. Investors and distributors who hold their assets in an Investor CSD that is not a Technical Issuer CSD need to investigate the potential financial consequences of this model. What are the financial impact of the target operating model on stakeholders? Asset managers will need to carefully assess the potential financial impact of the target operating model they want to implement. Changing their current model will not only affect themselves but also their investors and distributors. In the absence of T2S fee schedules from the major CSDs, such an analysis is currently not possible however once available, pricing will need to be an import factor to take into consideration beside operational processes and level of service. Funds expect Investor CSDs to provide efficient services in terms of transparency with the provision of regular position reports. Key takeaways The implementation of T2S will require a number of asset managers to review their current model with regards to settlement in clearing systems and the potential migration of this activity to T2S. In particular, they will need to pay attention to: Issuance and whether they need to change their current model or continue with the As Is; In case the current model needs to be amended, carefully review the drivers that will lead to a decision and ensure the impacts on all stakeholders (asset manager, service provider and distributor) have been assessed; Depending on the asset manager distribution strategy and countries targeted, several options are possible with regards to issuance; Asset managers will continue to interact with Technical Issuer CSDs but in some cases, they will also interact with Investor CSDs for transparency purposes for example. What requirements do funds expect investor CSDs to fulfill? The choice of an investor CSD can negatively impact the asset manager in case of lack of transparency on participant holdings. This means that the asset manager will have no view on who is holding the fund shares in a particular CSD. 11

12 II. cash & share settlement As a result of fund shares being included within the T2S framework, these transactions, similar to other euro security trades today, will be settled through Central Bank funding. Fund trading within Euroclear France and Clearstream Frankfurt today require Central Bank funding. Within the T2S infrastructure, payment banks is the term used to define who can hold accounts with the country specific National Central Bank (NCB). By definition these will be commercial banks who meet the European System Central Bank (ESCB) requirements. The ESCB has agreed fixed rates that will be applied in each NCB for the management of cash accounts and settlement of trades within T2S The asset manager, transfer agent and other non CSD account holders will continue to deal in Commercial Bank money. They may experience changes in their cut-off times and credit facilities linked to euro settlement for securities and fund shares traded within T2S. Some of these changes would have happened as a consequence of the dealing in existing euro denominated securities. These changes could trigger a review of existing Central Bank account rationalisation by payment banks. CSDs will only have a bank account relationship with NCBs to support corporate actions activity. The new T2S framework will provide the ability to improve cash management from the payment bank perspective with the only requirement a relationship with one NCB. Similarly investors and distributors through their commercial bank arrangements may also consider rationalising to one euro account to settle all euro denominated trades within T2S. The T2S platform is based on the concept of euro denominated transactions settling on a T+2 cycle which took effect in October 2014 as a precursor to the implementation of T2S. This will not be mandatory for the normal fund investor trades with the exception of Exchange Traded Funds (ETF). Where a fund predominantly holds euro denominated assets which will settle on a T+2 cycle and the asset manager elects to retain the investor trades on a T+3 or longer settlement period, the asset manager will be responsible for effective cash management to meet country specific liquidity regulations based on the fund structure. Trade execution for investors, distributors and transfer agents will experience minor changes during the transition period in Starting in 2017 there will be significant opportunities for the settlement of trades in euro denominated fund shares to be more efficient. The concept of the CSD Link to support automated transaction movements between CSD s and the ability to appoint a single issuer CSD will be available. All these topics will be reviewed in more detail in the following Q and A section. 12

