The publication last August of a consultative report by the Committee of European Securities Regulators and the European System of Central Banks (CESR-ESCB), threw fuel on the flames of an already bitter dispute between European banks and depositories centring on what the former characterise as the latter’s wholly inappropriate commercial aspirations (see IPE passim).
Now, after what CESR disingenuously describes as “conflicting comments” on the part of market participants - ‘rejection’ and ‘fury’ would perhaps be closer to the mark - the CESR-ESCB working group has issued a revised draft of the paper.
Based on the existing International Organisation of Securities Commissions and the Committee on Payment and Settlement Systems (IOSCO-CPSS) recommendations for securities settlement systems - issued in November 2001 - the original CESR-ESCB report offered up 19 new standards which sought to “increase the safety, soundness and efficiency of securities clearing and settlement systems in the European Union”.
It was the CESR-ESCB working group’s proposed application of specific standards not only to depositories but also to those major custodian banks ascribed to be operating ‘systemically important systems’ (SISs) or possessing “a dominant position in a particular market” that prompted the ordure to hit the fan.
The outrage engendered by the yoking together of depositories and custodians in this fashion - whereby the latter would be subjected to Central Securities Depositaries (CSD) standards in respect of governance, transparency and client access - was exacerbated by the suggestion that all intraday credit extended to market participants by operators of SISs should be fully collateralised.
The Association of Global Custodians (AGC) maintained “additional regulations that may be appropriate for depositories, as the infrastructure components of the EU clearance and settlement system are neither necessary
nor appropriate for highly regulated custodian banks”.
For its part, lobbying group Fair & Clear, set up by those European agent banks non-plussed by the competitive and risk implications of the infrastructure providers’ expansionist tendencies, argued that the ESCB-CESR proposals contravened the Giovannini Group’s key criteria of cost efficiency, prevention of systemic risk and fair competition.
As one custodian told IPE: “Institutions should be able to choose their own level of risk - having it forced upon them is not right. This is a sledgehammer that doesn’t recognise that, in terms of acceptable risk, this is a three level market - private investors, advised private investors and professionals. The risk tolerance increases as you move up through those categories, and so different levels of regulation are appropriate.” The custodian added that in a worse case scenario “securities transactions might be driven offshore or into different markets such as ADRs”.

To add insult to injury, after much obfuscation, it finally emerged late last year that the panel of market experts appointed by CESR (as per its usual practice) to advise it on whatever subject is currently under review, was overloaded with representatives from depositories and exchanges - namely Euroclear, Clearstream and five other infrastructure organisations - but wholly bereft of any custodians. Moreover, both the International Central Securities Depositaries (ICSDs) must already collateralise open transactions. Coincidence, or evidence of bias? You be the judge.
However, in urging the collateralisation of all open transactions - which would mean that banks would only be permitted to finance their clients if they took collateral, in the process taking a hit of “seven to eight basis points per transaction”, according to one custodian - the new standards reveal the imprimatur of not CESR, but rather the ESCB.
That body may draw its powers from European treaties and protocols that cover payments systems as opposed to the securities industry, but as John Gilchrist, founder and managing director of Luxembourg-based consultancy reGEN, has noted: “The ESCB is taking a strong interest in securities settlement systems precisely because the pan-European payment system (TARGET) is dependent on collateral mobilised by SSSs to mitigate risk in real-time gross settlement payment systems.”
Gilchrist points out that the primary concern of both the ESCB and the European Central Bank is to ensure financial stability and efficiency, and therefore the avoidance of systemic risk in the Euro-zone and euro. “Securities clearing and settlement is now real-time, with the simultaneous exchange of cash and securities,” he adds. “Coupled with the vital role played by an SSS in collateral movements for monetary policy operations in the Euro-zone…essentially settlement and payment systems have become interlinked and dependent.”
If that explains why the ESCB
is focusing on the efficiency and
safety of European settlement systems/depositories, how have custodians got dragged into the equation? It would appear that Fair & Clear’s efforts to persuade the powers that be that Euroclear and its ilk should be subject to the same regulatory burdens as the banks has backfired rather spectacularly.
Fastening on the statistic that the Fair & Clear banks handle some 80% of European cross-border equity settlement volumes, CESR-ESCB has decided that a significant portion of these flows are ‘internalised’ on custodians’ books. Accordingly, they should have to comply with the same new, ‘one size fits all’ standards as settlement systems and central counterparties.
