We are seeing worldwide an accelerated pace of change in the securities and settlement market place. On the trade side, we are witnessing fragmentation of trading systems and perversely, at the same time, seeing moves towards convergence of settlement systems.
Five years ago, the London Stock Exchange would have been regarded by most UK investors as the primary trading platform for both domestic and international securities. But that position has altered dramatically in the last couple of years and this pattern is set to continue. NASDAQ is coming to London. In addition, the Trade Point Exchange, which has not been notably successful to date, may well be revitalised with the arrival of new and more powerful shareholders. The Archipelago grouping which brings in some of the larger investment banks, and the emergence of the European Trading Platform are also noteworthy developments. These will put the focus on the ‘Euro Top 300’ stocks, of which around 40% are UK stocks. So the market is fragmenting. And this is not just a UK phenomenon, it is a global one.
There are risks associated with this, such as the fragmentation of market liquidity, which could impair capital formation. But what these changes also certainly do is to complicate post-trade processing. This is happening at a time when there is also change in underlying market processes, such as the move to T plus 1 and the need for T plus 0 matching. We are also seeing an exponential increase in trading activity. These are among the factors leading to a demand for more and much faster information on trade to settlement activity. So we are heading into quite a difficult time, as there is also a major mismatch in the technological competence of market users in every single segment of the market. That differentiation in the technological competence is often a matter of competitive advantage or disadvantage. Those who are very advanced in terms of the technology curve say: “We do not want the infrastructure to meet these developments, as we want to maintain competitive advantage”. While those further behind on the technology curve say they want the central infrastructure actually to undertake such development. So there is a great deal of tension. Let us hope that it will not be as destructive, as it was in the case of Taurus!
As mentioned, on the settlement side we are seeing consolidation of depositories. To date, this has, with one or two notable exceptions, been limited to concepts. No one has actually put anything really into practice. What’s happening are not ‘simple’ mergers and alliances. The political aspects will be as hard to manage as the putting together of the nuts and bolts of integrating organisations and systems. We are talking about infrastructures in different countries with cultural, structural and legal divergences. But will custodians be redundant under these new arrangements? I believe that the announcement of our demise, which has happened many times before, is somewhat premature. The scenario whereby the centralised depositories start to become full scale custodians is really a world away. Depositories are now playing with a series of models. For example, the linkage model, where a depository links with another depository and offers the remote services through its home country – the so-called spaghetti model. Then you have integrated models, known as ‘hub–spoke’, with all common functionality in the hub and all other functionality in the spoke – this is the Euroclear model. Then there is the ‘clearing house’ Cedel model, which in reality is an integrated single service provider, much like a custodian. This model in fact is the real, if elusive, target of all depositories.
This trend to market settlement side convergence, does give rise to a number of material issues. Key is governance of systems because we have different constituencies to satisfy: such as issuers, investors, brokers, custodians and other intermediaries . We have to make sure the future mega system is robust as, if it fails, no settlement at all can take place. And it has to be stable – we have seen major increases in trading – so there has to be scalability in these systems. Around 18 to 25%, seems to be the international norm of growth in volumes. All this means we must revisit much of our traditional thinking, as it may no longer be relevant to the current environment.
The European Securities Industry User Group (ESIUG) which comprises 16–18 of the leading global firms said: “The vision we should be working towards as far as clearing systems and depositories are concerned is a single integrated process in Europe for clearing and settlement. This must offer reliability, integrity and scale-ability, and so enable reductions in investment and running costs”. Expenditures on infrastructure development in these areas have been estimated to be running at $350m per annum and this is being paid for in every single settlement.
Real concerns abound that markets are reaching the peak of their capacity. The level of trading is definitely placing stress on the external and internal systems across markets. The trade and settlement period time reduction will definitely lead to higher failures in settlements. The T plus 1 target in the US means the whole of the market infrastructure has to change, with both of the depositories there having to re-engineer. This means that the users will have to re-engineer as well. And T plus 1 will require that everyone examines and upgrades their contingency procedures in addition. The International Securities Services Association is beginning to scrutinise these issues with the aim of defining from a practitioner’s perspective what changes need to happen in the future in market processes. They are looking to produce a series of principles , a modern equivalent of the landmark G30 recommendations on clearing and settlement .
So what is happening in the world of custody itself? We really are seeing a consolidation within the industry, from two main angles. The first are the moves to consolidate among the billion-dollar custodians, while the second is the change occurring in the big custodian utilities, such as the depositories. But the danger in many of these restructurings is that they can mean management taking their eyes off the ball in the core operation, which in fact is undergoing its own re-engineering at the same time. So we are entering into a higher risk world. The changes in the industry is another factor adding stress to the system.
The changes at the International Central Securities Depositories at Cedel in Luxembourg and Euroclear in Brussels are very meaningful. They are all key to the market infrastructure and must not fail either in terms of process integrity or service quality. The market is dependent on these utilities to a much greater extent than other suppliers for they are effective monopolies and there are no, or limited, alternatives in each market. The ICSDs and other depositories, do not operate in the competitive world of the custodian. They offer a different service to that provided by custodians, The utilities focus on efficient markets, and it is much easier to offer services in, say, Switzerland than in many emerging markets. They tend to be more supply – centric than customer focused – they provide a menu and you have to take it or leave it. And there are serious limitations on the duty of care side. Their capital base is limited. These are organisations that cannot take on any risk and so they either mutualise or have to limit their duty of care.
The depositories are not, and could not be, taking on the custodians. They provide wholesale services to that sector which in turn is changing. The custodians are moving up the value chain in the face of the trend to back office outsourcing.
The current global moves on enhancing matching infrastructures is bound up with the industry’s “Global Straight Through Processing Association” (STP) initiative. It is one of the key catalysts for much of the process change mentioned. We do not know if this initiative will succeed, but we do think it will change the technological and business framework in the market. We are going to a T plus 1 environment, we have to change the matching environment. The Global Straight Through Processing Association model is the only model that has custodians, investment managers and broker dealers around the same table trying to find a common solution to the matching and post trade pre settlement problems. This is why we are supporting it and why it is symbolic of a cultural shift that will facilitate the move of post of trade processing into the modern age.
John Gubert is head of group securities services at HSBC. This article is based on a speech to clients at a recent markets briefing staged by HSBC's Global Investor Services