13 What is the difference between commercial and central bank money? A common feature of developed economies is the wide variety of ways in which payments are made and the forms of money used. Central banks provide funding in the form of both banknotes and deposit liabilities. Commercial banks (settlement institutions manage private money (commercial bank money) represented as deposit liabilities. A central bank is a banker s bank. It is normally part of or connected to the government of a country and has oversight for the country s financial system. A commercial bank provides banking services to businesses, institutions and individuals. The money it receives from customers is offset with positions held at the central bank. Commercial banks have accounts at the central bank to meet regulatory liquidity requirements and for borrowing to offset any temporary shortages of cash. All European countries participating in T2 and T2S will have a central bank. Both central bank and commercial bank money play an important part in facilitating economic activity. The most effective and efficient financial system is one in which there is competition among banks and in which central bank money is used where its particular features are most important. Central bank money is generally completely safe in its jurisdiction. Central banks are more: Credit worthy institutions than commercial banks in their own country and currency; They have explicit and implicit state support; Can always cover their obligations by issuing their own currency; Tend to be risk-averse institutions which seek, as far as possible and engage only in low-risk financial activities. The creditworthiness of commercial banks is tested through their ability to convert on demand their sight liabilities into the money of another commercial bank or into central bank money. The main difference between central bank money and commercial bank money leads in the counterparty risk that commercial banks as financial institutions potentially represent to their counter- part and vice versa. This risk could translate into a systemic risk. Settling in central bank money would indeed reduce this systemic risk offering a more robust environment. The arguments in favour of a central bank being the settlement institution fall into five broad categories. They are: Risk - the use of a risk-free settlement asset can help reduce systemic risk; Service continuity - the use of a default-free settlement institution can limit the risk of service interruption; Liquidity - the ability to create unlimited liquidity in domestic currency may be important for the smooth operation of the system; Competitive neutrality - the use of central bank money means participants do not have to rely on a competitor for settlement services; Efficiency - the use of a single settlement institution to settle different sorts of transactions may enable participants to economise on, for example, liquidity usage. The value of central bank money can be perceived as an added value in terms of security and safety of the business. However, some institutions argue that central bank money or commercial bank money does not make a big difference for their own business. 13

14 II. cash & share settlement What are the costs of using central bank money today? Will this change with T2S? One of the key benefits of T2S will be a significant reduction of securities settlement fees in Europe, in particular for cross-border transactions. With the current fragmentation of settlement over a multitude of platforms run by different CSDs, settling across borders today still costs many times more than settling within the same country. Cross-border and domestic transactions will be processed in the same way and therefore at the same price within T2S. Thanks to the economies of scale that come from consolidating settlement volumes from many platforms onto a single platform, T2S will allow substantial reduction of the settlement fee in Europe. This represents a significant potential benefit for investment funds. Do you use central bank money today and how will the process change in 2016? Luxembourg funds that are already distributed in France and Germany will de facto be included in T2S. They are eligible in Euroclear, Clearstream and LuxCSD who use of central bank money for settling Euro denominated transactions. Euroclear France, as the French CSD, uses central bank money with Banque de France as illustrated here below: Investor Order 10 shrs Custodian bank Fund accountant NAV at 15 EUR Centralising agent Settlement instruction Participant custodian bank 1 Euroclear France Centralising agent Fund X Settlement instruction 10 shrs 10 shrs Banque de France Bank 1 Centralising agent 150 EUR 150 EUR 14

