Internalisation and Consolidation of the Settlement of Payments and Securities Transactions. Hermann-Josef Lamberti

Transcription

1 Internalisation and Consolidation of the Settlement of Payments and Securities Transactions by Hermann-Josef Lamberti Member of the Board of Managing Directors Deutsche Bank At the Global Conference on Private and Public Sector Challenges in the Payment System Frankfurt, Germany 12 and 13 June 2003

2 Thank you very much, Jeff Marquardt, for that kind introduction. I am delighted to have the opportunity to speak to you today. Today's topic is "The internalisation and consolidation of the settlement of payments and securities transactions", a very long title, I must admit. I would like to begin by taking stock of what is going on in the markets, and what the underlying trends are. Then we will take a closer look at the processing of securities and payments, examining each one separately. Finally, I will conclude by presenting German and continental European perspectives on aspects of consolidation in clearing and settlement. I hope that some of these observations will prove useful for our later discussions. If you take a look at the development of cross-border activity on the securities markets, you will see that there has been a tenfold increase in the volume of gross trading in crossborder securities, measured in billions of U.S. dollars, in eight-to-ten year cycles between 1980 and This increase means that by around 2008 or 2010, we might even reach the 10,000 billion US dollar mark in total turnover. This includes both what US investors trade in foreign stocks and what investors outside the US trade in US stocks. Of course, this trend was disrupted by generally depressed trading in 2001 and 2002 but this does not negate the long-term prospects. If you look at the payments side, however, you will find an altogether different trend reflected. Currently, roughly 62,000 million payments are transacted per year in Europe. Of this figure, Deutsche Bank processes about 1,700 million transactions in its domestic German market alone, which represents roughly 98.7 percent of its total payments volume. A mere 1.3 percent is cross-border, which means there is a huge imbalance between domestic and cross-border payment volumes. This situation can partly be attributed to deficits in the pan-european infrastructure necessary for cross-border payments: across continental Europe, there is a proliferation of payment infrastructures, while the market has suffered from non-harmonised approaches to Automated Clearing Houses (ACH) and an inconsistent central banking system, to name just a few.

3 - 2 - Furthermore, Brussels, motivated by the important goal of integrating the European payments landscape into one currency zone, has ordered banks to offer cross-border payments at the same flat rates as for domestic retail payments. I will present some of the impacts of this later on. An examination of consolidation shows that both on the payment and securities sides, a tiered structure is developing. This is a structure in which the top five industry leaders around the world are consistently gaining more market shares in the financial services business. This is true for their market shares in cash clearing activities in US dollars and euro. Over 60% of the total CHIPS cash clearing activity in US dollars in 2002, for example, stemmed from the top five players. And this is also true for securities trading, where the top five handle roughly 45% of the market trading in DAX shares on XETRA, for example. I believe this is a trend that indicates that some very significant changes have taken place in the basic conditions under which financial intermediaries used to operate conditions which, I believe, represent permanent rather than temporary shifts. There are basically three trends that shape how intermediaries work: - First of all, for many years, the industry used to enjoy a much higher interest rate environment. I do not believe this situation will return in the near future, which means banks will no longer be able to subsidise cash trading or securities settlement services through interest income flows. - Second, we can expect a higher degree of concentration in the financial industry, driven by changes in market participants' activities, especially those of institutional investors. As to securities settlement the dramatic increase in basket trading, where very high volumes are traded at extremely low price differences, has meant that the bottom has almost completely fallen out of commissions in cash equities trading over the last three years. This is a trend I believe will not reverse at any time in the near future. - The third trend is that customers expect banks to move towards a flat fee, and away from the old pricing scheme of charging basis points against certain notional amounts. This expectation applies to both securities settlement and payment transactions, and represents a serious development for everyone in the settlement business.

