Internalisation and Consolidation of the Settlement of Payments and Securities Transactions. Speech by. Giovanni Sabatini,

Transcription

1 Internalisation and Consolidation of the Settlement of Payments and Securities Transactions Speech by Giovanni Sabatini, Chief Executive Officer, MonteTitoli Chairman, ECSDA At the Global Conference on Private and Public Sector Challenges in the Payment System Frankfurt, Germany 12 and 13 June 2003

2 Distinguished colleagues, Ladies and Gentlemen I would like to thank the Committee on Payment and Securities Settlement Systems and its Chairman, Dr. Padoa-Schioppa, and the European Central Bank for giving me the opportunity today to present my views on such a challenging subject. As a former regulator, I would like to start my presentation with two disclaimers: First, I am fully aware that this conference has a global perspective: nevertheless, I have decided to focus on the European context. The reason for my choice is that Europe represents an excellent observatory for studying current trends in the field of clearing and settlement: the problems identified and efforts and solutions experienced here, aiming at creating a single capital market, might also provide useful background work for other geographical areas currently addressing similar issues. Second, for the purpose of this presentation, I propose to use the terms SSS and CSD synonymously, considering that, in this context, the custody function has to be regarded as intimately linked to the settlement function. Let me start, as is usual, by setting the scene: what is the environment in which we are moving? One of the most important features of the current financial scenario has been the explosive growth in market activities, i.e. the increase in number and volume of both domestic and cross-border transactions. Although in more recent times, due to endogenous and exogenous factors, we have experienced a contraction in the global

3 2 activity of financial markets, it is difficult to believe that the long-term trend can be reversed. In particular, the increase in cross-border transactions and the globalisation of domestic economies is both the result and the source of the progress of information technology and financial innovation, and of a higher level of harmonisation in market practices and regulation. A simple figure testifies to this growth: the total volume of transactions on equities traded on world markets increased on a yearly basis almost 63 times between 1980 and In Europe, this trend was amplified by the introduction of the single currency and by the efforts of both European and national authorities to build a more homogeneous and integrated financial system. At the same time, three important developments have reduced settlement risk in the global financial markets, simultaneously increasing the complexity of the overall liquidity management by intermediary banks: The adoption of real-time gross settlement payment systems and the establishment of delivery versus payment (DVP) settlement systems require the timing of payments to be carefully monitored and scheduled in order to reduce the need to maintain substantial money balances throughout the business day; The introduction of PVP (payment versus payment) settlement by means of CLS (continuous linked settlement) on the foreign exchange market has increased the need to make large, timed payments in non-domestic currencies during a small time window, and in some cases, outside normal domestic banking hours.

4 3 Furthermore, the growing interdependencies between financial market infrastructures, both domestically and internationally, and the continuing integration of capital and currency markets, have increased the potential for any isolated or systemic factor that might affect one system or market to be immediately translated into another. As a result, public regulators and overseers are increasingly concerned about financial stability issues. In this context, we look forward to the forthcoming standards for securities settlement systems prepared by the ECB/CESR Task Force, which aim at customising the CPSS/IOSCO recommendations to the European environment. The adoption of solutions that can reduce costs and increase efficiency in settling crossborder transactions would meet the specific needs of market participants and would also support the creation of more competitive and attractive EU financial markets. Large banks want to be able to approach several markets from a single access point, enabling them to make the most efficient use of collateral and to minimise costs. Institutional investors require that the return on their investment is not substantially reduced by trading and post-trading costs. Issuers need access to deep and liquid markets, where they can efficiently raise funds. Retail investors want access to the widest possible range of financial instruments at a reasonable cost and without additional complexity. These market needs must be mirrored by new cost-effective solutions offered by providers of settlement services.