15 LuxCSD performs settlement in central bank money through the ASI procedure 6 which allows the use of accounts in TARGET2 held with any Eurozone central bank. 21:30 00:00 6:00 07:15 8:00 9:00 10:00 11:00 12:00 13:00 14:00 15:00 16:00 17:00 18:00 19:00 20:00 20:35 Customers Instruction Pre-Matching and Settlement Information End of Day Reports Creation* Continuous Settlement Processing End of Day Processing Mandatory & Optional Settlement Period (13:40/14:50/14:55 provisioning end times) DVP/ RVP/FOP Optional Settlement Period (16:40 / 17:50 / 20:35 provisioning end times) ASI Night-time / Daylight Procedure 6 Interface for EUR CeBM settlements (last cash provisioning cycle for CeBM settlement is triggered at 16:00) LuxCSD TARGET2 / BCL *operated by CBL Source: LuxCSD Customer Handbook Clearstream Bank Frankfurt performs settlement in central bank money through the ASI procedures which allows the use of accounts in TARGET2 held with any Eurozone central bank. Cash side Cascade TARGET2 procedure 6 (P6) TARGET2 procedure 6 (1 funding cycle ) STD (FoP, EUR-DvP) RT-STD (FoP, EUR-DvP) 19:00-01:30-21:00 06:00 FoP 07:10 Cont-SDS1 (FoP, EUR-DvP) TARGET2 procedure 6 (7 funding cycles ) 10:00 SDS1 (FoP, EUR-DvP) Cont-SDS2 (FoP, EUR-DvP) SDS2 (FoP, EUR-DvP) 10:45 13:15 13:45 Cont-SDS3 (FoP only) 18:00 TARGET2 P2 RTS (Gross processing) (EUR-DvP) 07:00 No settlement confirmation during SDS1 No settlement confirmation during SDS2 16:00 TARGET2 P3 DD1 09:30 * * DD2 13:45 DD3 15:15 * Creation 07:00 Foreign Currency-DvP No settlement confirmation during SDS1 No settlement confirmation during SDS2 17:30 * Direct Debit 1/2/3 (= credit/debit custody payments) Source: Clearstream Frankfurt handbook 15

16 II. cash & share settlement Do asset managers need to change their settlement times to participate in T2S? No. T2S was designed and built to be as flexible as possible. While the T2S offering is linked to Euro denominated securities, settling is on a T+2 basis. This settlement cycle will not be mandatory for the fund investor trades. Where an asset manager predominantly holds Euro denominated securities which will settle on a T+2 cycle and the asset manager elects to retain the investor trades on a T+3 or longer period, the asset manager will be responsible for liquidity cash management to meet Luxembourg fund regulations. What does CSD Link mean and how does that benefit fund transactions? T2S refers to the bridging of transactions by CSDs to be a CSD Link. This allows the central securities depository to provide their clients with access to securities maintained in another CSD, without the clients needing to be direct participants in the other CSD. The Link feature is thus an important means to enable cross-border securities transactions and contribute to market integration CSD linking is the direct link between each of the participating CSDs, which allows the transfer of securities from one CSD to the other. These links will require bilateral or multilateral agreements to be in place for the participating CSDs. Asset managers will need to determine how they wish to influence the terms in these agreements specific to fund share movements and associated reporting. Three link types are required: Security CSD Link, CSD account Link and Eligible Counterparty Link. With the Security CSD Link a security can be defined as being eligible for settlement. Also the CSD is defined who is the maintaining entity for the securities reference data; With the CSD account Link the linkage between the accounts of two CSDs is defined; With the eligible Counterpart CSD Link the CSDs define who will accept each other as counterpart for settlement. How can share trading efficiencies be gained in T2S? In the pre T2S world many Luxembourg domiciled funds are already present in multiple CSDs throughout the Eurozone where the funds are registered in the respective countries. Each CSD has its own processes for the acceptance of such funds, for the order routing, processing and settlement as well as for reconciliation and reporting services. This in turn requires asset managers (or their agents) to invest in and maintain country specific infrastructures. Each of these infrastructures has its specific costs adding up to a significant overall fixed cost. Indeed pre T2S in the absence of efficient CSD Links, it is difficult to achieve unit costs reductions by using the infrastructure of one country in order to deliver fund shares to another. T2S changes this constraint by delivering a cross- CSD share settlement service which is as efficient (cost, timeliness, risk perspective etc.) as the domestic service within a single CSD. In addition it introduces competition between CSDs themselves for the benefit of all participants. From an asset manager perspective, the most efficient model will be model 3 which is based on the use of a single CSD to deliver fund shares into all Eurozone countries available in T2S through their respective CSDs. The transaction efficiency realised from that is the cost associated with country specific market infrastructures. Indeed with T2S such duplicate infrastructure can be replaced by a single point of access to all Eurozone markets. 16

