Securities Services: The indefinite article
Article 47.3 of the technical standards of EMIR is about to pose challenging questions for Europe’s custody banks. Cécile Sourbes finds out why
Details can be crucial – and yet they often go unnoticed. Take Article 47.3 of the technical standards of the European Market Infrastructure Regulation (EMIR), for example, where the European Commission recommends that any non-cash initial-margin collateral for derivative trades be held with securities settlement systems – often operated by central securities depositories (CSDs) – to ensure “full protection”.
Those recommendations come in line with the Commission’s plan to reinforce the use of CSD market infrastructure, placed at the end of the post-trade process to perform the registration, safekeeping and settlement of securities. EU policymakers argue that using a CSD enables investors to get their collateral back efficiently if one member in the derivatives chain defaults.
However, not everyone believes that holding collateral with a CSD will reduce risk. According to Andrew Lamb, CEO of the CME Group clearing house, CME Clearing Europe, CSDs do not currently offer the account structures and legal protections necessary to provide the level of client protection, especially in terms of segregation and separation, sought by institutional users of derivatives.
“We feel that a narrow interpretation at this stage of Article 47.3 ignores the comprehensive regulatory and supervisory environment already covering bank custodians,” Lamb insists. “Limiting the ability of clearing houses to enter into secure arrangements with bank custodians means significantly reducing the number of institutions that can offer custodial services. We do not know if CSDs will in future be able and willing to modify their arrangements to offer the range of services to end-investors provided by bank custodians today.”
Pension funds argue that, without account segregation, in the event of default their collateral could be lost by being wrongly seen as part of the estate of the party defaulting. Some central clearing counterparties (CCPs) have responded by signing ‘quad-party’ agreements, signed between the CCP, the custody bank, the clearing member and the end-user client, which enable the latter to keep track of its assets and transfer them automatically if a clearing member or a CCP defaults.
But here is the issue: present quad-party agreements only include custodians and make no reference to CSDs. Earlier this year, CME built up an industry group comprising custody banks and end-user clients to urge the European Securities and Markets Authority (ESMA) to shed some light on Article 47.3, hoping for greater flexibility on the settlement of cleared OTC trades by custodians.
But in a questions-and-answers document released in March, ESMA was unambiguous: “Depositing financial instruments with an operator of a securities settlement system via a custodian does not constitute a deposit with an operator of a securities settlement system for the purposes of Article 47.3 of EMIR.”
Understandably, custodians are angry. Laurence Caron-Habib, member of the public affairs department at BNP Paribas Securities Services in Paris, argues that ESMA’s position seems at odds with the competition objective set out by the EC, and could also create new sources of risk.
“Instead of reinforcing end-investor protection, the interpretation of ESMA on article 47.3 could result in increasing concentration risk for their assets under custody and operational risk due to the new complexity,” she argues.
Equally understandably, CSDs are pleased by ESMA’s stance – and are holding out the olive branch to their custody-bank friends. For example, Saheed Awan, head of collateral services at Euroclear, which operates the national CSDs of Belgium, Finland, France, Ireland, the Netherlands, Sweden and the UK as well as the ICSD Euroclear Bank, points out that his firm has enhanced its tri-party collateral management platform and that custodians and CCPs are already plugging into it.
“This ‘collateral highway’ now has the largest number of CCPs ever assembled in a single collateral management infrastructure and the largest number of both clearing members of different CCPs and the custody banks of the buy-side,” he claims.
A custodian using the Euroclear ‘collateral highway’ will have determined in advance with the clearing member how much margin should be posted by the end-user client for a trade.
The CCP then sends the margin call to the clearing member, before the latter passes the margin call on to the buy-side – for instance, a pension fund. Once the pension fund agrees on the amount of collateral to be posted, it informs its custodian to meet the margin call.
“That’s where Euroclear steps in,” Awan explains. “If the non-cash securities of the clients are held in Euroclear, the custodian only needs to instruct Euroclear to deliver those assets into the client clearing account with its clearing member. The margin from the buy-side is delivered into a CCP’s physically segregated third-party pledge account. Such an account is bankruptcy-remote from the clearing member who is given a security interest over the margin pledged.”
This is not dissimilar to the CCPs’ quad-party agreements, except that Euroclear, as the CSD with the clearing members, CCPs and custodians all as clients, becomes the ultimate link in the derivatives chain. So even though Awan stresses that the Euroclear system does not eliminate custody banks from the chain, their role could be diluted, should market players turn directly to CSDs to settle their trades.
CME Clearing Europe is supportive of Euroclear’s initiatives and is currently seeking to plug into its platforms. Nonetheless, it voices general concerns over CSDs’ lack of readiness.
Tina Hasenpusch, executive director in clearing solutions at CME, argues that today the main users of these platforms are banks. The buy-side is not directly participating.
“We are working with both traditional and new CSD entrants to expand our full segregation offering for buy-side clients,” she says. “But our concern around Article 47.3 is about forcing the entire market into a structure which, while it undoubtedly works perfectly well for one segment, for other segments such as asset managers and pension funds, [may not be the most] cost and risk-efficient.”
The solution for custodian banks might be to open a CSD business line, following the example of BNY Mellon (see case study). However, most custodians have looked down this path only to abandon their plans due to the administrative and cost burdens.
Many first considered such projects in 2011, when EU policymakers started to define their vision of a common settlement platform. At the time, the European Central Bank (ECB) developed its Target 2 Securities (T2S) project, which sought to address the complexity of the current system that involves at least two CSDs and often also one or several custodians, as well as the problem of national monopolies.
Under T2S all CSDs in Europe will interact with one common platform, with a view to making cross-border settlement identical to domestic settlement in terms of cost, technical processing and efficiency, and a single set of rules, standards and tariffs being applied to all transactions. The migration to the T2S platform is planned for 2015-17.
The project appealed to derivatives market players who anticipated a more transparent system and lower settlement fees. On the other side, it also means new market opportunities for companies offering access to the system.
“End-investors will benefit from T2S in two ways,” says Alain Pochet, responsible for clearing, custody and corporate trust services at BNP Paribas Securities Services in Paris.
“First, their custodian intermediaries will have the ability to manage the settlement of collateral in the most efficient ways, meaning settlement services will become cheaper.
“Second, having only one system for most of the securities in Europe will bring a lot of efficiency in terms of liquidity and collateral requirements.”
But there is an obvious snag for custodians. For simplicity, the ECB states that only CSDs should be able to connect to the T2S platform. Custodians will have to rely upon CSDs to gain access.
Whichever way you look at it, as regulators increasingly aim to make CSDs the centrepiece of the EU settlement market, it seems that the role of custody banks in the OTC derivatives post-trade process will change drastically in the near future. Taking the decision about how to adapt to that change will be a very big call for all of them.