7 DOMESTICATING CROSS-BORDER SETTLEMENT Pierre Francotte Significant consolidation within the European settlement infrastructure has begun, both within certain domestic markets and on a transnational basis. Euroclear now regroups the largest international CSD with the CSDs of France, Ireland and the Netherlands, with Belgium and the UK to join soon. Even so, approximately 20 CSDs continue to operate in Europe. Consensus opinion is that there are still too many for cross-border transaction costs and inefficiencies to be adequately reduced for market participants. Two reports recently issued by the Giovannini Group and CEPS have calculated the 'all-in' cost of cross-border transactions in Europe. Of significance, the reports cited that the fees charged by the international and national CSDs represent a relatively small (5%) portion of overall transaction costs. The estimated cost of using local agents as intermediaries between settlement providers represents about 35% of total transaction costs. But the largest component is the back-office costs of the users, who are paying dearly for the inefficiencies arising from having to maintain relationships with so many intermediaries and service providers in terms of systems, communications, staff and training. For example, automating an interface with just one settlement system can cost a user up to US$1 million in up-front investment. Insufficient consolidation also means that there is sub-optimal use of collateral, resulting from investor holdings being dispersed among a large number of service providers. In the current environment, securities collateral is less mobile than cash, forcing users to borrow collateral if they do not have the right amounts of collateral available in the right place at the right time. However, not all the costs incurred in the back offices of the financial community are due to the relatively high number of CSDs operating in Europe. One of the biggest costs is derived from the heterogeneity of legal, regulatory and tax rules among European countries, as well as differing market practices. Unlike the US, Europe is not a single country. Notwithstanding recent European legislation to foster a single European market, there are significant market and regulatory rules in several European countries that are slowing down the development of a truly pan-european equity market.
8 Domesticating Cross-Border Settlement BARRIERS TO EFFICIENCY From a settlement perspective, national laws or stock exchange regulations in some European countries require that trades in listed securities settle on the books of the national CSD. In other markets, listings on locally regulated stock exchanges must be recorded locally. Such regulations mean, in practice, that trades executed on a local stock exchange have to settle only in the local CSD. This prevents competition among settlement providers for on-exchange transactions and, ultimately, blocks users from centralizing their settlement activity in fewer systems, thereby perpetuating the high infrastructure cost mentioned earlier. The development of sector trading in equities, for example, has been hampered by local market infrastructures, which tend to integrate national trading, clearing and settlement services in a vertical manner. This structure hinders the introduction of competitive post-trade services for equities listed on competing exchanges, and retards the development of truly pan-european markets. Users that choose to trade on a given stock exchange should be allowed to settle their equity transactions in the settlement system of their choice, rather than be forced to use the national CSD of the stock exchange. Otherwise, the European financial market infrastructure will continue to develop with trading platforms exercising undue influence over settlement in a vertical silo structure, which would create the worst-case scenario: duplication of expensive investments without the benefits of competition or even user-governed consolidation. Moreover, market makers in European government bonds have to comply with a multitude of local market regulatory requirements including, among others, the settlement of primary market transactions in the local CSD. These rules preclude market makers that are active in several countries from realizing the cost savings derived from settling trades in fewer settlement systems. In addition, several European countries still require the involvement of a local credit institution to ensure the application of withholding tax on outbound dividend and interest payments, and/or to offer withholding tax relief. This imposes yet another link in the custody chain and increases the cost of cross-border holdings. The problem is exacerbated by the fact that withholding tax relief procedures vary substantially from country to country, resulting in great complexity and administrative costs for the market. This is not to imply that settlement is badly managed in the individual European markets. To the contrary, domestic market settlement is generally cheap and efficient. But concurrent, albeit strong, national structures do not make for a good pan-european structure. While a significant portion of eurobond and government-debt trade settlement is now concentrated in Euroclear and a few other providers, no single settlement provider currently offers a complete, pan-european equities service at sufficiently low cost. Vertical integration per se is not harmful as such. Insofar as it ensures efficient flows from trading to clearing to settlement, it can reduce costs and risks. What is harmful, however, is exclusive vertical integration (where a trading platform or a central counterparty forces users to use a single settlement platform), which prevents users from choosing other settlement platforms, even if they are more secure, more efficient and cheaper. This is likely to be the case when the owner of the settlement provider is a stock exchange that is competing with other exchanges or trading platforms. We strongly believe that maintaining an open architecture, where links can be established to connect with any stock exchange or central counterparty in Europe, will fuel a natural process