17 What is the impact on share reconciliation? CSDs and other parties using T2S will be required to perform daily reconciliations of positions held in T2S. The impact on share reconciliation will depend on the model adopted. Refer to Chapter 1 for the various models. Model 1, share reconciliation is required to be brought up to T2S standards which call for a daily reconciliation. The current reconciliation process itself does not need to change given that the CSD Link is not in place. Model 2 with the interaction between multiple Technical Issuer CSDs, the reconciliation needs to take into account transfers (or realignments) that will take place between CSDs. Given that such realignments will be the result of movements which are settlement dated as per CSD practice, particular care will be required to reconcile versus the trade dated positions in the register in order to avoid potential problems on redemption orders. Model 3, share reconciliation is simplified insofar that the complete holding of all T2S CSD accounts will be represented in a single omnibus account in the register. Hence all subscriptions and redemptions can unambiguously be allocated. Will share settlement change in 2016 with migration to T2S? At the investor level there will be no change. The share settlement in T2S will be done DVP. The securities settlement accounts are identified in T2S by the BIC of the CSD participant and the BIC of the CSD. The account has to be linked to a Dedicated Cash Account (DCA). Through this DCA the cash settlement is done in EUR (DKK is planned for 2018). The DCA is funded from the TARGET2 RTGS account. All parties placing orders in T2S will need to ensure the BIC identifiers are captured correctly on the respective instructions. The settlement day in T2S is harmonised and applicable to all markets. Are there transactions which are not impacted by T2S? T2S as an infrastructure does not require all securities of the same type to be held in T2S. Hence T2S is compatible with the register model insofar that the fund shares held in T2S can be represented by an entry on an omnibus account in the register in parallel with other account holders in the register. As a consequence register account holders which are not interested to hold their positions within T2S are not required to change their current model. The processing of their subscriptions and redemptions will remain unchanged. Fund shares denominated in currencies other than Euro will not be impacted by T2S in the current phase of migrations. There are plans to include other currencies in T2 and T2S in the future. Who can own an account with the central bank? Payment banks who meet the ESCB requirements can open an account with the central banks. TARGET2 already allows payment banks to open central bank accounts in the names of their customers, and T2S will now allow securities settlement banks to do the same, while preserving the benefits for customers of settlement agency services. The term payment bank refers to any holder of a cash account with a central bank. The opening of a cash account is subject to the authorisation by the relevant central bank, in accordance with its own rules and criteria, and in compliance with the eurosystem framework. The following types of entities are eligible for direct participation in TARGET2: a. Credit institutions established in the European Economic Area (EEA), including when they act through a branch established in the EEA; b. Credit institutions established outside the EEA, provided that they act through a branch established in the EEA; and c. NCBs of EU Member States and the ECB. 17

18 II. cash & share settlement How does the cash reconciliation and cash management process work? Within T2S and using Central Bank funding this process will be performed by the Commercial bank cash reconciliation team who will then advise their client of any settlement issues. Depending on how the payment bank has structured their accounts with the NCB and using the RTGS account in T2 linked to DCA s in T2S, there is the facility to provide direct cash reporting activity if required by the custodian/ transfer agent or asset manager. NCB CSD PB CSD Part. DCA PB PB CMB Source: BCL Presentation June Key takeaways The inclusion of investment funds within the T2S infrastructure presents changes for cash management efficiencies and opportunities to improve fund distribution. The primary areas for fund participants to consider are: 1. Change in share dealing cycle to match the T+2 settlement in T2S. Where fund assets are today predominantly settle on a T+2 basis, asset managers may wish to consider adjusting their share dealing cycle to be on the same settlement basis to reduce impact on liquidity management. This change for fund share dealing cycles is not mandatory. 2. Expanded distribution capabilities for domestic funds within the CSD network. This will be possible with the availability of CSD links supported by bilateral agreements between the participating CSDs. Assetmanagers would need to also consider the impact on marketing material and registration of fund in different countries. 3. Asset managers ability to perform treasury activities with the move to central bank money. This will require discussion with the respective payment (commercial) bank to provide segregated DCA arrangements within T2S to allow direct access to these accounts by the asset manager. 4. Rationalisation of commercial bank relationship to support fund share activity within and outside T2S applies to all participants who maybe using multiple banking arrangements today to support settlement of shares trading activities. 5. Consolidation of custodian services linked to the CSD network for distributors and investors, where security positions are now held with multiple CSDs and ICSDs plus the inclusion of investment funds within this infrastructure. This could provide opportunities to merge existing positions with fewer custodians that offer compatible services and possibly allow for improved fee negotiations. 18

