Introduction
There is now clear acceptance in the investment industry that invested assets are exposed to custody risks as well as investment risks. This arises from a growing awareness that custodian banks do not mitigate local capital market infrastructure risks for investors. Investors must determine these risk exposures themselves as regulators have placed responsibility for assessing market infrastructure risk exposure firmly in their court.
The purpose of assessing what is commonly referred to as ‘post execution risk’ is to determine the extent to which an infrastructure minimises recognised risks and maximises asset safety for investors. An investor who turns over their portfolio once a year is exposed to various settlement risks for 3 days (or however long the settlement cycle is) and exposed to various safekeeping and asset servicing risks for the remaining 362 days of the year. Any assessment therefore should include both when transactions are settled and how securities are held in a particular country, and assess the effectiveness of the organisations (i.e. exchanges, CCP and CSDs) and their processes in minimising investors’ risk exposures in post-trade settlement and safekeeping.
It is also important to understand that within the markets there are developments occurring either to the processes or to the infrastructure that will change the risk exposures. These changes may either increase or reduce the risks. Usually the infrastructure providers will implement process changes that reduce risk. But of more concern is that many of the infrastructure changes that are occurring are related to cost reduction or efficiency improvements, which may have the impact of increasing risk exposure.
Readers of this Handbook who follow the daily activities in the exchange world will note a few examples of exchange consolidation, and many cases of ECN consolidation, where the original investors are now cashing in on their investment, and even a few examples of new trading mechanisms, especially in the fixed income world.
This article focuses on consolidation at the CSD level where Thomas Murray track and rate over 85 countries in terms of their post-trade infrastructure risk, by analysing over 140 CSDs globally. CSDs provide safekeeping facilities for approximately 85% of the world’s securities. Thomas Murray is the only provider of capital market infrastructure risk ratings of this post-trade chain.
Tracking these risks in this post-execution area has become increasingly complex and time-sensitive, driven not least by the increasing dynamism of the environment as markets consolidate infrastructures at all levels (i.e. exchanges, CCP and CSDs) both nationally and cross-border. The consolidation drivers are primarily cost reduction and improving the efficiency of cross-border business, not necessarily improving the models of risk containment employed.
Exchange influence
Exchanges are not disinterested in the trend for consolidation at the CSD level; indeed, Thomas Murray can identify 55 CSDs where the exchange has some level of ownership and over 30 CSDs where the exchange has more than 50% ownership. Exchanges can force consolidation downstream as in the Czech Republic and Romania, or they can block consolidation to protect their own interests, as RTS may do in Russia if it acquires a controlling stake in DCC, blocking any merger with NDC. After all, an exchange has a responsibility to ensure that there is an appropriate mechanism for the settlement of its transactions and the efficiency of this can impact exchange liquidity. Consolidation at the exchange level can impact the downstream CSDs – if the merger between Deutsche Borse and the London Stock Exchange had gone ahead, it was not beyond the realms of possibility that settlement could have been switched in the longer term from CRESTCo to Clearstream, and clearing switched from LCH.Clearnet to Eurex Clearing.
The middle ground – where CCPs sit in the value chain – can also be contentious. Should the exchange or the CSD own or have major influence over the CCP? There are examples of the CCP being embedded in the CSD rather than owned by the exchange (e.g. CBLC in Brazil) but nevertheless vertical silos (where the exchange effectively owns all the downstream infrastructure) are a popular model.
Drivers for consolidation
The major facilitator for consolidation within Western Europe has been economic and monetary union as a result of introducing the Euro. Now that accession states have joined the European Union, it is driving wholesale changes within these markets as well. Elsewhere we are seeing other such unions e.g. the United Economic Space (Russia, Ukraine, Kazakhstan and Belarus), which is also a form of economic union, and we expect similar initiatives may occur in the Asia Pacific region, possibly among ASEAN countries.
One of the things investors always complain about is cost, particularly the cost of cross-border services. There has been much debate in Western Europe about how expensive it is to trade cross-border, especially compared to the USA. So, one driver towards consolidation is the attempt to reduce the number of depositories involved in cross-border clearing and settlement.
Finally, although it is more of a facilitator to consolidation, a number of stock exchanges (and CSDs) have demutualised. Once an exchange or depository demutualises it comes into play in terms of consolidation as it can be acquired just like any other publicly listed company.
In the major economies the consolidation has been driven by strong individuals who have seized the mandate to improve the infrastructure. Notable absences are the UK, which has sold most of its infrastructure, and Italy, which looks like going the same way. In Scandinavia the influences come from the local oligarchs.
Consolidation models
There has been much debate about the benefits of vertical versus horizontal integration, but in the meantime there has been a lot of tactical tidying up going on as fragmented domestic infrastructures are rationalised. This strengthens the local market, preparing it for the strategic battles to come once the vertical vs horizontal options are tackled.