9 of consolidation where STP is achievable without having to build a vertical silo. THE BENEFITS OF CONSOLIDATION Concentrating cross-border settlement activity on the books of a single settlement provider can make cross-border transactions as cheap and efficient as domestic transactions. Electronic bookentry settlement of a transaction between two counterparties on the books of Euroclear, for example, costs as little as US$ 0.50. Settlement occurs instantaneously on a delivery-versus-payment (DVP) basis. To settle a cross-border transaction where only one counterparty is a member of Euroclear will require the involvement of a local settlement agent and can cost anywhere between US$ 5 and US$ 30. Furthermore, the transaction may take several hours to achieve finality. It also entails friction risks and costs, for example, with respect to credit. The tangible benefits of consolidation were amply illustrated in December 2000, when Euroclear in-sourced from the Irish authorities the CSD role for Irish government bonds. As a result, Euroclear was able to immediately reduce - by 83% - its tariff for the settlement of trades in these securities. Further evidence can be seen in Euroclear Bank's recent announcement to offer book-entry settlement for French equity trades, following its merger with the French CSD, thereby generating savings of up to 90% for its users. Euroclear aims to consolidate settlement of domestic and cross-border transactions, in both bonds and equities, onto a single system. In effect, this will eliminate the price, speed and efficiency distinctions between cross-border and domestic settlement. Consolidation will also reduce credit usage by users and makes it easier and more efficient for them to manage their large pools of centralized collateral for cross-collateralization, central counterparty or monetary policy operations. In addition, service providers can take advantage of consolidation to broaden the range of services they offer, and their clients can exploit the complementarities that arise from concentrating their settlement activity in one place. For example, settlement infrastructure consolidation has reinforced Euroclear's role in new issue and post-trade settlement services for Euro Commercial Paper. Initiatives such as EPIM, an automatic system for allocating ISIN codes to new issues, jointly developed by Euroclear, Clearstream and the Depository Trust & Clearing Corporation, will exploit the synergy of service offerings. Moreover, settlement service providers are expanding beyond bonds and equities to offer services for other types of securities. FundSettle, Euroclear's platform that automates STP order processing and custody operations for fund transactions using standardized order-input formats, is a good example of this trend. INITIATIVES UNDERWAY Euroclear has been successful in reducing cross-border transaction costs for fixed-income transactions, with about 90% of the business at Euroclear settling on a book-entry basis on Euroclear's books. Various initiatives are now underway to implement book-entry settlement for cross-border equity trades. Euroclear, SegaInterSettle and Crest have achieved this in the settlement of virt-x trades. Once book-entry equity trade settlement is widely in effect, cross-border transactions would cost a fraction of what they cost now. The process can be done via a central counterparty (CCP) or on the settlement provider's books. Euroclear believes that the most effective solution in Europe is to 'internalize' transactions,
10 Domesticating Cross-Border Settlement i.e., to have settlement occur on the books of a consolidated service provider. Then, whether transactions are cross-border or domestic will no longer matter. At first, stock exchanges were hesitant to create feeds to settlement providers outside their home market, as this might weaken the position of their national CSDs (particularly as many national stock exchanges own the national CSD). Clearly, there were, and still are, political ramifications to consider. Nevertheless, several major stock exchanges have agreed to put in place arrangements allowing their users to settle equity trades on a book-entry basis in Euroclear. Besides Euronext, whose traditionally domestic CSDs are now part of the Euroclear group, this trend is emerging elsewhere. The London Stock Exchange decided to establish a feed to Euroclear, in addition to Crest, the UK's national CSD, almost one year before Euroclear and Crest agreed to merge. Virt-x's offer of settlement choice among three settlement systems is also a good example of the evolution towards user choice for the settlement of stock exchange trades. The consolidation of trading activity to larger but fewer exchanges or trading platforms will create deeper pools of liquidity in each, the cumulative effect being a cohesive market that rivals the US. The consolidation of trading platforms does not only mean merging national stock exchanges; it can also involve merging trading activity for different sorts of securities within an umbrella organization. A recent example is the creation of Euronext from four national stock exchanges, while integrating LIFFE. The consolidation of national stock exchanges is likely to have a leveraging effect on policymakers and regulators to harmonize market rules and practices. The creation of a single order book at Euronext, so far the only trading platform to create a cross-market set of trading standards, is a good model of how market forces can influence these decisions. The adoption of common