As the European Union authorities and market practitioners struggle to fulfil the single market dream ? a regional Europe with a strong euro ? they may have underestimated the innovative and regenerative powers of issuers who need to raise euro finance, investors who seek tax efficient returns, and a multitude of intermediaries competing to extract their share of the wallet. This is wealth creation, and the primary goal of any market.
The wealth creation process lies at the heart of economic growth and prosperity and is largely responsible for the massive weight of investment flows that is constantly sloshing around the globe. It is clear that markets must be orderly although the EU authorities, and there are many, should consider well the impact of their actions in terms of regulatory creep ? or indeed regulatory smog.
It is interesting to note that a less significant intervention by the US authorities in the sixties spawned the Euromarket which has diversified, grown and flourished to become the International Market; largely homeless, innovative and constantly repositioning to meet issuer, intermediary and investor needs, avoiding regulatory pressures wherever possible. While such a market may well prove once again to be the solution to global market users, it will no doubt be a source of irritation to European visionaries and regulatory authorities alike; it will offer a highly liquid home to the Euro wealth creation process irrespective of the success or failure of the EU single market.
Whether by accident or design, clearing and settlement has become the centre of attention in this great European single market debate. The back office has become fashionable and no longer regarded as the sewage system of the capital markets. Indeed, EU clearing and settlement has an unfortunate foundation whereby the baggage of history carried by each of the 25 EU national markets, with significant differences in market practices, laws, regulations and cultures, appears more suited to anarchy than unity.
Lack of harmonisation and an extremely complex technical and regulatory environment has meant that national capital markets had to rely on providers of clearing and settlement services which were unable to develop, or interested in implementing, a network of links between themselves that would allow market users to efficiently trade and settle such trades, regardless of the legal and regulatory regime of the seller, the purchaser and the issuer. This distinctive capability has been secured by the International Market, while Europe suffers under cumbersome and fragmented national legal regimes and complex directives. While the International Market has flourished in bond financing, trading and post-trade processing, European equity trading and post-trade infrastructures have become trapped between a rock and a hard place, reacting to trends in national issuance and trading while increasingly being regarded as risk hubs and ?embedded? supervisory mechanisms by national regulatory authorities; but the landscape has changed.
Indeed, clearing and settlement, the once proud domain of central securities depositories or Securities Settlement Systems (SSSs), has become confused and no one is sure whether clearing is a process associated with the novation of risk in central counterparty arrangements, or whether settlement in a real-time gross settlement environment is an alternative form of payment system. Where national essential facility SSSs once saw the ICSDs as a threat, they are now combining with the ?enemy? and the synergy of such a combination has raised the hackles of the agent banks who find themselves competing with highly merged entities like the Euroclear Group in what the agent banks regard as a far from level playing field.
Within Europe, it is generally accepted that such national differences be eliminated and a more harmonised approach to regulation adopted. It is, however, somewhat ironic that we have to introduce a whole new corpus of financial regulation in order to remove the obstacles to a single market in financial services. Indeed, in the grand European scheme, the European Council set the European Union an ambitious goal to become the most competitive economy by 2010.
A significant component of this is the integration of the European financial market, with an established deadline of 2005 for the completion of the Financial Services Action Plan, which is a set of some 42 legislative and non-legislative measures. The Committee of Wise Men proposed a four-tier approach to European securities regulation, with two new committees, the European Securities Committee and the Committee of European Securities Regulators (CESR). This four-tier approach appears straightforward enough, with Level 1 consisting of legislative acts, Level 2 covering implementing measures and Level 3 comprising measures to improve the common and uniform implementation of Levels 1 and 2. At level 4 the European Commission will strengthen the enforcement of Community law in this area; in practice this is far from straightforward.
At the methodological level, an essential innovation of EU regulation and the various directives is the recourse to committee procedures (comitology*) with a view to the adoption of implementing measures. Herein lies the dilemma facing market practitioners and regulators. The fundamental principle of comitology is acceptable only on condition that the directives are sufficiently precise at the outset ? unless you want the tail to wag the dog. On the one hand, the majority of market practitioners and regulators agree on the need for harmonisation, supporting the aim of securing a single market. On the other hand, differences in market practices lend themselves to drafting proposals for directives, which attempt to cover excessive ground or reconcile national differences. Perhaps European Directives are striving for a harmonised European regulatory structure in advance of tackling the primary problem ? differences in law as highlighted by the Giovaninni Report. At present only Murphy?s Law can be relied upon.
After two volumes from the European Commission-appointed Giovanni Group, 140 pages from the Group of Thirty, and the expected introduction of a new Directive on clearing and settlement, it has to be hoped that exasperation does not generate further controversy; the regulation of European securities clearing and settlement systems ought not to be controversial. That said, there are many stakeholders in the process ? and many are keen to muddy the waters.