Domestic consolidation
As a preliminary step to either vertical or horizontal silos, many markets have adopted domestic consolidation, reducing multiple exchanges, clearing institutions and CSDs into a streamlined model. This streamlining then easily leads to a vertical silo, in which exchanges, clearing houses/CCPs and depositories come under the control of a single holding company (e.g. BME in Spain).
In the USA there used to be around 20 or so different depositories and exchanges. Although the USA had a single currency and common legislation (certainly at a federal level, but not on state level), it still took them 20 years to consolidate the depositories’ activities into DTCC. It is therefore clear that depository consolidation does not happen overnight. Spain has consolidated its depositories into a single organisation called IBERCLEAR, while Croatia has rationalised its three depositories (the Ministry of Finance, the Central Bank and SDA, the equities depository) into a single CSD around SDA. In the UK, even the Bank of England transferred its depository activities to CRESTCo and outsourced its registrar responsibility. In Australia RITS, the Government debt depository, has been transferred to Austraclear to consolidate all debt settlement into one entity.
These four examples (Spain, Croatia, UK, Australia) set a trend for central banks withdrawing from depository activities, something which they fell into almost by accident at a time when domestic CSDs were not well developed. In China, the two depositories servicing separate exchanges, Shenzhen and Shanghai, have been consolidated as branches of a single holding company based in Beijing. In the Czech Republic, they are planning to unify UNIVYC (the clearing house) with SCP. The same thing is happening in Romania, where they have just announced that the Bucharest Stock Exchange will take over SNCDD’s settlement activity, and in Thailand where the Thailand Securities Depository will take over the settlement activity for government securities, currently being undertaken by the Bank of Thailand.
There is therefore ample evidence of a global trend in infrastructure consolidation which would allow for cross-border mergers with foreign depositories and foreign infrastructures. Another footnote to history is what is happening in Eastern Europe, where many infrastructures are privatising and demutualising into a hostile environment – there are predators out there willing to take ownership in these depositories as soon as they become available – for example Hungary, which appears to have been sold quite cheaply to the Austrians.
Vertical silos
There are many examples of vertical silos. Germany, Italy and Spain are good examples, although Germany started out with the horizontal consolidation of CEDEL and DBC. Primarily, vertical silos are a defensive structure, to make themselves too large to be acquired by hostile entities. Both Spain and Greece appear to have adopted this strategy. Finland was successfully creating the first regional vertical silo via a blitzkrieg through the Baltic States, Estonia and Latvia with Lithuania in its sights, until it was hijacked to become part of the Scandinavian solution. In Russia, the two effective silos are battling it out for supremacy: the equity focused RTS/DCC and the fixed income focused Micex/NDC. In the Czech Republic, they are creating a vertical silo owned by the Prague Stock Exchange and the same is going to happen in the Slovak Republic and Romania.
Horizontal consolidation
Horizontal consolidation is much more difficult to achieve (Figure 1), especially at the CSD level. It goes across currencies and legal frameworks and threatens local interests. The benefits are greater but so is the effort.
Figure 1: Difficulty of consolidation
Source: Thomas Murray
Euronext/Euroclear is obviously the major example of horizontal consolidation. Euroclear’s driver is to reduce the number of depositories people need to use in Western Europe and hence reduce costs.
The Nordic CSD has a slightly different driver. Scandinavia has historically tried to present itself as a single economic region for investment, but the market infrastructure has always been fragmented and previous attempts to integrate it have failed. However, the latest initiative centred on the merger of the Swedish (VPC) and the Finnish (APK) depositories and a single trading platform appears likely to succeed.
Alliances
In some instances, markets with low liquidity and market capitalisation have increased their attractiveness either by pooling their resources into a single market or seeking alliances to increase cross-border liquidity. The longest running successful example of this is, surprisingly, in the West African French Franc zone which comprises eight countries. These markets share a single currency, a single exchange, a single depository plus a single settlement bank, with the hub in the Ivory Coast servicing the other ‘satellite’ markets. A similar situation is also evolving in East Africa where the new Kenyan depository, CDSC, will provide for settlement and safekeeping of Ugandan and Tanzanian securities and a new electronic trading system will be sited in Nairobi to also service trading in Ugandan and Tanzanian securities.
Lately, a United Arab Stock Exchange (Egypt, Jordan, Lebanon, Tunisia, Morocco, Kuwait, Oman, Dubai) has been announced to be sited in Egypt, which would allow for blue-chip stocks from the constituent markets to be traded on a single exchange and settled in a single depository. A memorandum of understanding has also been signed in the Eastern Mediterranean (Greece, Turkey, Israel) to allow for greater cooperation between these markets.
In practice, alliances rarely succeed since these looser ties are unable to withstand conflicting commercial and strategic tensions among its member states. These tensions can only be contained through more intensive commitment via a vertical silo or horizontal consolidation. We have seen few examples of successful alliances, but many which have fallen apart.