19 III. transparency Asset management firms are already struggling with the ever-increasing amount of data and reports intermediaries are providing, and how to make those useful in their oversight and compliance activities. T2S will make this challenge even more complex to address at a time when asset managers are reinforcing their distribution oversight duties. In this context, we will approach how should transparency be dealt with when reporting on distribution activities to asset managers and the distribution chain. What are the challenges of T2S for the funds distribution? Unlike other securities, funds are following specific processes which will not be accommodated by T2S infrastructure itself: Periodic primary market issuance (daily for most funds); Distribution oversight: Sales monitoring; Due diligence and on-going monitoring of distribution; Mis-Selling/Suitability/ appropriateness of investment; KYD/Distributor Selection/ Distribution Agreements; Trailer fees/rebates or service fees management; Local distribution rules; compliance AML/KYC Compliance. Product Investment restriction monitoring; Real time position tracking. The main challenge for asset managers is to define the framework around T2S which will allow asset manager to benefit from the efficiency brought by the T2S infrastructure while managing these specific processes. A key feature is the identification of the order giver (e.g. investor/distributor/intermediary) for orders and transfers, which is at the heart of investor protection and distribution oversight. Why is transparency important? As previously mentioned, a management company has to ensure that any investment in its fund is: Compliant with regulation (e.g. AML/KYC checks); Eligible (e.g. client acceptance, investment restriction, compliance with local sales and marketing rules); Suitable and appropriate (e.g. information on investors, suitability and appropriateness checks); Such controls should ideally be performed ex-ante to avoid mis-selling and that a non-eligible transaction is booked in the fund. The management company also needs to monitor the performance of the sales team, the distribution agreements, and to get information on the trends and habits of their clients. Did these challenges already exist pre T2S? In order to reach more investors, while simplifying the operating model, the fund industry has seen the increasing importance of intermediaries, such as platforms, custodians or icsd, who collect orders and centralise them within an omnibus account opened at the transfer agent (TA). Identifying the real investor/distributor behind these intermediaries is already a challenge. Even if some solutions to improve transparency have been implemented, they are not widely used and, as such, use of standards will be beneficial for the entire fund industry. In some models, the TA could receive a redemption order from an investor for settlement in the omnibus account of its intermediary. The TA is only able to check the omnibus position of the intermediary, but not the position of the investor. Therefore, it creates a risk to settle this transaction and to redeem shares that are actually not owned by the investor. 19

