Thomas Perna outlines his model system
Participants in the European capital markets have been aware, for some time, that there are significant barriers to achieving greater European financial market efficiency, due to the fragmentation inherent in the clearance and settlement of cross-border trades. Increased diversification and globalisation has led to a rapid increase in cross-border trading, further taxing the resources of these fragmented settlement systems.
The ultimate goal of same-day, or T+0, transaction settlement will reduce risk and counterparty exposure, increase liquidity, and enable the market to absorb increased transaction volumes. Most participants agree that what’s needed is an achievable model that addresses all aspects of the cross-border transaction process, from trade execution to settlement, creating true straight-through-processing for European transactions. This can be attained only through efficient, secure, real-time, cross-border trade execution and settlement in all markets. The current European infrastructure is not equipped to handle a shortened settlement cycle, and increased transaction volumes, without a major overhaul.
The information needs surrounding securities processing can be categorised into three levels. At each level, the current model for cross-border trades is a complicated, sequential process, involving notifications, allocations, confirmations, matching and affirmations, and settlement instructions among multiple participants. As settlement cycles continue to contract, this sequential settlement model will no longer be feasible, particularly for cross-border trades. It will need to be transformed into a parallel processing model, where all processes become interactive. The current inefficiencies imbedded in each part of the settlement cycle at each level will have to be addressed and corrected if there is to be any chance of shortening the settlement cycle.
The first level, involving investment managers’ communications with their broker/dealers, entails pre-trade notification and trade execution.
At the second level investment managers allocate transactions to underlying investors/accounts, and broker/dealers confirm the transaction for the manager to review and affirm.
The third level extends beyond the investment manager and the broker/dealer. The broker/dealer sends settlement instructions to its clearing agent, while the investment manager sends settlement instructions to its global custodian.
It is not until this point that the global custodian instructs its subcustodian in the local market. A further step which must be taken, either by the global custodian or sub-custodian, is to notify the local CSD, after which local matching and trade settlement can occur.
In evaluating the various models proposed to enhance transaction settlement efficiency, we first need to specify the key costs and benefits produced by each model, who is impacted and in what way.
Most participants agree that the current structure is inefficient, and an alternative or alternatives are needed to decrease both the risks and costs of participating in the European capital markets. The ‘open protocol messaging’ model covers only the first level of the transaction process, and is intended to streamline the information flow between investment managers and brokers, through electronic communication of indications, orders and executions. As an open message standard, it can be structured to match the business requirements of any user. Both the costs and the benefits principally accrue to brokers and managers, who are able to reduce the amount of telephone and fax communication, but must bear the cost of putting the necessary links in place.
The ‘transaction flow manager’ model covers information flows in the second level of the settlement cycle, and involves all participants in the trade process. In essence, this model calls for simultaneous, real-time cross-border trade instruction, confirmation and matching among investment managers, brokers, cash correspondents, clearing agents, and global custodians. The logic is seemingly irreproachable: if all participants know the same thing at the same time, the likelihood of error is reduced. However, this model fails to address the necessary local market instruction and matching portion of the transaction process.
The majority of the costs associated with this model will be borne by broker/dealers, investment managers and global custodians, who will have to build the necessary links to support the real-time information flows demanded by this model.
The Local CSD Multi-Link model covers only the third level in the transaction process, and concerns mainly global custodians, local custodians and local CSDs, as well as broker/dealers who are concerned with access to the local markets. By comparison to the current system of multiple-access to local market CSDs, the major benefit of the multi-link model lies in the direct linkages among exchanges and the potential for investors to access the European market through a single interface.
On its face this model appears to enhance efficiencies and provide economic gains. However, it is highly complex, and will require enormous investment by the local CSDs to effect all of the linkages necessary. Furthermore, any benefit to be realised would depend on the number of local CSDs that agreed to participate in the network. Local CSDs are the primary beneficiaries of the system, since they gain an enhanced role in processing transactions for international and local investors and traders.
The ‘hub-and-spokes’ model proposes that, rather than each domestic CSD developing bilateral links with one another, they access one another’s markets via a single International CSD or ‘hub’. While this model eliminates the need for multiple links, a major concern voiced by market participants is the prospect of a monopoly held by the ‘hub’ ICSD, possibly negating any cost-savings. The primary beneficiaries of this system are investment managers and broker /dealers, who would have direct access to the ICSD, removing the need for multiple CSD access.
By comparison to the ‘hub-and-spokes’ model described above, a
fully fledged Eurohub (or Super
International CSD model) would allow all local investors to sidestep domestic CSDs and route all their domestic and international trades through a centralised clearing agent.
This model provides local-market direct-access in its purest form, and is the best able to generate economies of super scale and scope in settlement and clearance. Another benefit is that a single set of settlement rules would be imposed on all participants, significantly reducing information and transaction costs for all concerned.
A Super ICSD would alleviate many of the costs associated with international investing, making internationally diversified portfolios easier and less costly to achieve. Market participants would avoid local CSDs with their variable settlement and priority rules and restrictions and benefit from the associated economies of scale and scope. Ideally, in order to avoid concerns over monopolistic pricing practices, a Super ICSD should be user-owned and controlled.
Participants in the European capital markets need to identify the leadership which will grasp hold of the confusion surrounding the myriad models proposed and the multiple interest groups involved. There should be no consideration given to individual institutional or political issues which may influence the development of an efficient, secure, rational settlement system that will further promote capital markets activity in Europe.
Thomas Perna is senior executive vice president at the Bank of New York