Outsourcing
Consolidation can be an expensive exercise but an alternative is outsourcing. There are some countries that have taken this route – Ireland and Namibia for instance, where Ireland uses the LSE trading system for Irish equities, the Xetra trading system for fixed income securities, LCH.Clearnet and Eurex Clearing (to come) for CCP services and CRESTCo for settlement of equities and Euroclear Bank for settlement of fixed income securities. Namibia has outsourced its infrastructure to South Africa and uses the JSE and STRATE (the South African CSD), both of which in turn are based on foreign solutions.
Poland has recently appointed advisers for the privatisation of its infrastructure and the preferred option is a strategic partnership, which may well lead to an outsourced solution.
The importance of the post-trade infrastructure
As outlined at the beginning of this article, it is the end investor that is ultimately exposed to the CSD and the local capital market infrastructure during settlement, safekeeping and asset servicing activities. This is because at various stages in these processes the sub-custodian will be reliant on the actions of the CSD, CCP, payment system (often run by the central bank), paying agents and information providers. At these stages, responsibility for efficient and correct processing of these actions rests with the relevant third-party provider and the sub-custodian is no longer in direct control. Sub-custodians generally do not accept responsibility for client losses triggered by these parties since they argue that they are obligated to use these market utilities once a client initiates investment in that market. This reality is reflected in the legal contracts – an investor will have a robust contract with the global custodian and the global custodian will have a robust contract with their appointed sub-custodian, but the sub-custodian does not have a contract with the CSD, CCP, payment system or others, they are merely members or participants. Although client losses triggered by the actions or omissions of these third parties may possibly be recouped, the lack of direct contractual relationships between the sub-custodian and these third parties may make the compensation process a long, expensive and torturous route.
These risk exposures are assessed by Thomas Murray in the form of Capital Market Infrastructure Risk Rating Reports. The ratings are risk exposure ratings based on an absolute and hence comparable ratings scale (see Table 1). The ratings measure the capital market infrastructure risk exposure a fund suffers irrespective of which infrastructure organisation is present in the country or what particular method is adopted to settle and safe-keep securities.
It is impossible to directly compare DTCC in the USA with CBLC in Brazil. It is however possible to compare the relative risk exposures which investors in the USA and Brazil are exposed to when buying or selling securities in those markets. Thus the particular method chosen to prevent, for example failing settlements (auto-borrowing, buy-ins or blocking of securities/cash) is not important, but the effectiveness of the chosen method to minimise risk exposures arising from failing settlements that will determine the rating, is.
Table 1: Thomas Murray local capital market infrastructure risk rating scale
| AAA | Extremely low risk |
| AA+ | Very low risk |
| AA | |
| AA- | Low risk |
| A+ | |
| A | Moderately low risk |
| A- | |
| BBB | Acceptable risk |
| BB | Less than acceptable risk |
| B | Quite high risk |
| CCC | High risk |
| CC | Very high risk |
| C | Beyond acceptable level of risk exposure |
| N/a | service unavailable in the market |
The Thomas Murray Capital Market Infrastructure Risk Ratings are used globally by stock exchanges, CSDs, central banks, risk, compliance and treasury officers and institutions. One illustrative example of how the ratings have been used is seen in a Bank of England, Financial Stability Review, December 2004 article which drew on the Thomas Murray Capital Market Infrastructure Risk Ratings in proposing a risk framework of assessing the mitigation techniques employed by the securities settlement systems most used by UK market participants (see Table 2).
Table 2: Key securities settlement systems for UK Markets*
| Country | SRR statistic** |
| United Kingdom | 100 |
| United States | 16.3 |
| Germany | 16.0 |
| Netherlands | 9.2 |
| France | 8.1 |
| Italy | 7.5 |
| Belgium | 5.8 |
| Switzerland | 3.7 |
| Luxembourg | 3.7 |
| Japan | 2.8 |
Original article: Bank of England, Financial Stability Review, December 2004
Sources: IMF, ONS, Thomas Murray and Bank of England calculations
* Top ten SSSs in 2004 Q2
** Presented as an index where UK = 100
Conclusion
Infrastructure developed in domestic isolation is now subject to global market forces and the pursuit of efficiencies, pressure on costs and the regulatory imperative for best market practice will continue to drive consolidation. However, the drivers for consolidation are not the same drivers to minimise risk and inevitably, just as the cost structure changes with consolidation, so does the risk profile. Sometimes reducing cost is at the expense of greater risk and this serves to complicate the task of investors in assessing and monitoring their exposure to these capital market infrastructures.
Thomas Murray is a custody risk rating and advisory company specialising in the global securities services industry. The company privately/publicly maintains opinions on over 300 custodians, 89 capital market infrastructures and 140 central securities depositories worldwide. Thomas Murray is the single largest provider of public and private ratings and risk assessments on global custodians, agent banks and capital market infrastructures. For further information, see www.thomasmurray.com.
