T2S: in Europe and beyond

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1 T2S: in Europe and beyond An article by Jean-Michel Godeffroy, Chairman of the T2S Board, based on his intervention at a seminar organised by the People s Bank of China Since 1999, a growing number of European countries have decided to share a single currency: the euro. The euro is now the second most traded currency in the world after the US dollar. However, the economic difficulties that the euro area is experiencing today indicate that the economic and financial co-ordination between the European countries sharing the same currency can still be improved. Strategies have to be created to prevent the same problems from emerging again in the future. But, contrary to what you often read in the international press, the present crisis will not slow down European integration; in fact, it will speed it up! There are several signs of this. If you go to Frankfurt, you will see the most apparent one: the ongoing construction of the future headquarters of the European Central Bank on the River Main. And if you are a post-trade specialist, you will find even more evidence of our determination to promote the future of the euro in the significant progress we have made in constructing the new European securities settlement system: T2S. Using the words of Mario Draghi, the ECB President, during a speech in May 2012, [T2S is] a very powerful signal of our determination to proceed on the route of [European] market integration. In this article I would like to answer three questions: - What benefits do we expect T2S to offer? - Where are we with the project? - What is the impact of T2S on European integration? 1) The six main benefits of T2S The origins of T2S can be traced back to a very technical debate which took place among the central banks of the Eurosystem in the period to define which securities settlement model they should adopt. In most countries, securities settlement relies on the interaction between the national CSD and the central bank, using a mechanism called the interfaced model. Typically, to execute a settlement order in an interfaced model, the CSD first blocks the securities that the seller is willing to sell; then, it asks the central bank to transfer the funds from the buyer to the seller in its books; and finally, after receiving confirmation that the transfer of funds has taken place, the CSD transfers the securities from the seller to the buyer in its own books. 1

2 Figure 1 - The traditional DvP model: the interfaced model When the CSD function is fulfilled by a central bank, the central bank usually organises DvP on its own single IT platform. In such cases, the processing of the data transfer is simpler and less risky because it takes place within the same technical platform. This integrated model is used by Fedwire in the United States, to name an example. Figure 2 - The integrated model in a central bank environment Yet another arrangement was established in France in 1997, when the Banque de France agreed to outsource to the French CSD the management of the cash accounts it maintained for banks. 2

3 Figure 3 - The integrated model with outsourcing of cash accounts Later on, this integrated model with outsourcing was also adopted in other European countries, such as the UK, Sweden, Belgium and the Netherlands. For a few years, securities settlement in Europe worked well with the two different models coexisting: the traditional interfaced model on the one hand, and the integrated model with outsourcing of cash accounts on the other. There were no serious competition issues because the European marketplace was segmented by currency. It was the local national central bank that decided how its currency could be used for settlement, either using an interfaced or an integrated model. With the advent of the euro, new forms of competition between CSDs became possible. This led the banks and CSDs based in countries using the traditional interfaced model to request that either their central banks adopt the integrated model with outsourcing of cash accounts or, alternatively, that such an integrated model no longer be allowed in any euro area country. For some central banks of the Eurosystem, the idea of outsourcing to private entities the management of part of the accounts they maintain for banks in their country was simply unacceptable. For the other central banks of the Eurosystem, it was the idea of moving back to a less efficient interfaced system that was unacceptable. It took us some time to realise that there was only one logical solution to this dilemma: namely, to adopt the integrated model, i.e. the most efficient model from a technical viewpoint, but use it in a reverse way, with CSDs outsourcing the management of their securities accounts to the central bank, instead of central banks outsourcing the management of their cash accounts to the CSDs. 3

4 Figure 4 - The T2S model: the "reverse" integrated model This concept of the reverse integrated model was completely new and broke the trend of the previous twenty years, when central banks in Europe had progressively withdrawn from post-trading activities. This leads to the first advantage of T2S. T2S makes it possible for CSDs to use the most efficient settlement model while allowing central banks to retain full control of the cash accounts they maintain for banks. From the start it was clear that T2S, being based on a completely new concept, required the building of a new infrastructure - to be used by as many central banks and as many CSDs as possible. One way to achieve this could have been to leave it to each and every central bank in the Eurosystem to build its own new IT application. Figure 5 - Market with reverse integrated model: what if each central bank had developed its own system separately? 4