5 4 The Giovannini Group s reports clearly show that the expensiveness and inefficiency of clearing and settlement have substantial economic negative impacts: first of all on markets, causing fragmentation, and second on resources, which cannot be efficiently pooled. This also constitutes a major disincentive to financial transactions and to the optimal allocation of economic resources. Moreover, in such cases, risk allocation becomes expensive, while securities prices do not convey much information. In short, as noted by Mr. Padoa Schioppa in his introductory speech, structural inefficiencies in the clearing and settlement harm the economic functioning of financial markets. The key question is then: can the operators of SSSs meet this demand and support these needs? Before addressing this issue, let me first analyse the key features of SSSs. They carry out settlement on a DVP basis. The settlement of securities transactions in this fashion ensures that securities are only delivered when cash is available and received and vice versa, thereby eliminating principal risk. SSSs are able to offer settlement in central bank money, where practicable. The use of central bank money to settle the ultimate payment obligation arising from the transaction eliminates credit and liquidity risks potentially resulting from the failure of the settlement agent, thus ensuring the stability of the financial systems. The European SSSs, notified by their states for the purpose of the Settlement Finality Directive, are able to provide the transaction with as much protection as granted by the

6 5 directive itself. This means that, from the moment of their entrance into the SSS, transfer orders are legally enforceable and, even in the event of insolvency proceedings against a participant, settlement is binding on third parties. SSSs are the channels through which monetary policy operations are executed. They receive special permission to perform this activity after they have been assessed to fulfil the ECB s standards. Another advantage of the SSSs is that they can use links, many of which are also assessed on the basis of the ECB s standards. Almost all SSSs have a number of links with other entities performing the same activity in other jurisdictions. This means they are virtually able to transfer securities wherever they are held in custody. This is mainly true for ECSDA s members, who have developed and signed a specific model agreement to regulate the settlement of transactions both on a free-of-payment basis and on a deliveryversus-payment basis. The advantage of these connections would be exploited if the relayed link model were used. This model would allow cross-border operations to increase by avoiding exponential growth in the number of links, making it possible for an SSS to settle through a single link with many CSDs. If SSS-1 and SSS-3 have direct links with SSS-2, they can save the effort of building a direct link between them if they are willing to settle their trades via SSS-2. If this method is applied to the maximum extent possible, the number of links grows only as fast as the number of SSSs in the network. ESCDA supports the relayed link model, and is considering measures to address the

7 6 potential additional risks that could arise when settlement occurs in a chain of linked SSSs. Finally, it is universally accepted that the efficient functioning of clearing and settlement of securities transactions is crucial for the efficiency of securities markets, as well as for the smooth conduct of monetary policy operations and the stability of the financial system. For this reason, SSSs are highly regulated and supervised in their home countries. Moreover, at an international level, multiple standards have been developed to address pre-settlement and settlement risks in order to promote the efficient and safe functioning of SSSs worldwide. Assuming that SSSs share the goal of supporting an integrated financial market, as mentioned before, how can this goal be achieved? The answer to this may be obvious, i.e. integrating the SSS systems to make them work together as a single process, but the practical solutions are not. At present, two strategies prevail: a centralised or consolidated approach versus a decentralised or network one. In the former, the corporate consolidation of providers of settlement services precedes the technical integration of platforms, thanks to mergers and takeovers. This solution prevails in the US, where a single operator, DTCC, handles the settlement processes for most financial instruments. Nevertheless, it is true that

8 7 1) comparison between the US and the EU systems is misleading: Europe is a political entity which substantially differs from the US; its legislation is still fragmented and not sufficiently homogeneous (for a more significant comparison, we should compare the cost of settling a transaction between the US and Mexico, and a transaction between Italy and France); 2) in case of consolidation, deeper involvement of supervisory authorities would be required to offset the absence of control executed by the market through competition and risk arising from the monopolistic position of the single operator; 3) the initiatives that are intended first to consolidate the corporate infrastructures of settlement service providers will deliver initial results in terms of cost reductions and economies of scale only after the integration of the technological platforms; 4) a merger between two different providers would oblige a choice to be made between adopting a brand new clearing and settlement platform, or using an existing platform (which may not always be the most efficient one). In both scenarios, intermediaries would be required to change their interfaces and back-office procedures, with potentially high sunk costs. On the other hand, the decentralised approach focuses first on the technical integration of platforms and on the creation of a network, which may also include the development of common interlinking infrastructures.

