The evolution of adding value
By Frederic Hannequart (Executive Director, Euroclear)
New economic, business and regulatory challenges are creating the need to re-examine conventional business models. In addition, perceptions are changing about the definitions of both value-added and core services. Is the difference growing between what people are willing to pay for and what is taken for granted? Are our regulators putting such a strain on the industry that all value-added services are doomed to become core?
Many industry professionals are asking themselves these questions. Yet, I am not sure these are the questions we need to ask ourselves as an industry.
While nobody wants more regulation, I am increasingly convinced that some of the new regulations will deliver much-needed changes to our industry. We’ll see increased transparency, reduced risk and the creation of a more competitive marketplace. On the other hand, we should be careful not to artificially restrict and constrain the businesses of national or international central securities depositories (CSDs/ICSDs).
When I look at many of the Asian and emerging markets, I am struck by how innovative their CSDs are in providing commoditised services to their local markets and governments. It seems that they have avoided prolonged debates about which services are core and not core, or which type of firm should or can take which part of the pie. We need to learn from this experience and see how we can better co-operate and innovate as an industry to reduce costs and risks so that we can make room for (new) value-added services. Frankly, if we don’t, others will.
If there is something we’ve learned from the crisis, it's that there is a lot of value in what we call “core”. For example, the industry has learned the true meaning of SAFE keeping. Taken for granted, particularly in a bull market, these services are essential for the well-functioning of our industry. When everything is going smoothly, clients begrudgingly pay safekeeping and settlement fees. But, when a counterparty or service provider is in financial difficulty, their first and only concern is to protect their assets. At that point in time, SAFE keeping is the only feature they value.
Over the past few years, securities market infrastructures like CSDs, ICSDs and CCPs have been tested like never before. At every occasion, these infrastructures have demonstrated their ability to cope with everything thrown at them. In fact, they have been solid as rocks and used as “safe havens” by market participants during the heat of the crisis.
Those infrastructure service providers with a banking license use it for very limited purposes. When credit is extended, it is only intra-day and fully backed up with liquid collateral. We manage liquidity risk just as closely. And because we recognise that infrastructures, by their very nature, consolidate risk we ensure that we have disaster recovery procedures in place which set market standards. For example, Euroclear operates three data centres – two primary and a third located hundreds of kilometres away. These are costs you don’t want to duplicate too often and, therefore, should be considered as core.
Judging by a recent European Commission report, the CSD cost component for holding securities is less than 4% of the fees paid by fund managers. At the same time, studies have estimated the total cost of custody in Europe to be around €5 billion a year. And, studies have shown that the market loses about €1 billion each year due to missed deadlines, non-executed rights, and so forth. Clearly, we have some way to go.
Setting new standards
Discussions about implementing standards pre-date the Giovannini Group reports, which have just celebrated their 11-year birthday. Progress in some areas is good. In key markets, we see 60-70% compliance with the new standards and plans are in place to achieve 90% by 2013. A key challenge will be to get issuers on board.
One of the solutions to reduce the cost of cross-border settlement in Europe is Target2-Securities (T2S). This project will commoditise what most of us would think is a core CSD business – namely settlement. Naturally, if you take away such a core function, then CSDs will be forced to explore other, more value-added functions.
T2S, as a stand-alone project, will not reduce the cost of post-trade services. In fact, it might lead to short-term increases. But, if it acts as the catalyst to force differences in market practices to harmonise, reduce technical complexities and speed up legal reforms, then T2S would be a big leap forward.
But we need to be careful.
We need to be sure that separating settlement from all other CSD activities does not lead to additional risks and reduced service levels, which will again increase costs. In addition, while market-practice harmonisation is important, we need to be vigilant, particularly during times of economic duress, to prevent local markets from protecting their own franchises, especially those markets where trading and post-trading operate in vertical silos.
Without the harmonisation and simplification of market practices, the benefits of T2S will be low. Like today, most cross-border trades will continue to be handled by agent banks, ICSDs and custodians. Some CSDs will try to compete with ICSDs and custodians in providing a pan-European service and, in doing so, will try to redefine what we think of as core CSD services.
Understandably, we anticipate a high degree of unbundling between asset servicing and settlement as a result of more competition arising from the forced segregation of the two CSD activities by T2S. Unclear today is to what extent the further unbundling of services will happen within the asset servicing domain. For example, will clients choose different service providers for tax services than those delivering pure corporate actions services? Will we see a separation of roles between corporate action information provision and processing?
Five years ago, the European Commission adopted the Shareholders’ Right Directive. It required companies to provide investors with timely access to complete information in order to vote at general meetings and enable investors to vote electronically by proxy.
CSDs are, by nature, well positioned to bring issuers closer to their investors by streamlining the end-to-end voting process. Euroclear’s alliance with Broadridge provides a cost-effective voting solution to issuers and their agents, bringing greater transparency to the market and improving communication between issuers and their shareholders.
Issuers, on their side, are keen to gain access to their shareholders’ identity. Very recently, Euroclear and Capital Precision agreed to co-operate in order to provide issuers with a complete picture of their shareholder base, both in their home market and abroad, against their peers. This will allow companies to target a wider shareholder base, arrange more effective investor road shows, explain the business rationale of proposed resolutions to their shareholders well in advance of the meetings and increase voting participation rates.
These two examples also demonstrate that one doesn’t have to build these services from scratch. A wiser approach may be to partner with well-established firms that are experts in their domains.
Collateral is at the centre of our healing process after the crisis and is core to the success of many upcoming regulatory changes. Collateral is now becoming the new normal.
Over the past few years, we have seen a significant number of new counterparties availing of the triparty collateral management environment as a safe way to invest cash. And there is a lot of cash these days.
Access to central bank liquidity has also become a vital focus point and a lifeline to some. Euroclear is rolling out a global ‘Collateral Highway’ to create the first fully open global market infrastructure to source and mobilise collateral across borders. The “Collateral Highway” will help market participants move securities from wherever they are held to serve as collateral for access to central bank liquidity, CCP margins and secured transactions such as repos, derivatives and loans.
In essence, we are turning our triparty collateral management services into an open architecture that we can “plug in" to other CSDs to help clients access collateral centrally, no matter where the securities are held. This will allow banks to manage a single pool of collateral and avoid so-called liquidity traps.
The biggest demand for collateral, however, is yet to come.
Regulators around the globe are pushing for central clearing of most OTC derivatives transactions, including those conducted by the buy-side. Moreover, margins will have to be segregated to a certain extent. This all comes at a time when collateral is already a scarce resource.
Of course, the increased demand for quality collateral provides new opportunities for securities lenders to enhance returns on their portfolio. In fact, securities lending will become an important liquidity mechanism. However, we will need to engage in this activity prudently, as the MF Global and Lehman Brothers crises still haunt us, particularly the concerns about re-investing cash balances.
Providing the infrastructure to pool and mobilise collateral across markets and instruments in a safe and seamless way is what our systems are designed for. Whether it is to support the growth of the repo market, collect initial CCP margins, transform collateral or generate liquidity at the central bank, we’re ready to assist.
A new way forward
So, what is core and what is value added? What will be the role of a CSD, ICSD, agent bank and custodian? Which services should be provided by which type of firm? Frankly, that’s the wrong debate.
Rather, we should see how we can leverage each other’s competencies and develop shared solutions that will reduce costs and risks for our clients. We also cannot fall back into our bad habits by duplicating developments and protecting vested interests.
Darwin’s theory about adaptability to change is admittedly old-fashioned, but it’s still relevant today. Darwin was, of course, referencing the evolution of species over millions of years. Our industry doesn’t have that much time left.