4 - 3 - These driving forces are now all pointing in the same direction: industry players must now seek new and different forms of integration. Internalisation is one of these forms of integration, and in this area Deutsche Bank has developed what it calls PIP, which stands for Price Improvement Platform. This is only one example of how we are attempting to address the trends described above. The basic concept behind PIP is to (re)organise equities trading into one straight-through processing (STP) settlement environment. This environment starts with the trading process and order routing, encompasses price improvement, and concludes with the settlement process. PIP is offered electronically to retail customers; it allows for the immediate execution of a retail order as an OTC transaction; and it provides the possibility for in-house netting. An order can still be routed to an exchange if the client wants this or if we decide we do not want to keep the internal execution of certain products on our own books. The client's advantage is that Deutsche Bank's PIP guarantees that the execution price is within the spread available on the reference market's order book. In addition, our STP platform subsequently allows us to completely consolidate our settlement and clearing activities. With internal netting, we are able to simplify the custodian network and can apply a completely different infrastructure charge to the entire process. If you compare the costs of the three dimensions, namely i) trading and order routing, ii) price improvement, and iii) settlement through the traditional securities process, roughly 50-60% of your cost base could be sheared off. Not only that, our retail clients can access a service that used to be available exclusively to institutional clients. Furthermore, it is possible to adjust the fee equation, allowing you to pass on cost savings to your customers.

5 - 4 - At the moment, all of this is in an early operational phase. Thus, it is unlikely that the majority of Deutsche Bank s retail equity trading volumes will shift to PIP. Nevertheless, the growth rates are encouraging despite the lacklustre securities markets. Even though I placed retail business in the foreground, this also has a wholesale aspect. Because it is an electronic platform, this type of procedural environment can be offered on a white label basis to other banks. And this represents a major advantage we canleverage: we have gained extensive experience of this in other markets. Deutsche Bank s "Autobahn" product, which we have had in place for several years now, is a comparable example for fixed-income markets. I would now like to take a step back and look at how the developments just described in the securities industry may ultimately transform the industry itself. Let us take the situation in Germany as an example. The German securities industry is characterised by processing and structural redundancies. The procedural steps involved in order flow management, execution services, transactions processing, clearing, settlement and asset servicing all partially overlap. The industry has tried to address this problem through vertical and horizontal integration. Vertical integration means, for instance, that exchanges simultaneously offer settlement and custodian services, otherwise known as the vertical silo approach. Horizontal integration, on the other hand, means that service providers at the same point on the processing value chain basically join together and consolidate the market in terms of scale and scope, with at least the potential for a cross-border future. Horizontal integration not only allows existing IT environments to be leveraged, but it also provides the industry with a much better control structure, minimising execution and operational risks by providing more intelligent ways to make use of the underlying liquidity. This is by far the most important effect. Because of the need to minimise risks

6 - 5 - and make better use of assets, the challenges facing both horizontal and vertical integration in connection with redundant processes will not diminish. The questions here are: how do we make integration happen? What are the players doing to balance each others' interests? And will the entire industry rearrange itself? I have not yet touched on issues in connection with changing the regulatory and legal framework required to consolidate Europe s clearing and settlement systems. The discussions on the consolidation of CCPs and clearing hubs is of particular importance, and I think everyone knows we are still in the middle of this process. Instead of having less service providers, new markets are developing their own CCP services. A central counterparty, for example, was introduced here in Germany just a couple of months ago. Turning to clearing hubs, market participants are obviously very interested in having a single pipeline to one large clearing hub, branching out into a network of local CSDs across Europe. This would provide all kinds of services required, either via indirect links or directly from the clearing hub itself. Of course, this has not yet become reality. At Deutsche Bank, for instance, we still have five overlapping clearing networks stacked on top of each other, but I am pretty sure that in the next 12 to 18 months we will have sorted this out. I am also fairly certain that ICSDs - and some of those present are affiliated with the ICSDs - are working hard to get it right. The discussion about the Clearstream and Euroclear bridge agreement is just one example of how service providers can respond to market participants' desire for a single pipeline. When it comes to payments, the picture looks decidedly dismal. Because of the new EU regime requiring cross-border payment charges to be trimmed to a retail level, the price and the costs incurred have been legislated in excess. Germany was hit particularly hard in this context as a very efficient, low-cost domestic structure was already in place.