9 8 The possibility of creating a network is based on the idea of enabling existing systems to interact with each other. Since such a network approach tends to use present infrastructures, it is a more time-to-market solution. Compared with the proposal to merge the different providers of post-trading functionalities into a single entity, the idea of building a single network process ensures a more gradual process and allows a minimisation of sunk costs for intermediaries. It ensures a higher level of competition, fosters innovation and reduces the level of concentration of risks within a single entity. Finally, the proposal is compatible with the different governance models of the European CSDs/SSSs. In the long term, the two models might also converge: once the barriers identified by the Giovannini Group have been removed and greater harmonisation of the legal framework has been achieved (including the completion of the Securities Account Certainty project), the market will be in a position to choose the best solution. Until then, it is essential to focus attention and efforts on very pragmatic solutions. Based on the clear indications and strategy provided by the Giovannini Group, private sector associations (e.g. ECSDA), along with national governments and regulators (such as ECB-CESR), are currently working on the removal of 15 different operational, technical, legal and fiscal barriers, targeting issues such as:

10 9 - the adoption of technical specifications of minimum standards and message standards - the implementation of common market practices (i.e. in the field of corporate actions) and the harmonisation of operating hours and settlement deadlines - the development of standardised model agreements and of an internationally accepted model for the settlement of cross-border transactions These actions, which should be implemented in the short to medium term, represent essential first steps with the aim of delivering efficient and integrated EU clearing and settlement arrangements, in line with the Financial Services Action Plan (FSAP) of the European Commission. However, as Securities Settlement and Payment systems are becoming increasingly connected, we should not only focus our attention on the settlement of the securities leg, but also on the cash leg of a securities transaction. Current arrangements for the settlement of the cash leg of a cross-border transaction are not optimal and do not offer the required functionalities to easily achieve cross-border DVP settlement. They do not allow an SSS to control the exchange of cash in a secure and efficient manner, for the following reasons:

11 10 - The use of local paying agents to access a foreign national central bank entails high fees and is therefore considered expensive. - Remote access to foreign payment systems is not coherent with current Eurosystem rules (one major problem being the access to intraday liquidity). - The third alternative, settlement in commercial bank money, is not a viable solution, since not all SSSs are granted the status of a (limited purpose) bank, and since settlement in commercial bank money is not regarded as being as secure as settlement in central bank money. Providing more efficient solutions for the settlement of the cash leg and the integration of securities settlement and payment systems is also necessary to be in line with the approach of the new ISD proposal which, upon verification of some conditions, provides market participants with the right to choose the location of settlement. In this context, the TARGET2 project offers a unique opportunity for close cooperation between payment and securities settlement systems; it also represents an important chance to transform the current European financial landscape into a more favourable environment for the maximum benefit of all market participants.

12 11 In the meantime, the current TARGET infrastructure could be enhanced by additional functionalities, whereas in the longer term, the planned technical harmonisation of the TARGET interfaces would contribute to further integration. Let me just mention some of the (possible) enhancements that, from the point of view of an SSS, could be realised in the short to medium term. A significant achievement would be the introduction of cross-border mandated payments within the TARGET infrastructure (a prerequisite, however, would be to have a European-wide standard for such payments, including consistent rules of finality). How would the mandated payment work in practice? An intermediary with remote access to a trading platform in another country could authorise an SSS to effect mandated payments from its account held at its national central bank. The trade would be transferred to the SSS where the settlement of the securities will take place. The new feature is that the transfer of the cash would also be initiated by the same SSS sending a debit message directly to the foreign national central bank of the intermediary, where the account debit will be carried out. The advantages of this solution are: - the SSS has a better control of securities settlement and related payments (facilitating DVP models such as remote access or the ECSDA link model);

