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Opening up Europe's Architecture
The formation of a single European securities market is being held back by the lack of a central clearing and settlement facility open to all participants.
The lack of a centralised clearing utility remains one of the largest obstacles to building a single European securities market. For a number of reasons, clearing houses within the Eurozone continue to resist consolidation.
Undoubtedly, there are fundamental differences between consolidating the US market and consolidating the European market, and comparing the two markets can be dangerous and misleading. But the fact remains that it is far more expensive to settle a trade in Europe than in the US. One of the main reasons US costs are so low is the fact that all trades are pushed through the single netting infrastructure, allowing for true consolidation of cost and better use of collateral.
There has been extensive debate over the formation of a pan-European clearing and settlement facility, with particular focus on forming a European central counterparty (CCP). The consensus is that the ideal outcome is the creation of an infrastructure like that of The Depository Trust & Clearing Corporation (DTCC); a single centralised market utility.
Currently European clearing houses are tied to domestic markets. Although some progress has been made in catering to the growing cross-border market volumes, no real solution exists that is (a) based on an open architecture and (b) user-owned and governed, untied to any exchange.
Nasdaq Europe, together with DTCC, plans to address this by creating a clearing service that meets the market's requirement for a European-wide service without any affiliation to a specific exchange or market. This horizontal model is based on the concept of allowing members to settle trades in the most appropriate depository for a stock, at domestic rates, effectively cutting out the cross-border costs.
The proposed solution is very similar to the model developed and lobbied for by the European Securities Forum (ESF), a group set up by the major financial institutions to represent the user's needs for the formation of a CCP within Europe. The ESF is specifically interested in maintaining a horizontal model that is user-owned and governed and that provides a single process for netting.
"Our existing clearing and settlement process provides links through Euroclear Bank and Clearstream Banking Luxembourg," says Jim Weber, chief operating officer of Nasdaq Europe. "We plan to expand this capability, offering participants an increasing number of depositories with which they can settle directly. But this is just one part of our clearing and settlement solution. At the same time we are working with DTCC to introduce a central counterparty, which we believe will help reduce risk and some of the costs associated with cross border transactions. The principal is to be open to clients' needs, breaking out of the vertical silo model that is prevalent across Europe. It's about settlement flexibility and improving efficiency," Mr Weber adds. "In conjunction with DTCC we want to implement a complete solution that takes advantage of pools of liquidity with an open architecture, therefore utilising agent banks and custodians where most liquidity naturally lies to take advantage of efficiencies. Our main reason for entering into the market is to provide a tangible solution that addresses the fragmentation problem responsible for inflating the cost of trading in the market."
The CCP is not exclusively controlled by Nasdaq Europe and will be open to other exchanges, a first for the region. Evidence of the project's merit is provided by the highly successful link between the DTCC's clearing subsidiary and the Canadian Depository for Securities (CDS), which sees some of the highest cross-border activity in the global market. DTCC wants to replicate the same type of solution for Europe, providing all netting and clearing services demanded by the market, similar to those available at LCH and Eurex, with trade guarantees.
"There is no need to build a solution from square one," Mr Weber points out. "DTCC can handle up to five million trades per day. This is unheard of in Europe, giving us a handle on the market. It's a matter of customisation rather than building from scratch."
The solution proposed by Nasdaq Europe and DTCC will pave the way for real-time, cost efficient processing. However, time is of the essence. The final report of the Lamfalussy 'committee of wise men', published on February 15, states that Europe's current regulatory environment is a hindrance to consolidation:
"The Committee notes that an almost consensual view has emerged that the European Union's current regulatory framework is too slow, too rigid, complex and ill-adapted to the pace of global financial market change. Moreover, almost everyone agrees that existing rules and regulations are implemented differently and that therefore inconsistencies occur in the treatment of the same type of business, which threatens to violate the pre-requisite of the competitive neutrality of supervision. The common view is that the EU's regulatory framework does not work; hence the need for reform."
The Lamfalussy report also highlights the fact that Europe has to address the problems associated with clearing, developing a CCP is of utmost importance.
Straight-through processing (STP), involving trade automation and the transparent flow of information from trade execution to settlement, is the securities industry's Holy Grail, and has acted as a catalyst for the reinvention of the industry. For the benefits of STP to be realised, however, the market needs to provide a robust, scalable and capable infrastructure that supports the efficient flow of information from exchanges to depositories and clearing houses.