Adding to the murk and confusion, the Committee of European Securities Regulators (CESR) and the European System of Central Banks (ESCB) published a report containing a list of standards for the operation of securities clearing and settlement systems in the European Union. The European securities industry can be forgiven a sense of exasperation.
Such exasperation is not as a result of CESR being involved. CESR is no more than a group of national regulators, each operating their own mixture of regulations, laws, and enforcement procedures. What matters about this report is the engagement of the European System of Central Banks (ESCB). This body has a much narrower brief, and a more focused and cohesive approach. It also draws its powers from statute: from European Treaties and Protocols.
Those Treaties and Protocols do not cover the securities industry or securities clearing and settlement. They make reference to payment systems only. The ESCB is taking a strong interest in SSSs precisely because the pan-European payment system (TARGET) is dependent on collateral mobilised by SSSs to mitigate risk in real-time gross settlement (RTGS) payment systems. Indeed, the European Finality directive was introduced largely to protect (from conflicts arising in national law) the ESCB in respect of collateral pledged for TARGET payments in the event of insolvency.
This provides an interesting insight into the concerns of the ESCB and the increasing complexity of that concern as it relates to clearing and settlement. The primary concern of the ECB and the ESCB is to ensure financial stability and efficiency, and therefore the avoidance of systemic risk in the Eurozone and the Euro. While their roles are taken for granted in respect of payment systems, it is less clear in respect of securities clearing and settlement, which is largely the responsibility of the prudential supervisor in each national market.
This means regulation is to some extent behind technological and infrastructural reality. Securities clearing and settlement is now real-time, with the simultaneous exchange of cash and securities. This, with the vital role played by SSSs in collateral movements for monetary policy operations in the Eurozone, has resulted in pan-European payment systems and SSSs becoming interdependent, operating like fuzzy sets. This explains ESCB concerns; the safety, soundness and efficiency of payment systems cannot be separated from SSSs.
This is reason enough for the central bankers of Europe to want to play a full part in the restructuring of the clearing and settlement infrastructure of Europe; but then European politics have their part to play in this decision since the European authorities have no desire to further increase powers granted to the ECB and the ESCB. Further, EU authorities have spotted another trend which impacts payment systems and clearing and settlement ? namely, netting and cross-margining. This adds a further layer of complexity to the challenge of ensuring financial stability in the Eurozone and the euro, in the shape of the central counter-party clearers, or CCPs. In the same way that payment systems and SSSs have become interlinked and interdependent, so too have CCPs. They too are attracting increasing interest from the ESCB and the national prudential supervisors.
It would be easy to conclude ? and many have ? that the ECB and ESCB would be happiest with one European payments system, one European SSS, and one European CCP, because one of each would be easier to supervise and control. This is perhaps why central bankers and indeed other EU authorities might be thought to be sympathetic to EU consolidation initiatives, for example, the Euroclear Group.
It is clear that Europe is struggling to come to terms with the challenges it faces and is stifled by a combination of ignorance and fear; it is trying to build its dream on a foundation of shifting sands.
However, as Europe struggles, the International Market repositions.
Figure 1: International market ? Outstanding debt
Source: BIS, reGEN
Outstanding debt has increased from USD5.4tr at year end 1999 to USD12.8tr as at September 2004 an increase of nearly 240%.
Figure 2: ISMA Trax turnover
Source: ISMA
ISMA Trax turnover has demonstrated a significant growth, increasing from USD129.7tr in 2001 to USD167.1tr in 2004 an increase of nearly 30%.
Four trends give weight to the International Market?s ability to reposition to provide a solid base for a new euro-capital market and indeed for equity processing in a highly fragmented Europe.
Firstly, there is a realignment of the disparate associations which support the International Market. The Bond Market Association (BMA), the International Securities Market Association (ISMA) and the International Primary Market Association (IPMA) intend to integrate their European-based activities into the newly created International Capital Market Association (ICMA) to establish a global partnership to ensure consistent and coordinated global representation of the international capital markets.
Given the fragmentation in Europe, the second trend can be found in the increasing demand for efficient equity financing, trading and post-trade processing and the International Market has the strength and capability to position in this market in much the same way as it has for bonds. Since the demise of SEAQ International in the early 1990?s, no equity trading platform has managed to create the levels of liquidity demanded by international players. Indeed SEAQ International was the impetus for the major market reforms in the major continental European financial centres. EASDAQ also attempted a new model, whereby it developed a new state-of-the-art trading platform which was scaleable to exceed peak NASDAQ volumes and where settlement was provided by the ICSDs, Euroclear Bank and Clearstream Banking Luxembourg and where securities were administered in a common depository rather than a CSD; all that may have been missing was an ICMA-style rule base or an ?alternative market? status ? a relatively new phenomenon.