5 Such a solution would have allowed some national specificities to remain in the different markets. However, European banks were very clear: they wanted the Eurosystem to build a single common infrastructure in order to save on IT costs and, as much as possible, they wanted to eliminate national specificities in the medium term. Therefore, T2S had to be built as a single infrastructure. Figure 6 - Schema of T2S: a single IT platform for 23 CSDs and 18 central banks This brings us to the second advantage of T2S. T2S allows for economies of scale without necessarily requiring the merging of CSDs. As already mentioned, the reverse integrated model was not in line with the trend of the previous twenty years, during which central banks gradually gave up a large part of their operational role in post-trade activities. In 1990, for example, in France, the UK, Italy and Spain the central banks were responsible for the settlement of government securities. By 2006, in all four countries this business had been sold to the private sector. This is why the idea of T2S was very controversial when it first emerged, and the T2S project even encountered some political resistance. The T2S idea was discussed by European political authorities, in particular by the European Parliament, and the debate focused on whether such an endeavour fell under the responsibility of the Eurosystem central banks or not. What made T2S possible from a political perspective was its potential to substantially reduce the cost of cross-border settlements. Today, cross-border transactions in Europe are about ten times more costly than domestic transactions. T2S offers a solution to this issue because, instead of being built as a common infrastructure to perform DvP arrangements at national level, it was conceived as an engine which would allow any securities in T2S to be directly settled against funds deposited in any central bank participating in T2S. For example, in T2S a German bank will be able to buy French securities using its cash account with Deutsche Bundesbank and its securities account with 5

6 Clearstream Frankfurt. Today, this is technically possible, but very expensive and relatively inefficient (and this is one of the reasons why custodian banks are normally used as an alternative). Figure 7 - DvP relationships in T2S Because T2S will process domestic and cross-border settlements within the same infrastructure, it will charge the same fees for both kinds of transactions. Most cross-border transactions, which today need to go through a complex processing chain involving CSDs and custodian banks, will be processed by T2S in a much simpler way. Hence, the third advantage of T2S is that T2S will dramatically reduce the processing costs of cross-border securities settlements. This is the main reason why European politicians finally lent strong support to T2S. Furthermore, alongside its efficiency gains, T2S simplifies the settlement process and increases the likelihood that securities transactions, especially cross-border ones, are settled directly in central bank money, which is the safest settlement asset. Therefore, T2S brings a fourth advantage, which is very important from a public policy perspective: T2S fosters financial stability. T2S was originally conceived to serve the euro area, as a means of establishing a level playing field between market participants in the single currency zone. However, during the EU discussions held in Brussels, several non-euro politicians and civil servants noted that the benefits of T2S could also extend to European countries which have not adopted the euro. Indeed, this could be a win-win situation: on the one hand, non-euro countries could have access to an infrastructure which offers attractive settlement services, technically and financially; and on the other hand, from our T2S perspective, the inclusion of non-euro transactions could increase settlement volumes and therefore reduce production costs per unit. 6

7 Figure 8 - DvP relationships in T2S are possible between any CSD and central bank, in any participating currency This leads to the fifth advantage of T2S. T2S will be a multi-currency system, in which DvP will be possible in central bank money. For the time being, Danmarks Nationalbank (the central bank of Denmark) is the only non-euro area central bank that has decided to outsource the management of its currency accounts to T2S. Other central banks in Europe are in a wait-and-see mode and my hope - I would even say my expectation - is that all European countries will join once T2S is in operation and is delivering the benefits we expect. In the recent years, and especially since the present financial crisis arose in , securities settlement systems have increasingly been used as a way to facilitate the delivery of securities to the central banks for collateralisation purposes. T2S can be a very useful tool in this respect, especially in a cross-border context. Here is an example. Danish banks are typically very active in the euro area; imagine that, at a given point in time, a Danish bank has excess collateral in euro but lacks collateral in the Danish currency. Within T2S, it will be very easy for that bank to transfer collateral in euro to the securities account of Danmarks Nationalbank in order to get a loan in the Danish currency in exchange (as long as Danmarks Nationalbank accepts collateral in euro, which is the case in practice). Without T2S, this would be possible in theory, but not necessarily in practice at least, it would not be as easy as in T2S. Therefore, the sixth advantage of T2S is the following: T2S makes it easy to transfer collateral across borders. 7