When looking to promote market efficiencies it is impossible not to take into account the necessity for STP. At the present stage, the highest risk is of a failure to implement a sound STP infrastructure, the securities markets' 'plumbing'. The establishment of a centralised market infrastructure paves the way for further enhancement, as seen with the push for collapsing the settlement cycle to T+1 in the US.
Rising volumes and increased cross-border activity have been some of the key drivers for a united European infrastructure. The creation of Euroland has been a slow and often painful process, fraught with regulatory impediments and massive cultural issues. However, the underlying premise is that a united European marketplace makes sound economic sense, especially as far as cross-border investment is concerned. As it stands, national barriers promote increased costs, duplication in services and sustain inefficient infrastructures.
Following the debate, the UK marketplace has moved to T+3 settlement, with a view to collapsing the cycle in line with the US in the very near future. Other major European markets operate within a T+3 or T+2 environment, and there are further reductions on the horizon. The resulting pressure on the markets is immense, especially as domestic markets become less defined, cross-border traffic increases and globalisation becomes a reality.
Much of the pressure for shorter settlement cycles is coming from the regulators, anxious to reduce exposure to settlement and operational risk; the US has been swift to take up the challenge by setting a date for moving to T+1 (settling trades within 24 hours) to be enforced by mid 2004. The US has the advantage of a consolidated marketplace that supports best practices, especially when it comes to clearing and settlement.
John Gubert, head of Group Securities Services for HSBC, believes discussion on reducing settlement to a single day has been too focused on reducing credit risk, without taking into account operational risk. He says T+1 will only be realised through a real-time infrastructure that is dependable and accurate. The current environment is reliant on batch or multi-batch processing which, according to Gubert, may be just sustainable for a T+3 settlement cycle but is certainly unrealistic for any further reduction in trade settlement.
"A lot of institutions will have to adjust their whole processing environment because the bulk of their transactions are on batch with only a small number being handled intraday on an exception basis," says Mr Gubert. "So at a depository settlement system level we are going to have to revisit, not necessarily the architecture, but the processing environment. We have to introduce routines or structures that take into account a global transaction processing environment."
For T+1 to become a global reality a centralised transaction mechanism is needed. Currently competition has erupted between two players: the Global Straight Through Processing Association (GSTPA) and Omgeo. Both parties have developed and funded separate solutions to achieving T+1 and are based on pure STP principles.
The GSTPA has developed the Transaction Flow Manager (TFM), while Omgeo has designed a Central Trade Manager solution. Each development has to some degree incorporated a centralised matching mechanism that will enable the smooth and fast transmission of trade information between trade counterparties in a central point of communication.
The concept of centralised matching is based around the need to implement standardised messaging and efficient transmission of information. To hook up to either or both mechanisms, practitioners will have to incorporate STP practices, enabling 'just-in-time' trade information enrichment and clean, standardised data.
However, Richard Hughes at Omgeo believes that moving to T+1 will involve more than a centralised matching mechanism. "The current practice of passing back and forth redundant data is just not an option in a T+1 environment and is a prime cause of error input," he says. "The solution is to pass transaction details on to an information centre. Fund managers are seeking to outsource their responsibilities to data specialists that are able to enrich the trade process."
Mr Hughes adds, "Increasingly the front and back offices will disappear. Historically, concentration has been placed on maintaining the distinction between front, middle and back offices and in a T+5 environment there is breathing room to accommodate this set-up. However, in a real-time trading environment this is no longer feasible and companies will have to migrate to exception processing. This cannot be achieved with an architecture that utilises disparate systems."
The technology explosion of the 1990s saw a lot of money invested in the front end. However, the same consistency and sophistication is just not evident in the mid- to back offices. As the regulators continue to push for change the need to comply will force many participants into outsourcing. Economies of scale are one of the strongest drivers for change in the industry.
The securities industry is undergoing a paradigm shift of sorts, and in order to achieve the most efficient trading environment possible, participants will have to undergo intense reorganisation of trading practices. STP remains at the top of the priority list. However as regulators continue to push for shorter settlement cycles a secure and transparent infrastructure needs to be in put place. Europe has operated at an inefficient level for too long, at a cost to market participants and the proposed CCP is the first step towards creating an efficient market environment on a par with the US.
Robin Devereux is an independent financial journalist
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