White Paper. T2S Towards post-trade efficiency. Abstract

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1 White Paper T2S Towards post-trade efficiency - Sushama Jaiswal and Prashanth Krishnamoorthy Abstract TARGET2-Securities (T2S) intends to create a pan-european settlement engine that will provide centralized delivery versus payment (DVP) in European central bank funds. This is expected to reduce the cost of settlements, create a unified market, increase competition and foster greater harmonization. The system, initially proposed in 2006, is expected to go live in In this paper, we take a close look at T2S the infrastructure challenges to be overcome, the benefits and regulatory implications. We also study the changes in infrastructure and its impact on key market participants. A high level plan for market participants expected to be impacted by the T2S system is also listed.

2 Introduction The European financial market and the systems supporting trading and settlements are highly fragmented. With systems and technology focused locally, there are challenges in cross-border settlements and efficiency, with multiple platforms for post-trading settlement and multiple parties to be dealt with in trade processing. The trading infrastructure in European financial markets was targeted mostly at local needs and catered to a limited geography. The practice was to create two players in the market to keep the whole system simple and hassle-free an exchange for trading and a central counterparty for clearing and settlements. Furthermore, this infrastructure was designed to handle securities that were only denominated in the local currency. With the increase in trading and settlement activities across borders, it became essential to look at an infrastructure that could handle local as well as cross-border dealings while managing the complexities associated with multiple markets, channels and currencies. There is also a significant gap between the US and European markets from a financial market infrastructure perspective. The US has a highly centralized clearing system in which DTCC (Depository Trust and Clearing Corporation) takes care of the clearing and settlement of all corporate bonds and equities. The Federal Reserve System, on the other hand, handles securities issues by the US government, federal agencies and government-sponsored enterprises. Europe still has to match the US in this respect. This has spurred Europe to look at revamping their settlement system to make it high-tech and integrated. The T2S vision came into being in the year 2006, with the intent of creating a securities settlement system that could target settlements beyond boundaries. Despite delays in the project, European authorities are pushing for its completion and development is at full swing with a scheduled go live in June 2015 (as updated in a recent communiqué). Figure 1: Fragmented European landscape and comparison with the United States Note : The shaded boxes indicate groups of companies resulting from mergers and acquisitions. Reference : European Central bank 02 Infosys

3 Current landscape Market infrastructure Until the recent past, European markets focused on the alignment of their pre-trade processes with the Markets in Financial Instruments Directive (MiFID) and prime brokerage systems. Post trade processing is an area where a lot of things still need to be unified across Europe. There is now a strong focus on the highly fragmented post trade settlement process and related infrastructure. Although there have been mergers in the European Central Securities Depositories CSDs to attempt to make the post trade settlement integrated, progress has been slow. Furthermore, mergers and acquisitions are unlikely to deliver an integrated single system for settlement because the systems are locally focused. The fragmented system and processes make settlements costly. Investors are virtually penalized by being made to bear the brunt of existing processes, which, if anything, only add to the costs and effort involved. There is a pressing need in today s market, due to the financial instability, to bring in efficiency and lower costs. THE CURRENT LANDSCAPE OF EU SETTLEMENT CSD A CSD B CSD C MARKET PARTICIPANTS CUSTODIANS CSD X CSD E CSD D CUSTODIANS Figure 2 : Lack of an integrated settlement system Issues The major issues and challenges thrown up by the current system are: Each CSD has its own set of systems and interfaces for post trade settlement with a focus on local legal requirements. The interactions between CSDs are cumbersome and costly Since deals are conducted in local currencies, cross-border settlement is a major issue Local regulations and legal bindings create hurdles rather than encourage trading Current setup is multi-layered, fractured, has many players in the processing cycle and is unable to deliver the required efficiency Regulations The existing market setup is locally regulated and hampered by Giovanni Barriers (GB, refers to technical or market-practice barriers, legal barriers and barriers related to tax procedures). The Giovanni Barriers are 1. Different nations should have their own infrastructure to facilitate trading in the financial markets 2. National clearing and settlement that requires using multiple systems 3. No common rules to define corporate actions, beneficial ownership and custody activities 4. Intraday settlement is cumbersome due to differences in time and availability 5. No remote access to national clearing and settlement systems 6. Different time zones have different operating hours for settlement timelines T2S encompasses the ideas of the Lisbon Strategy (also known as the Lisbon Agenda), which aims to have a single and competitive European market for financial services and remove the Giovanni Barriers. Infosys 03