8 2) T2S is under development Figure 9 - Development of T2S: where are we? The Eurosystem presented the T2S concept to market participants for the first time in July At that time, T2S was merely a proposal. The technical and political discussions with market participants and European political authorities mentioned earlier lasted almost two years. Finally, the definitive decision to launch the project was taken by the Governing Council of the European Central Bank in July Among the many milestones achieved in this project so far, I would like to mention: 1) the decision to freeze the T2S User Requirements Document in January 2010; and 2) the signing of a binding legal agreement with 23 CSDs in May and June Other important milestones still to come in the next few years will be the delivery of the T2S software for user testing in February 2014, the go-live of the system in June 2015, and the completion of the CSD migration period by January From the beginning, we have opted for maximum transparency vis-à-vis the industry and the public in general. On our website ( you will find a lot of detailed information. In particular, you will find out that our investment costs are estimated at EUR 420 million, that the T2S running costs per year will be EUR 76 million, and that we expect to pay EUR 65 million in interest rate costs. T2S is not subsidised by the Eurosystem and its full costs will be recovered through the fees levied on participating CSDs. The high costs of T2S are partly a result of the very sophisticated features that its software will offer, such as optimisation algorithms and the auto-collateralisation functionality (i.e. the possibility for participants to use the securities they are purchasing as collateral to obtain from the central bank the funds needed to finance the purchase). One of the topics related to T2S that have been most extensively debated was its governance. In a nutshell, all important decisions related to T2S are taken by the Governing Council of the European Central Bank. The Governing Council has entrusted the T2S Board with three main tasks: 1) to maintain a dialogue with the main stakeholders - CSDs, banks and central banks; 2) to draw up 8

9 proposals to put before the Governing Council; and 3) to take decisions on matters that have been delegated to it. For instance, as regards the technical design of the system, the user requirements belong to the exclusive field of competence of the Governing Council and cannot be changed without its consent, while the detailed functional specifications, based on those user requirements, are steered by the T2S Board autonomously. Figure 10 - The T2S area In figure 10 we can observe a new map of Europe: the map of the T2S area. T2S is not compulsory. CSDs were free to join or not, and the boundaries of this area reflect this freedom of choice. The map covers the countries in which at least one CSD has decided to join T2S. The T2S area does not cover the entire euro area because it does not include Ireland (which shares its CSD with the UK) and it comprises only one of the two Greek CSDs. However, it does cover five countries outside the euro area, where the national CSDs have decided to participate in T2S: Denmark, Hungary, Lithuania, Romania and Switzerland. Of course, other CSDs may join over time and, indeed, I expect all European CSDs to get on board as soon as the benefits of T2S become a reality. 3) A new European model for settling securities In the last part of this article, I would like to explain how we expect T2S to contribute to reshaping the way securities settlement is organised in Europe. 9

10 Europe is composed of a number of nation states that decided about sixty years ago to undertake economic integration (the 27 countries of the European Union) and later, for some of them, even monetary integration (the 17 countries of the euro area). Nevertheless, integration of financial infrastructure in the post-trade field is still limited. EUROPE UNITED STATES Trading BME Group Deutsche Bórse Nasdaq OMX Nordic MTFs e.g. Chjix/ Turquoise LU S.E. Euronext PT, BE, FR, NL London Stock Exchange Borsa Italiana Six Group NYSE MTFs e.g. BATS Nasdaq Clearing Eurex Clearing EMCF Euro- CCP LCH Clearnet SA LCH Clearnet Ltd. Cassa Di Comp Six-x Clear NSCC FICC Securities Settlement & Asset servicing Iber clear Clear stream Banking Frankfurt Clear stream Banking Luxemb. VP CSDx Inter Bolsa Euroclear BE FI FR NL SE UK & IE Monte Titoli SIS DTCC FED Cash Settlement... NCBx SNB Target2 Figure 11 - The European Union today: a fragmented market infrastructure (simplified overview) Until T2S goes live, national monopolies will remain in securities settlement in Europe, like anywhere else in the world. Even in countries where there are two CSDs, they rarely compete against each other: usually, in fact, they settle different classes of securities. There are very few exceptions to this non-competition rule. The main reasons for this situation are to be found in the large fixed investments and the network externalities pertaining to the settlement business. In Europe, we want to move away from this model, since in a currency union/single Market it may no longer be justified to have one or even two CSD(s) per country. Because most CSDs are now private entities, they cannot be forced to merge so that in the end only one or two CSDs remain in Europe, as is the case in China, in Japan or in the United States. Looking at the different functions of a CSD, it is worth noting that the function which triggers the most important economies of scale and the most significant network externalities is the settlement function. Thanks to T2S, CSDs will be able 10