message format standards, like ISO 15022, is also a move in the right direction to streamline back-office technologies. From a clearing perspective, many in Europe are urging the development of a single central counterparty, covering all European securities, to provide the anonymous trading, netting, margincall efficiencies and risk management benefits that the European market needs. The consolidation of different trading platforms, particularly among those that have exclusive relationships with specific clearing entities, may very well serve as a catalyst for the consolidation of Europe's clearing service providers. This could help make a major contribution to the cost reductions and efficiency enhancements that users are demanding. Euroclear wants to ensure that the needs of its users are represented in the evolution of trading and clearing. Indeed, Euroclear has acquired 20% of Clearnet to guarantee the effective representation of its clients' interests. Euroclear also makes its users' requirements heard in the service offering development of the London Clearing House (LCH) through its joint governance of the European Securities Clearing Corporation, along with LCH, GSCC and representatives of LCH's users. A DOMESTIC MARKET FOR EUROPE Euroclear's merger with Crest, announced on 4 July 2002, is significant in itself in the process of infrastructure consolidation. Once the merger is completed, over 60% of the Eurotop 300 equities will be covered by the combined entity, as will about 52% of the domestic fixed-income securities outstanding in Europe and 62% of the eurobonds held in the common depositories. Based on historical results, the combined entity is expected to settle over 120 million transactions a year, worth over US$ 225 trillion and will hold close to US$11 trillion of assets in custody. The merger is also significant in that it signifies the launch of a new business model that has the potential, not only to realism significant efficiency savings for customers, but also to transform the European financial markets. It is designed to extend the availability of services from one of the European domestic markets to all of the domestic markets grouped within Euroclear. A 'domestic market for Europe' will be created by rendering traditionally cross-border transactions into book-entry transactions of eligible securities
11 between Euroclear members. By 'internalizing' these transactions, the current costs and complexities of cross-border settlement will be eliminated. Fairness and pricing transparency will be assured by virtue of the combined entity's strong user-governance principles and practices. Euroclear is acutely aware that consolidation of the settlement infrastructure in Europe will only be successful if the combined entity continues to offer all of the services currently available to all customers in the respective markets, for the same price or less. Accordingly, Euroclear will offer customers a choice between two service packages: the Domestic Service package (offering, at the same very low cost, the services provided by each of the domestic settlement systems within the group) and the Full Service package (low-cost access to international markets, based on Euroclear Bank's current multi-market service). Customers will also be free to choose the legal regime under which their securities are held: either direct ownership under the local legal regime of the relevant securities for which the combined entity acts as CSD, or indirect ownership via a pool of fungible securities held at Euroclear Bank under a single legal system. All Euroclear group customers will be able to access all of their securities, irrespective of the legal regime that governs them, via a single account. Euroclear's Full Service customers will be able to choose between settlement with payment in central bank money (either directly from the central bank or from a commercial bank backed by central bank money) or commercial bank money (provided by Euroclear Bank or other banks). Euroclear is working with the relevant central banks to ensure that all customers of the Euroclear group will be able to continue to use their existing central bank accounts to settle all their securities transactions in Euroclear. The Domestic Service tariff will continue to be based on the principle of "enhanced cost recovery", currently in use in many domestic settlement systems. The Full Service package will follow the current competitive pricing of Euroclear's multi-market service. MIGRATION TO THE NEW PLATFORM Delivering the technology platform to support the new business structure across several domestic and international markets will take time. We have already defined a high-level migration path that seeks to deliver significant benefits from 2005 without forcing customers to make costly investments themselves and to proceed in an orderly way to further platform consolidation thereafter. Today, our customers are faced with maintaining multiple interfaces to multiple CSD platforms, depending upon the nature of their trading activity. The Euroclear group's five core settlement processing systems will be migrated onto a new Single Settlement Engine (SSE) in order to deliver the advantages of the new business structure. The target date for this first phase is 2005. We have taken a pragmatic and customer-focused approach to technology integration so as to meet the following aims: Deliver consolidation and remove duplication of investment through a realistic and phased migration path; Operate effectively within the context of complex and heterogeneous local market practices in Europe; Enable all customers to enjoy early a significant part of the benefits of consolidation at the same time as obtaining full value from their current settlement interfaces and back office systems; and Be readily extendable to further (I)CSD systems.