4 Future Landscape The way forward T2S is the outcome of a discussion process and a dream come true for all participants in the European financial market. A lot of thought and effort has gone into developing a single platform that makes post trade settlement activities in Europe efficient, cost effective and fast. T2S is a technical platform that extends borderless securities settlements and is expected to offer a set of superior and sophisticated technical features that will create one of the most advanced settlement engines in the financial markets. It will ensure real time DVP in euro as well as other European currencies by integrating securities and cash settlements into a common platform. The T2S platform would serve as the single interface between CSDs and T2S platform. T2S will handle both, the market participants securities account and their cash account with national central banks. These settlement cash accounts will be connected to the participants cash accounts held at TARGET2 and other non-euro central bank s real time gross settlement (RTGS) accounts. The use of such an integrated model will allow T2S to attach any securities account to a participating CSD and a cash account to a participating central bank, with the same currency. Direct access to T2S T2S platform Market participants CSDs / Custodians CSDs A/Cs Bank A/Cs Market participants Integrated settlement Figure 3 : Overview of the T2S platform T2S services can also be extended through CSDs to a market participant. Thus, the legal relationship structure will be from T2S to CSD to its customers, and T2S will not be obligated to banks accessing T2S services via their represented CSDs. CSDs can continue to provide efficient, secure and robust services to their customers, particularly in the areas of corporate actions, registration, taxes, regulatory reporting, etc. Some of the most prominent features of T2S include: Highly advanced and optimized algorithms to enhance settlement processing State-of-the-art auto-collateralisation system to improve and maintain liquidity An extensive liquidity management service through dedicated cash accounts Direct connectivity, i.e. banks with large settlement volumes would prefer to have a straight and uninterrupted network connection to the platform (as defined by the CSD under their guidelines and procedures) A single pool of assets for all the securities held by 16 participating CSDs. This will be interchangeable through the central bank, resulting in reduced costs and real-time transfers through a settlement system 04 Infosys

5 Figure 4 : Settlement process flow for T2S The T2S settlement engine provides market participants with a settlement service that covers any currency settlement, RTGS cash & netting, liquidity, DVP and auto-collateralisation. Infosys 05

6 Benefits T2S is designed to deliver Europe-wide settlements at low costs and with shorter cycle times to achieve significant economies of scale. Once T2S is deployed across Europe, the enhanced volume is expected to greatly reduce the costs of settlements, to the extent where it may be lower than the lowest price charged by any European CSD for existing volumes. Take the example of a transaction in German securities, settled using euros with a buyer from Italy and seller from Spain. Under the existing model, the transaction fee charged may be different for the buyer and seller. Once T2S is operational, this fee difference will be eliminated. Additionally, other benefits include : Increased security since payment settlements made using T2S will involve a central bank Improved security and efficiency standards to bring cross-border settlements on par with domestic settlements Reliable, scalable and robust system to handle the huge volumes of transactions* that are settled even in today s fragmented markets. Furthermore, transactions volumes are expected to grow after T2S is available. (*Around two million instructions are processed every day in the current financial market) Cash trading and collateral markets are going to see phenomenal growth. These markets contribute greatly to liquidity but are low-margin activities that are viable in cost/return terms only if the settlement is timely, reliable and inexpensive Real-time DVP settlements with auto-collateralisation system Significantly reduced settlement-related costs due to economies of scale in transactions Safe cross-csd settlement. T2S will provide real-time readjustment when securities issued in one CSD are settled in another CSD Issuer will get an access to deeper markets for raising funds while investors will be able to benefit from portfolio diversification at low costs Increased competition among third-party collateral managers since it will be easier to handle such services as a custodian 06 Infosys

7 Regulations The creation of regulations necessary for T2S, and to deal with the legal requirements required to harmonize local regulations, is in progress. The objective is to define the rules so that the system will work as a single competitive platform for all participants in Europe and benefit everybody as a whole. European Commission groups like the Clearing and Settlement Advisory and Monitoring Expert Group (CESAME 2) and Expert Group on Market Infrastructure (EGMI) have been invited to collaborate on creating a code of conduct without role duplications. The EU commission is also looking seriously at working with local regulators. Box I: General Principles of T2S 1. The Euro system shall take on responsibility for developing and operating T2S by assuming full ownership. 2. T2S shall be based on TARGET2 platform and will therefore provide the same level of availability, resilience, recovery time and security as TARGET2 3. T2S shall not involve the setting-up and operation of a CSD, but instead will serve only as a technical platform for providing settlement services to CSDs. 4. The respective CSD users securities accounts shall remain legally attributed to the CSD 5. The T2S settlement service will allow CSDs to offer their participants at least the same level of settlement functionality and coverage of assets in a harmonized way. 6. Securities account balances shall only be changed in T2S. 7. T2S shall require participating CSDs to be designated under the Settlement Finality Directive (SFD) 8. T2S shall settlement exclusively in central bank money 9. The primary focus of T2S shall be settlement services in euro. 10. T2S shall be technically capable of settling in currencies other than the euro 11. T2S shall allow users to have direct connectivity to its platform 12. The participation of CSDs in T2S shall not be mandatory 13. All CSDs settling in euro central bank money shall be eligible to participate in T2S. 14. All CSDs connecting to T2S shall have equal access conditions 15. All CSDs connecting to T2S shall do so under a harmonized contractual agreement 16. A CSD connecting to T2S shall have the same calendar of opening days and harmonized opening and closing times. 17. T2S settlement rules and procedures shall be common to all participating CSDs. 18. T2S shall operate on a full cost recovery and non-profit basis 19. T2S services shall be compatible with the principles of the European Code of Conduct for Clearing and Settlement Reference : European Central bank Infosys 07