20 III. transparency Why are these challenges more important with T2S? When a fund is distributed in a CSD market, the fund manages a sub-issuing account, either directly or through a third party, in the CSD and creates an omnibus account in its register. With the introduction of T2S, some investors may progressively use the T2S setup for dealing in securities, including funds, and that their positions would be transferred from their registered account to the CSD omnibus account. The opening of bilateral links between CSDs will mean that shares will circulate across the various CSDs without the asset manager being informed. In this situation, identifying the point of sales behind this CSD omnibus account will be even more challenging, and the existing risk even higher. What CSD models are currently used for Luxembourg funds? If an asset manager wants to effectively sell in these markets, it has to comply with the local market practices and to be technically issued in the domestic CSDs. Asset managers therefore appoint an issuing agent to centralise and collect orders from the CSD participants, to execute them at the TA, to manage the sub-issuing account in the CSD and to perform the settlement in the CSD for the fund. Currently, the Investor CSD is the same as the Technical Issuer CSD e.g. when Luxembourg funds are available in Euroclear France or Clearstream Frankfurt, participants in each CSD can invest only in funds circulating in their CSD, and all transactions are booked into the Technical Issuer CSD omnibus account opened at the TA. Tomorrow, in T2S, a fund could eventually appoint multiple Technical Issuer CSDs and will face multiple Investor CSDs. This will increase issues in terms of transparency. Current account structure : Luxembourg funds are distributed on a crossborder basis in CSD markets such as France or Germany. Investor CSD = Technical Issuer CSD TA Investor Account 1 Investor Account 2 Investor Account 3 Fund Sub-Issuing Account Issuing Agent / Technical Issuer CSD Account How is transparency managed in existing CSD models? Practices used by each CSD to address transparency are different per market. The methods used include: Order-marking, for example France, whereby all transactions recorded in the fund register are marked by the order giver with an identification code, the BIC1 or LEI, of the investor. Position reporting whereby the position of account holder in the investor CSD is provided on a periodic basis. Account segregation, for example Denmark, whereby all accounts at the Investor CSD are disclosed and segregated in the register of the fund. There are also markets where these practices are combined. 20

21 What are the operating models of each option? 1. Order-marking Order-marking is a model where only one omnibus account is opened in the fund register per Technical Issuer CSD, and where the order giver places the order to the fund with a code identifying the point of sale. This code will be used by the same entity placing the orders for transfers and reported back by the CSDs to the market participants (e.g. TA and asset manager). The model would work as follows: Investor 1 Investor 2 Investor 3 Distribution Oversight Asset Manager Transaction Reporting Investor 1 Investor 2 Investor 3 Order marking TA Issuing Agent / Technical Issuer CSD account 2. Position reporting The principle of position reporting is for the investor and issuer CSD to report to the asset manager all positions. 3. Account segregation In T2S, the Investor CSD will hold an account with each Technical Issuer CSD (if different). These Investor CSDs could potentially share the details of the investor in its books with the Technical Issuer CSD in order to provide transparency. The Technical Issuer CSD in turn could open as many accounts in its books as is necessary to achieve transparency, including the ones for which the Investor CSDs has provided details on. Full transparency would only be achieved if all CSDs share this information together with transfers between participants. The model would then work as in the following example where: TA Investor CSD = Technical Issuer CSD Issuing Agent / CSD accounts Investor Acct A Investor Acct B Investor Acct C Fund Sub- Issuing Account c/o Investor acct A c/o Investor acct B c/o Investor acct C 21

