Anthony Harrington looks at the introduction of the Europe-wide Target-2 Securities settlement engine for securities transactions
At a glance
• Migration to T+2 happened in October 2014.
• The current shift is to TARGET-2 Securities (T2S), the Europe-wide settlement engine.
• Testing is expected to start in February 2017.
In the aftermath of the global financial crisis the European Commission (EC) decided to address Europe’s conflicting national transaction settlement regimes for securities trading. The fact that each national exchange and the related central securities depositories (CSDs) had different regulations and opening hours made settling trades across European borders inefficient and expensive. Worse, the conflicting requirements exacerbated counterparty risk.
The patchwork of national regulations bearing on securities settlement also hindered another project. That is the introduction of a Europe-wide settlement engine for securities, TARGET-2 Securities, or T2S. While there were many inconsistencies across the settlement regimes, the EC’s attention focused on harmonising the time for settlement. Other inconsistencies would be resolved along the way.
Back in 2008, Germany was on a T+2 settlement date (trade date plus the next two business days) while Europe was on a T+3 settlement schedule. Since T+2 was more efficient and cuts counterparty risk by a third, it was decided the rest of Europe would move to T+2.
The T+2 migration happened in October 2014, which in turn paved the way for T2S, the Europe-wide settlement engine, which is currently being rolled out. With T2S, settlement is in central bank money, with the main CSDs having accounts at their central bank, all of which are either already on, or will soon be joining, the T2S platform. T2S gives all players involved in settlement access, directly or indirectly, to a single, common settlement platform. That makes for a higher level of efficiency.
Also, because settlement is done in central bank money, counterparty risk is virtually eliminated since failure would be at the level of a national default, rather than a single trading entity or CSD.
“The biggest securities trading firms in the US are also very active in Europe, so a lot of the learning from the European T+2 project is being applied to the US project”
As things stand, Europe and most of Asia are on a T+2 settlement regime while Japan and the US are still on T+3. However, as John Abel, executive director, settlement and asset servicing strategy at The Depository Trust and Clearing Corporation (DTCC) explains, the US has a project to move all market participants to T+2 by early 2017, while Japan plans to move by 2019.
“The biggest securities trading firms in the US are also very active in Europe, so a lot of the learning from the European T+2 project is being applied to the US project as well,” he says.
The DTCC expects testing to start in February 2017, with six months of testing, completing in about August 2017. The implementation date for T+2 in the US is expected to be September.
From the perspective of an investment manager and its clients, T+2 and the T2S projects are part of the plumbing and not something to concern themselves with, apart from some systems adjustments. Tony Freeman, executive director of industry relations at DTCC points out that settlement was something that investment managers left to whoever was providing custody services.
However, there are benefits for buyside firms, besides the reduction in counterparty risk. In 2012, the DTCC commissioned Boston Consulting Group (BCG) to carry out a cost-benefit analysis of what could follow from knocking a day off the T+3 settlement cycle. After interviews with market participants, BCG found that the cost to a large US buyside firm of moving to T+2 would be about $1m (€900m). Much of this would be automation costs and standardisation to enhance interfaces with broker-dealers and custodians.
The primary benefit would come from what BCG termed “attenuated loss exposure associated with market risk on in-process institutional trades”. Quantifying this is impossible, since it is hard to put a monetary value on achieving a higher level of confidence in the system. Broker dealers and custodians, on the other hand, gain operational savings, much easier to quantify.
For the US industry as a whole, BCG estimated that the payback period for the cost of moving to T+2, would be three years.
As things stand, with the US still on T+3 and Europe on T+2 there is a cost to investment houses. “If you want to sell US securities in order to invest in European securities, you can do the trade instantly,” says Freeman. “But you have to find funding to cover the day’s settlement lag from the US, since your European trade will complete in T+2, but you won’t get the cash from the US trade until T+3”.
Buyside firms understand this and it is not painful for them. However, they will enjoy the fact that the funding requirement vanishes once the US joins Europe on a T+2 settlement cycle.
For the industry, much of the benefits with T2S have to do with the improvement in efficiency that comes from having a platform providing a single pool of securities right across the EU. Ultimately, this will lead to lower trading costs in European securities. However, this reduction is likely to take years to come through. Tom Casteleyn, head of product management for custody, cash and foreign exchange at BNY Mellon, and its T2S expert, points out that many of the players involved have had to make a significant investment to implement T+2. They will need to recoup their capital investment before handing cash back to customers.
BNY Mellon has invested more than most, Casteleyn says, because it has used the move to T2S as a catalyst to change its strategy in the euro-zone market. BNY Mellon used to interact with the euro-zone via a mix of sub-custodians and direct connections to the main global custodians. It is now shifting to connect direct to the T2S platform as a direct account holder.
“We are now direct with the Netherlands and Germany, and we are in the process of moving to a direct connection with Italy, France, Belgium and Spain. This has made the T2S project a lot more complex for us than it is for the average global custodian, but the benefits will be much more significant as well,” Casteleyn says.
Central counterparty organisations (CCPs) have had to adjust their systems to link either directly or indirectly with the T2S platform. EuroCCP, the European Central Counterparty, formed in 2013 from the merger of EuroCCP and the European Multilateral Clearing Facility provides services in 19 countries. It aims to provide low-cost equity clearing and settlement services throughout Europe.
EuroCCP chief executive officer Diana Chan says it has chosen to opt for direct connections to CSDs who, in turn, have direct connections to the T2S platforms in all 19 of the markets in which it operates. “Legally, we are the CSD’s clients, but since we connect direct to the platform through them, they are not an intermediary. We are directly connected to the settlement engine itself,” she explains.
For her, the headline benefit T+2 brings is one day’s less uncertainty in the clearing process. In practical terms, she points out, this means that trading firms have to post one day’s less collateral. “Each day in the clearance cycle is a set of open obligations that have to be fully collateralised. So you now need one third less collateral, which is significant.”
Chan notes that when, back in 2008, the EC asked the equity CCPs across Europe how much collateral they were holding from market participants, the total amounted to €5bn. In the T+2 world that prevails in Europe, one third of that sum is no longer required.
T2S brings additional benefits, she says, since a direct connection to the T2S platform makes a range of additional features available.
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