8 Impact on participants (CSDs, banks and other market players) T2S is expected to have a significant impact on market participants, existing applications and processes. The custodians are expected to gain from T2S as it can potentially significantly enhance post settlement processing. Depositories may gain a wider customer base as they will be in a position to provide highly competitive services. Since T2S will focus on increasing revenue from settlement for all the participants, CSDs and other players may have to scale up their existing services and tap new sources of revenue. This would require fresh investments from participants. While large players should be able to manage, small players may feel the heat. The Challenge and Impact grid below depicts player-wise impact and challenges Market participant CSD Bank Regulatory Need to transition from local regulation to EU regulation for T2S Regulatory impact due to settlement of securities across national boundaries Investment/ cost Upgrade and enhance existing settlement applications to Connect directly to T2S Make changes to connect to CSD Participant fee structure and brokerage charges to be paid to CSD/T2S Need to make significant amount of investment due to T2S Change in cost due to fees, commissions and brokerage Technology IT changes to connect with T2S directly or through CSD Systemic gaps due to the new platform and regulations As T2S will be using TARGET2, the impact is expected to be minimal Operation & process Impact on existing operations and processes due to regulatory changes Changes in reporting and communication Relationship with existing intermediaries (sub-custodians) Train existing staff on the new processes Change in operational processes for T2S As T2S will be using TARGET2, the impact is expected to be minimal on existing policies Business Pressure to scale up existing services and tap new revenue streams Pressure to scale up existing services and tap new revenue streams 08 Infosys

9 Recommended plan Market players need to be ready to take the advantage of the changing market after deployment of T2S. A few of the areas have been identified below. Technology changes Consulting CSD Technology platform for connectivity Data warehouse and IT infrastructure creation Messaging infrastructure (ISO messaging standard to be implemented) Dashboard and regulatory reporting Intraparty reporting Migration of existing data and applications Testing of connectivity and processes Business and process framework consulting Feasibility study Analysis and estimation effort Requirement discovery Build/buy analysis Participants Technology platform for connectivity Messaging infrastructure Application enhancement Testing of connectivity and processes Business and process framework consulting Requirement discovery Analysis and estimation effort Banks Dashboard and regulatory reporting Enhancement of existing applications for new technology/process requirements Requirement discovery Gap analysis Infosys 09

10 Conclusion The market is still fragmented as each country operates with different systems and technologies, has very varied clearing and settlement practices, and differing rules and laws. With a plethora of directives and constantly-evolving regulations, the need for T2S has never been more evident. With much hope and expectation, T2S came into being way back in 2006 with a noble intention consolidate the fragmented post trade European market and create a single platform for an efficient, faster and risk-free settlement process. There have been delays and missteps along the way but, slowly and surely, the system is getting ready. The CSDs who agreed to use this platform are eagerly looking forward to experiencing the potential benefits of the system. T2S can significantly lower the cross-border settlement risks, which are still an area of concern and adversely affect the market. T2S is expected to improve banks efficiency in managing liquidity and collateral risks. It will provide ways for diversification and reduce risk for investors. It can also open new business opportunities for market participants and benefit investors and issuers across Europe. There is increased deliberation on the structure and regulations in the European market when T2S goes live in There is also nervousness among investors and market participants about further delays in the system. With the European crisis putting a question mark on the existence of the euro, there is increased concern about the future of T2S. T2S is one of the largest infrastructure projects launched in Europe. The participants who will benefit the most are those who understand the importance and benefits offered by the system and act on it. 10 Infosys

11 About the Authors Sushama Jaiswal is a Lead Consultant with the Capital Markets practice at Infosys. She has over 10 years of experience with the capital markets industry, during which she built solid expertise in disciplines such as global consulting and client engagement management around both, business & IT. Over the course of her career, she has worked in an array of financial services areas, including investment banking, asset management, private banking and derivatives. She also has experience in providing leadership for a global team consisting of members from diverse backgrounds. She can be reached at [email protected] Prashanth Krishnamoorthy is a Principal Consultant with the Capital Markets practice at Infosys. He has over 16 years of experience in complex program management and domain consulting in capital markets. His areas of interest and expertise include wealth management and investment banking. He can be reached at [email protected] References 1. T2S 2010 brochure By European Central Bank 2. T2S Harmonization First progress report by the European Central bank 3. Is T2S still relevant Gary Wright on the Finextra Blog 4. Securities Settlement in 2020: T2S and Beyond, speech by Vítor Constâncio, Vice-President of the ECB, ECB conference, October Settling without borders by the European Central Bank 6. T2S Harmonization Second progress report by the European Central bank 7. T2S Benefits CSDs by World bank.org 8. Future of T2S hangs in the balance 9. Swift-Target 2 Securities (T2S) ECB delays T2S settlement project again FT.com Infosys 11

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