“Why should CESR-ESCB stop at custodian banks?” asked Gilchrist.
“Do broker-dealers not ‘internalise’ their order flow and therefore their
settlement arrangements? Is that systemically important or does it give rise to public policy concerns? If a stock exchange introduces self-clearing
or combines trade execution with netting and central counterparty functions, as Jiway did, does that not concern financial stability?”
The standards would lead to “consolidation and polarisation”, with smaller banks being forced to outsource or exit in the face of unsupportable compliance costs. “The result will be fewer but larger banks, almost certainly the main actors in the Fair & Clear group plus Euroclear Bank,” he said. “They should embrace the concept of new standards, and so respond positively to the CESR-ESCB consultation document, for they can gain competitive advantage from their status as ‘regulated’ securities settlement and clearing intermediaries.”
However, BNP Paribas - along with Citigroup one of the Fair & Clear’s leading lights - clearly had no truck with that sentiment: its response was to issue a comprehensive and robust repudiation of the ESCB-CESR proposals and the ‘mixed function’ model wherein depositories mix infrastructure and intermediary banking services.

While BNP welcomed the standards as “a step towards a better regulatory framework for the infrastructures on which EU clearing and settlement depends”, it drew a clear distinction between custodian banks and depositories. Attempts to regulate both camps in the same ways would “distort the competitive environment” because the functions performed and the nature of the risks undertaken is different.
The concept of ‘systemically important banks’ is relevant only in the context of business continuity planning, and custodian banks should be removed from the standards since they are already regulated in respect of all risks connected with their settlement business, including credit and operational risk, BNP maintained.
As for the collateralisation issue, BNP noted that the specific rationale requiring ICSDs to collateralise all credit exposure derives from the decision by the ESCB to make some Eurobonds eligible as collateral for the Eurosystem monetary policy operations “in order to mitigate, to the largest possible extent, the currencies banking risk so created”. The ‘generalisation’ of this specific requirement by CESR-ESCB across all financial intermediaries “is inappropriate and missing the point”.
The bank noted: “As a core principle, a custodian bank must retain the right to select its portfolio of clients (and hence credit risks) and monitor them as appropriate. We believe the CESR-ESCB Group should demonstrate the added value of the proposed standards…which in effect would increase the cost for the market, seriously reduce market liquidity and eventually foreclose those banks deemed ‘systemically important’.”
An initial perusal of the 94-page revised consultation paper issued at the beginning of May suggests that CESR-ESCB has taken the criticism on board, although critics will argue that it still falls short of demonstrating that elusive added value. Standards 14 and 17, covering market access and transparency respectively, now mention only CSDs and CCPs, the reference to “custodians with a dominant position in a particular marketplace” having been deleted. Standard 13 has been subtly re-worded to make it more clearly applicable just to depositories and CCPs.
However, Standard 6, covering the regulation of CSDs and one of the key bones of contention, remains largely unchanged; only the admonishment that “in order to minimise systemic risks, depositories should avoid taking risks to the greatest practicable extent” has been removed. The current bland wording will do nothing to allay the banks’ disquiet over the ‘mixed function’ model.
Standard 9, covering collateralisation, has been significantly reworked. Instead of it applying to all ‘systemically important systems’, the new wording clearly splits up CSDs and custodian banks. “For those custodians which operate systemically important system, and in order to contain the systemic risks that are linked to their securities settlement activity,” it now runs, “national securities regulators, banking supervisors and overseers should address the risk mitigation policies in order to ensure that they are in line with the risks the custodians create for the financial system.”
Unfortunately, CESR-ESCB then adds the following caveat: “In particular, the possibility to increase the level of collateralisation of their credit exposures, including intraday credit, should be envisaged.” In other words, one step forward, one step back. CESR-ESCB does concede, however, that “a number of items will require further work”, the definition of ‘systemically important systems’ among them.
The custodian community is likely to be out in force at the open hearing on the new draft report that is set for May 25 in Paris. The stakes are certainly high: as the Working Group reiterates in the latest version, “these are not simply recommendations – the transformation from recommendations to standards implies that they will be more binding in nature and the relevant authorities will apply the standards and review compliance with them on a regular basis”.