12 Domesticating Cross-Border Settlement Using this strategy, the process of service integration will be much faster, impose less cost on users and be much less risky than alternatives proposed by other providers. The technical strategy for migration to the new platform will consist of a series of planned phases. PHASE ONE - 2005 The first stage of development of the SSE will involve identifying those functions that are core to each of these platforms and incorporating them into the SSE. This SSE will provide core settlement and payment functionality that will interact with each local customer-facing system (i.e. CREST, Euroclear France, Euroclear Netherlands, CIK (Belgium) and Euroclear Bank). Based on a preliminary analysis conducted by Euroclear and Crest, we believe that the SSE could be delivered by early 2005, from which date domestic markets could begin to migrate across to this new system. The SSE will need to reflect the complexity of the various systems with which it interfaces, in order to deliver the different forms of central bank money and commercial bank money, as well as facilitating a complex set of local deadlines and settlement practices. Non-core functions and those other functions which are only found in particular CSD platforms today will remain in the existing CSD systems during this phase: e.g. 'deliveries by value' in Crest, triparty repo in Euroclear Bank and automatic substitution in repo transactions with the Banque de France (pension livrée) in RGV. Similarly, customers will continue to access the SSE functions (as well as the functions of each (I)CSD system) through their interface with their existing (I)CSD during this phase and not with the SSE itself, using the messaging and reporting functions of that (I)CSD. It is important to note that this approach defines the character of the services that will be available during this first phase. Thus, although customers of each CSD will be able to access the full range of securities serviced by the combined entity at the completion of the first phase, the system functionality available to them will be that contained in the CSD to which they are connected today (e.g. 'deliveries by value' will only be available in Crest, triparty repo will only be available in Euroclear Bank and automatic substitution of repo contents will only be available in RGV during Phase 1). The resulting relationship between customers, the existing (I)CSD platforms and the SSE during this phase will, therefore, be as follows: This approach of building a common settlement engine for core functions while temporarily maintaining other functions in the existing CSD systems is an important feature of the migration proposal: The scope of the SSE is closely defined and, therefore, more easily deliverable; It minimizes the impact on customers' back offices and preserves the value of their investment in their CSD interfaces for a longer period; It focuses on the short-term delivery of a solution for core settlement functions where there is already a relatively high degree of harmonization in market and processing practice; and It recognizes that country-specific and other differences in market practice in each of the combined entity's domestic markets will continue for some while. Thus, there will be very limited change to existing business processing and to existing customer interfaces. Consequently, customers will continue to be able to use the combined system much as they now use their local CSD and to have information presented and transactions processed
13 much as they do now. We expect that this approach will deliver many of the benefits that our customers expect from a consolidated platform, both more quickly and with less risk than other consolidation schemes so far proposed, and without imposing significant cost of change on our customers. Those cost savings will arise because it will make it possible for all transfers within and between the combined entity's systems to become internal book entries. Thus, it will be possible for a Crest member to settle with a Euroclear France participant using his Crest interface, and yet to settle the transaction as a simple internal delivery. Even at this early stage, therefore, customers will be able to aggregate all their settlement activity in a single securities account and one payment facility, if they so choose, with the potential for reducing the costs they currently incur from segmenting that activity across several markets and systems. Once we have delivered consolidation at this level, the SSE will be the base from which the combined entity can deliver additional services such as custody, triparty repo and fail-curing securities lending and borrowing to all customers, across all of their securities positions. Together with the rationalization of the use of intermediaries, platform consolidation will allow customers to benefit from the low tariffs associated with internal book-entry settlement, provided the access is direct. We will look to harmonize customer interfaces in step with developments in market practice and standards for all customers alongside the technology consolidation, using standards such as ISO 15022 and XML. Customers will then have the opportunity of transitioning to this new standard over time, giving them access to the full range of the combined entity's services as described earlier, while decommissioning their legacy interfaces over a long timeframe. The customer interface will be developed and implemented gradually and to a timescale that is owned by market participants themselves. Customers will not be forced to abandon their residual proprietary national interfaces and business processing in the 'local CSD' until their market has decided, with us, that it is time to move forward. Our objective is real consolidation; to reach the point, expected in 2008, when there is no duplication of group functions, where each standard function is delivered by one integrated process accessed by one common interface. PHASE TWO - 2005 ONWARDS Beyond the delivery of the SSE, the combined entity will work to deliver further technology integration and benefits to customers. In particular, the other sub-systems operated in Euroclear Bank and each domestic CSD will be integrated and expanded, for example, for corporate action, central counterparty support and issuers' services. The choice and development of such sub-systems to interface with the SSE will be based on objective selection criteria such as value to customers, performance, functionality and ease of maintenance. Moreover, it will leverage existing software available in the various partners of the combined entity to the greatest extent possible, so as to minimize development cost and time. SAVINGS IN (I)CSD CHARGES Consolidation of the settlement infrastructure in a group that is user governed, and which seeks to lower fees and costs for users rather than just maximize shareholder benefits, can and should reduce these costs very substantially. Migrating to the SSE will allow cross-border transactions to be processed as internal book-entry transactions and, therefore, charged as internal book-entry transactions.