11 to use infrastructure which will pass on to them the benefits of such economies of scale and network externalities. Figure 12 - T2S will affect exclusively the settlement function of CSDs Therefore, with the creation of T2S, the case for full consolidation of the CSD business in Europe becomes less compelling than in other currency areas. Moreover, by breaking down national borders in the settlement business, public authorities will create market conditions that allow CSDs to compete against each other. The effects of T2S in this respect are likely to be enhanced by the new European CSD Regulation, which should come into force next year. This new European legislation will make it easier from a legal viewpoint for CSDs to compete with one another. The CSD Regulation will, for example, allow issuers to issue securities in the CSD of their choice, instead of being forced to use their national CSD. But T2S, on the technical side, and the CSD Regulation, on the legal side, would not be sufficient to simplify securities settlement in Europe and reduce its cost. An important effort is needed in parallel to harmonise settlement procedures, such as the handling of corporate events (coupon payments, redemptions, etc.). The Eurosystem is working with European banks and CSDs in order to obtain results in this field before T2S is launched in With T2S, the CSD Regulation and the harmonisation efforts, it is expected that competitive pressures will force some CSDs to merge. The remaining national CSDs will become European CSDs covering several countries in a non-exclusive manner. CSDs will compete among themselves, but they will also compete with custodian banks, in particular for cross-border business. Local (i.e. national) custodian banks covering only one country will either become European actors (active in several countries) or they will abandon the securities settlement business. In other words, T2S, the CSD Regulation and harmonisation will stimulate market forces that will require consolidation in order to drive down costs, especially for cross-border transactions. This will have important implications for non-european actors, who will have many more options when accessing European markets than today. Whether they are investors, broker-dealers or 11

12 custodians, they will have more options for accessing directly or indirectly the core of the settlement process between CSDs and central banks. Even those who choose to continue to use a global custodian should benefit from T2S, because global custodians will benefit from the new settlement arrangements in Europe. In other words, T2S will deliver on its promise to make Europe a better place to invest. *** In conclusion, I would like to broaden the perspective. T2S is a concept which arose in Europe because of a very specific political context linked to the willingness to deepen economic integration in our continent. But the benefits of T2S underlined in the first part of this article are not Europeanspecific. Thus, could T2S be helpful beyond Europe? I would like to be prudent in this respect because each country and each region of the world has its own specificities. It seems to me that T2S as a system might not cross European boundaries - for practical reasons, first of all (time zone issues for example), and also for legal reasons: the functioning of the T2S system is underpinned by a set of common legislative acts which are in part Europe-specific. But since the benefits of T2S that I described earlier do not seem to be linked to the European specificities, T2S as a concept could bring value in any part of the world, in particular wherever there is a willingness to develop regional economic integration. It is important to underline that the T2S concept does not require monetary integration since it is a multi-currency system. Moreover, the implementation of a programme similar to T2S might create strong incentives for harmonising settlement procedures, which is an important prerequisite for regional integration. The T2S concept could also help to establish links between the larger currency areas of the world. The increasing need for collateralisation, even intra-day, could be a driving force in this respect. The key issue with this undertaking would be the need to draw up appropriate legal arrangements and governance principles that would be acceptable to all actors, in particular to the relevant central banks and securities regulators. Yet, the implementation of the T2S concept is very costly. It would therefore be interesting to see whether the software that we are developing in Europe could be adapted to help CSDs and central banks elsewhere in the world to meet their customers needs. To conclude, it should be noted that most of the T2S benefits mentioned in this article would not be impossible, in theory, without an integrated system like T2S. However, the reason why the T2S concept is so powerful is that it makes it simple and cost-efficient to perform activities which, in a fragmented environment, are so cumbersome and expensive that they are not carried out at all in practice. And this may be true even beyond the European context. Frankfurt am Main, October