13 12 - the intermediary would have the possibility to regulate the cash in its own country, limiting the need for intervention by a local/global custodian; - the model is consistent with the approach of the new ISD (free choice of settlement location). Another alternative to be considered would be to allow intermediaries to earmark reserves of cash to ensure smooth securities settlement, not only in the domestic securities settlement system, but also within another foreign SSS. In this case, a domestic intermediary might allocate a portion of its total cap for securities settlement to its domestic SSS and a portion for settlement in another SSS. However, compared with the mandated payments, this solution has the disadvantage of fragmenting the available liquidity. Additional measures may entail the extension of operating hours for payment systems. Several SSSs have introduced night cycles, in order to guarantee optimal management of the clearing and settlement process and to enable to settle almost all transactions in the morning. However, if payment systems were able to interact during the night, the final transfer of securities and cash could be further anticipated. An extension of the opening hours would also allow better interaction with other SSSs in different time zones. Once such measures have been implemented, SSSs should, after the assessment of operational issues, elaborate solutions for the creation of a safe model for cross-border securities transfer. In the longer term, with the introduction of the new TARGET2 system, the ECB plans to provide a common interface to all national payment systems, which could mark a further

14 13 important step towards greater European integration. Furthermore, a single shared platform will be provided for those national central banks deciding to give up their own national platforms. It should be mentioned that this approach is based on technical integration and standardisation (based on the above mentioned interoperability approach). This means that, despite using a common interface or a shared platform, accounts and relationships may be operated by the individual national banks. The common interface will facilitate the exchange of cash on a cross-border basis and, therefore, facilitate possible cross-border DVP models. Cross-border DVP settlement will work faster, the total costs of a transaction will decrease, and the risks will be significantly lower. In this context, allowing SSSs to access foreign payment systems online might be considered as a further step to make the coordination of liquidity easier and to smooth the settlement process.

15 14 Conclusion: My intention today was to discuss the Internalisation and consolidation of the settlement of payments and securities transactions. I have tried to identify some elements; let me briefly recapitulate the four main areas: 1. The priority of market participants is to reduce cross-border settlement costs; 2. Until the regulatory, tax and legal framework is harmonised, the best interim solution is to implement interoperability between SSSs, promoting a safer and more efficient settlement environment (such a approach is applicable on a global scale); 3. Current projects like the Giovannini Report or G30 provide us with a clear strategy for the harmonisation of the securities leg, but new optimised solutions are also required for the settlement of the cash leg. The enhancement of the current TARGET system and the introduction of TARGET2 are considered to represent an excellent opportunity to advance the integration of payment and securities settlement systems; 4. Thanks to their key features, SSS are well-positioned to play a major role in the process of fostering the integration of EU financial markets, and to facilitate the management of liquidity across Europe by providing a safe and efficient bridge between the world of securities and the world of cash.

16 15 References BIS/CPSS (2001), Core Principles for Systematically Important Payment Systems CPSS-IOSCO (2001), Recommendations for Securities Settlement Systems, Basel Deutsche Börse Clearstream (2002), Cross Border Equity Trading, Clearing and Settlement in Europe ECSDA (2002), Comments regarding the Communication from the Commission on Clearing and Settlement in the European Union ECSDA (2002), ECSDA Cross-border Settlement ECSDA (2002), Report on Cross-border Corporate Actions and Events Processing Euroclear (2003), Delivering Low-cost Cross-border Settlement European Central Bank (2002), Public Consultation TARGET2: Principles and Structure European Commission (2001), Communication to the Council and the European Parliament: Clearing and Settlement in the European Union Main Policy Issues and Future Challenges European Monetary Institution (1998), Standards for the Use of EU Securities Settlement Systems in ECSB Credit Operations Group of Thirty (2003), Global Clearing and Settlement: A Plan of Action IOSCO (1998), Objectives and Principles of Securities Regulation Joint work of ESCB/CESR in the field of clearing and settlement (2002), A call for contributions from interested parties The Boston Consulting Group (2003), The Payment Puzzle Putting the Pieces Together The Committee of Wise Men (2001), Final Report on the Regulation of European Securities Markets The Giovannini Group (2001), Cross-border Clearing and Settlement Arrangements in the European Union The Giovannini Group (2003), Second Report on the EU Clearing and Settlement Arrangements