Post-trade regulation: the known unknowns

Henri Bergstrom, head of product management for CSD technology, Nasdaq OMX

The full impact of market and regulator driven changes on the post-trade industry is not yet fully understood, says Henri Bergstrom, head of product management for CSD technology within Nasdaq OMX’s market technology business.

The shift in regulatory focus from trading to post-trade continues apace. Dodd-Frank, EMIR and G20 rushed to regulate mandatory clearing of OTC derivatives products and Europe pushed it even further to regulate exchange traded products. Last year, the US had its first experience clearing OTC derivatives and Europe is moving that way as well.

CSD Regulation (CSD-R enters into force on 15 September 2014) and T2S are examples of Europe taking a lead compared to other key capital markets. CSD-R and T2S are pushing European CSDs to implement global standards for settlement and corporate action processing. Further European CSDs have agreed to move to mandatory T+2 settlement cycle from the beginning of 2015.

European CSDs are gradually linking into the T2S service – the first tranche will go live in June 2015 and there are waves of implementation through to 2017 – although interestingly, some major players have yet to announce their plans for participating in T2S.

It is unclear what their longer term strategy is, although to start with the service is focused on the eurozone and participation is not mandatory.

T2S will dramatically change the way CSDs operate – currently this service is provided by custodians with some depositary to depositary links, most of which are so-called ‘free of payment’ while others are delivered as payment links. Under T2S this will change to CSD-to-CSD links where T2S acts as cross-border facilitator. It should be noted that even with T2S, CSDs continue to have a business case in linking to other non-T2S markets in Europe and globally.

Collateral is a vital resource to support trading and clearing and T2S will support smooth and fast collateral movement between counterparties. As of September 2015 the CCBM will support tri-party collateral management services on a cross-border basis (currently such services are only supported domestically in the context of Eurosystem credit operations).

EMIR states that CCPs need to have their collateral assets with a direct relationship with CSDs. To establish or continue this business, CSDs should develop business relationships with CCPs in need.

There are some observers who doubt whether T2S will ever gain traction, but despite the inevitable challenges and issues I am confident that it will become the primary mechanism for managing Europe-wide portfolios and collateral.

One of these challenges relates to pricing and revenues. While pricing of T2S services has been agreed, there are some doubts as to whether T2S can keep to the prices they have promised long term. Also, capital markets have moved from securities based trading to derivatives and this has impacted revenue forecasts. As a result of this, according to sources, the ECB has approached non-European markets to see if T2S or components of it could be used to develop new T2S customers.

Service fees in some European CSDs have risen to reflect increased investment and this represents a challenge for the industry. However, the main business functionality and flows have been decided and I don’t see any major issues in relation to business processes.

A report published by Celent last year referred to the fragmented nature of the European post trade ecosystem and the coexistence of different market practices and messaging formats as one of the key pain points in the T2S adaption scenario. The report suggested that financial intermediaries need to devise an efficient and cost effective adaptation programme to realise the benefits of T2S.

Standardisation will drive efficiency, whether that is using ISO or Swift message types or acting on the findings of the Corporate Actions Joint Working Group. This would not only allow CSDs to offer their services seamlessly across Europe, but also to increase straight through processing of different transactions.

That would have two main impacts – firstly, interfacing with other service providers (either horizontally or vertically) would become much easier; and secondly, process automation would increase organisational efficiencies and reduce the number of failures or faults.

At the European Clearing & Settlement Conference in late June it was clear that there was some understanding of the potential consequences of CSD-R, T2S and Emir-related CSD regulation. However, I don’t believe that anyone has a full understanding of the cumulative impact of all these regulations.

Globally, CSDs have seen lower volumes in line with generally lower trading activities. As a result, CSDs have had to revisit their strategies and evaluate other business opportunities, even those outside traditional capital markets.

The likes of the London Stock Exchange (which has decided to create an ICSD in Luxembourg) and BNY Mellon’s CSD in Brussels are examples of new service offerings that combine collateral management and cash lending crediting, services that would previously have been provided by separate entities. This is a watershed in CSD business models.

The major players seem to be prepared for these changes and to have an understanding of how they will impact their businesses, but there seem to be a number of CSDs who don’t appreciate the likely regulatory impact not only on their business model but the organisation as a whole.

The CSD industry is about to see the biggest change to occur in decades and monopolies will crumble. If we take the European CSDs as an example, typically they have been monopolies and most still are – the only area where they will have faced some competition is where a listed company has taken a listing abroad directly without doing local issuance.

They might face competition on ancillary services but the actual keeping of the accounts, managing securities issuance, settlement and corporate actions are things that by law cannot be provided by any other party.

CSD-R introduces huge changes. I have spoken to a number of these CSDs and they accept that they have not really appreciated the organisational impact of the regulation and the need to create relationships with such parties as foreign issuers, lead managers, custodians and CCPs in order to maintain and grow their business.

Competition will drive CSDs to become more customer-focused organisations. Many national CSDs are not accustomed to providing marketing, sales or services beyond their national boundaries. In order to both gain awareness and attract new business outside of their current jurisdiction and to retain the customers they already have, the addition of these activities will become imperative.

The main area of competition between European CSDs in the future will be issuance. It sounds straightforward but offering pan-European services to issuers requires considerable investment in systems and service offerings. Reaching out to foreign retail investors in their local language is certainly one of the areas to consider.

There are some obvious actions that can be taken by CSDs looking to expand their range of services and asset classes – for instance, offering any service that would allow fault-tolerant service provision, which might include automated buy-ins or SLBs (part of CSD-R regulation as well). CSDs also need to take more steps to differentiate themselves as they may become niche providers in the future.

Providing services to the mutual funds sector across Europe rather than just locally can be quite expensive because of the cost of issuing warrants in different markets. In many Nordic countries, for example, issuers might pay more than 50% of the total cost of the CSDs.

Most CSDs are already focusing on specific types of securities, such as equities as well as fixed income where they provide safekeeping services rather than managing settlement of the trades. The ability to offer well defined and diversified collateral management services will be a significant factor in the future.

In most countries we currently have a two-level system. Due to EMIR and CSD-R, segregation of investor accounts should be offered but many CSDs may have a challenge to comply with this requirement. Issuers are not only interested in the cost of general safekeeping or issuing securities – they are also interested in the cost to investors of keeping their accounts.

My understanding is that the registrars’ ability to match trades between counterparties has been very limited and when mandatory clearing begins, the problems that currently exist will be multiplied with the volume of new trades. Challenges posed include selected codes such as LEIs and UTIs, which seem still to lack comparability when reported by parties as well as the large number of other matching criteria.

There are other issues to which the industry is looking for clarity, such as the emergence of new asset classes (energy, commodities, FX) to which mandatory central clearing could apply in the future. There is also the prospect of EMIR II.

In the past regulators have pushed out certain regulations that were insufficiently mature and proposals such as EMIR II are partly a recognition of this fact, as well as being a mechanism for regulating new products and asset classes.

This is not to say that new regulations have not had a positive impact – on the technology side they have encouraged positive changes to systems. However, I remain puzzled by depositories’ IT strategies, especially that even mid-sized CSDs are typically still using mainframe technology.

This represents a significant cost burden. A non-open solutions approach to software or middleware provision adds considerably to operational costs and also affects the CSD’s ability to adapt to market changes. Technology strategy should be regularly reviewed in the same way as business strategy.