14 Domesticating Cross-Border Settlement Reducing transaction tariffs from the levels ordinarily associated with cross-border deliveries to those of domestic deliveries could result in savings in some cases of over 90%. Illustrative examples for the potential for tariff reductions are set out in the table below. These are indicative of the level of savings that customers should expect from the successful implementation of the new business model. Customers themselves can compare their current costs with the indicative range set out above and reach their own conclusions about the direct and tangible cost benefits. A tangible indication of Euroclear's commitment to price reductions, as a result of effective mergers, and therefore also of the trend for the future, can be seen in the recently announced reduction in the cross-border tariff between Euroclear Bank and Euroclear France, making them up to ten times cheaper. SAVINGS IN BACK-OFFICE COSTS The second area of cost savings for customers is in their own back offices. As stated earlier, a large part of these costs arises from having to maintain interfaces to several different (I)CSD platforms whose technical specifications, messaging arrangements and methods of operating are mutually incompatible. This means that the investment a customer makes in interfacing with one (I)CSD can rarely be re-used when interfacing with another. For many customers, the prospective cost of interfacing to another (I)CSD in a market where that customer's activity might be quite small altogether outweighs the benefits of doing so. Our proposal for the creation of the SSE and the progressive integration of other functions on a new common platform will remove many of these barriers and thus enable customers to reduce their own back-office costs. As noted above, the Giovannini Group and CEPS Reports suggest that these back-office costs are substantially higher than the fees charged by (I)CSDs. The new business model also seeks to deliver synergies through lower operating costs and avoidance of future duplicate investment, allowing the combined entity to deliver new services at a lower cost than would otherwise have been possible and wherever possible to reduce fees for existing services. It is self-evident that developing and operating one sophisticated settlement system will be cheaper than three through: Operating fewer data centers (live and stand-by); Rationalizing CSD links and international operations; Combining purchasing power in procurement; Rationalizing common support functions and back-up arrangements; and Reducing the number of costly upgrades of proprietary systems that reach the end of their investment cycle. As described earlier, the first phase of the technology migration will provide the basis for transforming cross-border trades into internal book-entry movements through the use of a single securities account. As a result, the capital cost allocated to the settlement activity of customers could also be reduced significantly. CHOICE, CUSTOMER FOCUS AND CREDIBILITY A single European platform operating a single, rigid settlement and custody service would not meet the needs of all its customers. The consolidation of European settlement systems should not reduce competition, but should create the conditions that allow other providers of value-added services (e.g. agent banks, lending and borrowing intermediaries) to compete with each other and with the (I)CSDs. By 2005, Euroclear aims to have in place a single settlement engine for the five CSD markets
15 for which it acts as local CSD. Euroclear intends to continue to offer settlement, custody and related services for a broad range of securities transactions, including eurobonds and domestic securities from close to 30 markets for which Euroclear does not serve as sole CSD. The new system will be characterized by choice, customer focus and credibility. Existing and future customers will have a choice of: Service packages to suit their individual requirements; Holding and transferring securities in a domestic framework under local law or within an international service under a single legal regime (i.e., Belgian law) as is provided today for Euroclear Bank clients; Banks for the provision of credit and liquidity; and Central bank or commercial bank money for settlement. As Euroclear is both owned and governed by users, the commitment to customer focus will be reinforced by the creation of Market Advisory Committees in Ireland and the UK, joining those that already exist in Belgium, France and the Netherlands. These committees, having a formal status under the Articles of Association of Euroclear Bank, will serve as a primary source of feedback and interaction between Euroclear and the user community. There will also be a concentrated effort to include more market consultation on future developments. To deliver a program of this scale requires credibility. While we do not underestimate the challenge that developing the core of a truly pan- European settlement solution represents, our track record, in every part of the combined entity, proves that we can deliver high-quality services to our customers, on time and on budget. Infrastructure consolidation is the crucial pre-requisite for developing successful and cost-effective systems solutions that will allow the European market to develop to its full potential. Euroclear's vision for European settlement recognizes the interests of a wide range of market participants: retail and institutional investors, brokerdealers, custodians, fund managers, securities issuers, governments, regulators and competition authorities. It is based on the key principles of user governance, open access and competition. y Pierre Francotte is Chief Executive Officer of Euroclear Bank