7 - 6 - In Germany, we have for many years had bilateral clearing (known as garage clearing, i.e. clearing with separate remittance to provide cover), allowing for very low prices which, over the years, were passed through to retail customers. As the latter have grown accustomed to these low price levels, it has so far proven impossible to initiate price discussions with retail customers. The ruling that banks have to bring the price for cross-border payments down to the domestic level definitely means that banks have to carry a loss. Now is that bad? No, it is not. My answer may surprise you, but I think the pressure at this level introduced by the European Commission is exactly what intermediaries need to get their act together and work on a pan-european ACH. Without being pressurised, intermediaries would not have done so. Why not? Because intermediaries have a natural tendency to protect their margins. This is something we should keep in mind when discussing this issue. As intermediaries, on the one hand, we have vested, but nevertheless legitimate, interests in creating profit margins out of partially inefficient markets. On the other hand, we need to consider the macroeconomic environment and concede that a European currency without an integrated European payments clearing system will not be able to deliver the benefits expected from a single currency. So we have to strive for a solution that will most likely entail integrating the payments infrastructure. The question then is: what will this integration process look like? You will have heard of, or may even have been part of, the lively discussions on the EBA mission. The Euro Banking Association envisages two steps in consolidating the processing of cross-border euro-denominated retail payments. The first step (EURO1/STEP1) represents where we are now, with over 270 participants and a moderate per transaction cost level. It allows payments to be addressed to approximately 8,000 banks on the same infrastructure platform using one set of rules.

8 - 7 - The interesting part comes in STEP2. Why? Because in STEP2, a decision will have to be taken on how we want to handle our local, domestic clearing environments in light of this pan-european vision. STEP2 provides a pan-european ACH solution for the processing of bulk payments. If we continue to protect our local environments, then business in terms of volume will never move to STEP2, which means that the pan-european vision will not be able to deliver single-digit cost levels. Such cost targets can only be achieved if the large-scale volumes generated by the major macroeconomic environments such as Germany, France, etc. can be leveraged. If bulk payments go into one single system, corporate flow migration is the next logical step. Hopefully, we will have gained enough experience with SWIFTNet by then to make sure we all share the same lingua franca, i.e. harmonised industry standards and processes. Compared with the huge structural change inherent in STEP2, what will subsequently follow ("STEP3") should be an evolutionary development, providing value-added services to the platform's users. But what will the roadmap look like for harmonising the securities and payments infrastructure? At the moment, only a few major steps are envisaged. As I just mentioned, for clearing payments, we will have to agree on the vision of a pan- European ACH. Decisions will have to be taken on how the volume to be processed through the pan-european ACH can be increased. Basically, this requires domestic clearing systems to be shut down. I believe we can only achieve the vision of SEPA (a pan-european ACH) if we are willing to move away from our respective domestic environments in favour of a European vision. We also need to agree on how large-value cross-border payments in Europe could be made more efficient (TARGET 2), and what role should be played by the central banks. Central bank settlement on a cross-border basis constitutes a very important step, especially for removing the barriers to efficient cross-border clearing and settlement for securities as described by the Giovannini report. In a broader context, the Financial

9 - 8 - Services Action Plan (FSAP), which was initiated by the European Commission, and will hopefully be finalised by 2005, will provide the legal harmonisation required to improve the processing infrastructure. On the securities side, consolidation will be driven on two fronts: - First, institutions such as ICSDs, CSDs and exchanges will enter into competition with large agent banks in transaction and custodian services. Hopefully, this will be a breakthrough, especially here in Germany, leading to the integration of parts of our back offices. Although this issue has been on the agenda for more than two years now without much progress, I am still convinced it remains as important as ever. Back office consolidation generates enormous savings and can help to make the banking environment much more resilient for the future. This is an important factor, especially from the German perspective. - Secondly, a whole range of regulatory and legal issues need to be clarified to improve securities clearing and settlement arrangements. For example, how can we achieve harmonised settlement periods or harmonised processes to handle corporate actions and insolvencies? These complicated legal issues have not yet been fully addressed in the individual European countries, either. The different technical standards and legacy systems in operation are at the root of today s somewhat inefficient clearing and settlement environments. I would like to conclude by showing you this advertisement: Euroclear, the Brusselsbased ICSD, promises to settle French equities, for example, at 55 euro cents. I am sure there are many people in the custody business who regard this as a colossal joke, as it is far from feasible at present. Nonetheless, I think everybody in the room should thank Euroclear for throwing that particular stone into the water because it has created a ripple effect that should focus our attention on where we have to go. That is what we have to deliver. Therefore, I would like to leave that impression with you as I conclude. Thank you very much for your attention.