22 III. transparency What order-marking practices could be used? There is an ISO-standard and is recommended by EFAMA, called BIC1, and this standard is adopted by the French market, which is already working in a CSD environment. There are approximately 2,000 BIC1 codes, stored in a centralised database. These BIC1 codes are BIC 8 or BIC 11, allowing BIC1 to go beyond the entity of the order giver to identify the nature of its underlying activities (e.g. primary dealing, third-party dealing, insurance, etc.). The Legal Entity Identifier (LEI) could also be used to mark orders. The LEI will identify the legal entity placing the order, but will not identify the underlying activity. The usage of one common database for order-marking would be a clear benefit for the fund industry in order to standardise the identification of an order giver; e.g. order giver/ investor/distributor, and which is fundamental for an efficient transparency model. What position reporting practices could be used? An ISO standard that can be used by the industry participants to report the positions. It supports a custodian chain with up to 10 levels. How does each model respond to the challenges in the asset management industry? Challenge Segregation Order-marking Position Reporting Distribution oversight Ex-ante Ex-ante Ex-post Local distribution rules compliance Sales monitoring Trailer fees or service fees calculation Real time position tracking (this would include transfers) Product Investment restriction monitoring Suitability/appropriateness of investment Ex-ante Ex-ante Ex-ante Ex-post Ex-ante Ex-ante Ex-ante Ex-ante Ex-ante Ex-ante Ex-ante Ex-ante Ex-post Ex-post Ex-post No Ex-post Ex-post What is required to make these solutions work? For all models, it is key to reconcile with the position in the CSDs. Efficiency will come from the amounts and level of reconciliation required and the ability to have a real-time allocation of orders. 1. Order-marking This model provides transparency on orders, and allows a calculation of the positions based on the orders received. This model will need to capture all orders and transfers to avoid reconciliation breaks between the calculated positions and the actual positions. This model will require: The fund industry (asset managers, asset servicers, distributors/investors) to define and adopt order-marking industry standards such as BIC1 or LEI. A central database of order-marking for the industry to create and manage order marking codes for identifying uniquely a 22

23 business counterparty (e.g. institutional investor, distributor) across fund managers and across markets. Transfers between investors CSD accounts to be reported to the fund with the applicable order-marking to allow monitoring of distribution and to avoid reconciliation issues. The asset managers or their asset servicers will have to calculate their clients positions based on transactions received, and to reconcile these positions with the CSDs investor accounts. This reconciliation should be limited to exceptions if all transactions are order marked and reported to the asset manager. 2. Position reporting The fund market participants will need to cooperate for the position reporting to meet the requirements of transparency and to define the framework allowing the disclosure of information about their respective clients An example is the adoption of the ISO transparency of holding report which implies the following: Those CSD participants that use one account for holdings representing more than one commercial relationship with a fund shall report the breakdown of such holdings to their respective investor CSD. Investor CSDs compile any received reports of participant account breakdowns with the holdings recorded at the CSD participant level, and report this to their Technical Issuer CSD. Technical Issuer CSDs compile the reports received from their investor CSDs, and disseminate the information to the respective TAs and/or asset managers; Whenever relevant, the stated holdings are marked with the same identification as is used for order marking; and The TAs and/or asset managers use the position files for reconciliation and ex-post distribution monitoring purposes. 3. Account segregation Account segregation is market practice for most of the Scandinavian CSDs but not all CSD may support account segregation. It would require a total change of most models outside of Scandinavia, and may in the end not be supported by T2S. This model will require: Cooperation between CSDs to provide detailed information about their clients and accounts; Non-cooperating CSD will have to follow option 2 or 3 detailed below if they still wish to be transparent. Is there a need to review distribution agreements? There is no obligation to review distribution agreements in the context of T2S and more specifically when it comes to transparency. That being said, we would highly recommend asset managers to amend their distribution agreement if they want to achieve a good level of transparency perspective; i.e. they may want to impose certain obligations (e.g. order-marking obligation, position reporting obligation to the CSD to increase the visibility of account holders, ). 23

24 III. transparency Key takeaways T2S is making the distribution oversight challenge even more complex. This is a challenge which offers the unique opportunity to work on the transparency dilemma of the fund industry, supporting us far beyond T2S. To address this challenge, we need to combine transparency on orders and transparency on positions and to have a joint approach supported by all market players. This implies: 1. The definition of a central market-led database of order marking allowing distributors, in the T2S zone, but also outside, to be uniquely identified with all asset managers; 2. The order marking of orders (e.g. subscriptions, redemptions, switches) and transfers; 3. The implementation of incentives to ensure of gradual take-up of order marking practices throughout distribution chain, such as the application of front-end load fees for orders not being marked; 4. The implementation of a position reporting to the TA, as for example the new ISO transparency of holdings standard that should be adopted by all the intermediaries being in the custody chain. 24

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