Given concerns over regulatory creep in a Europe struggling under the weight of complex directives and the absence of a single supervisor, the third trend can be found in regulatory ?avoidance?. It is generally accepted by all stakeholders that private clients, Sid and Aunt Agatha, need to be protected, whereas the professional wholesale markets believe that lighter regulations should be applied; at the EU level the latter is neither perceived to be the case nor the trend. The International Market may well foster the creation of ?alternative markets? and the Luxembourg Stock Exchange, de facto the home of international bond listings, has announced plans to launch an ?alternative market?, whereby issuers will not be required to meet the financial information requirements provided for by the transparency and prospectus directives. While transparency may be a higher concern for equity markets, the innovative powers of the market practitioners will no doubt reconcile this challenge to accommodate commercial realities.
The fourth trend can be found in restructuring clearing and settlement, which the authorities argue is best left to market forces. In reality the complexity of governance arrangements, perceptions of abuse, disagreements about vertically or horizontally integrated market infrastructures and the overwhelming desire to create an EU DTCC has resulted in warring vested interest groups and a regulatory black hole.
Euroclear SA/NV, the new parent company of the Euroclear Group, has assumed ownership of the shared national SSS processing, and centralises the development of its new technology platform or ?single settlement engine?; it also delivers a range of services to the Groups? CSDs based in, e.g. Paris and the London. Clearly in centralising operations in this way, Euroclear will progressively seek out cost reduction benefits of integration, leading to a diminishing role for, or even closure of, the domestic CSDs and will no doubt recycle such cost savings into financing, for example, the ?single settlement engine?, projected to require a multi-million dollar annual investment, or to pursue its ambitions to position in European post-trade equity services.
Indeed, in responding to the call for European consolidation, Euroclear appears to have lost its distinctive ?international? identity. It has engaged in the complex process of integrating various European domestic markets to create a European DTCC capability while continuing to provide and develop its ICSD business activities found in Euroclear Bank. The intermingling of such diverse business activities must give rise to concerns in respect of risk and contagion since EU clearing and settlement activities are protected by European treaties, protocols and directives whereas non-EU international clearing and settlement activities are not.
Clearstream and its parent Deutsche Boerse AG have attracted other interest, particularly in the German market where it is perceived to have vertically integrated the market raising concerns in respect of free and fair access.
There have been a number of calls for Deutsche Boerse to unbundled its so-called ?vertical silo?, although it has to be argued that its business performance and customer reviews appear to support its straight-through processing efficiency levels in the German market while international market users appear unconcerned, leaving competitors and some regulatory authorities voicing opinions.
In reality, calls for divestment appear to be more logically directed at the Euroclear Group. The considerable amount of work required to create a European DTCC and the tremendous efforts of market practitioners and authorities to create a robust regulatory framework to support the need for financial stability and efficiency at the EU level may well be jeopardised by the intermingling of dedicated EU DTCC activities with Euroclear Bank?s ICSD capabilities. The settlement and safekeeping of, for example, Thai Bhatt or Mexican Peso securities over links to foreign custodian banks and CSDs using intermediary cash correspondent banks have totally different risks compared to a protected central European essential facility or European DTCC. This is particularly relevant given such an entity?s central role in collateral mobility for TARGET and interoperability at the level of national and European RTGS payment systems; this appears to be an unnecessary risk, increasing the potential for failure and contagion.
Euroclear, having led European SSS consolidation, will find its position, governance arrangements and synergistic product offerings subjected to intense interest and scrutiny. In reality a European DTCC makes sense and many support it ? but that is exactly what it should be ? a European DTCC. To achieve full ?ring-fencing?, Euroclear Bank would require to be demerged, becoming a totally independent entity.
Overall, European clearing and settlement faces restructuring and downsizing of significant proportions, resulting in a polarised market where the big players get bigger with small players forced to exit the business. The cost of restructuring Europe clearing and settlement will be high and so will the cost of compliance. Indeed, with the significant investment needed, legal costs, consultancy fees, downsizing and layoffs as well as increased compliance costs, the business case is far from convincing; this is unlikely to make the euro and the single market more attractive or lower cost for many years to come.
In a globalising market, risks can change in nature and significance. EU regulation in the absence of a single regulator will flounder, remaining fragmented, using outmoded directives and complex comitology procedures. On its current path, EU regulation will become more intrusive and demanding with the subsequent increase in cost across the entire breadth of market users; a phenomenon commonly referred to as ?regulatory creep?. The EU single market implementation scenario is nightmarish and the way ahead remains paved with barriers and politics; it will take a decade or more of dedicated effort to harmonise the process and the single market dream will have to wait its time.
However, the euro will continue to flourish, sharing the world stage with the US dollar; its dream will be realised. The realisation of this success will have little to do with the EU single market visionaries or the authorities and their directives; it will be more to do with avoiding the confusion and the muddle. Indeed, the continued success of the euro capital market and the euro will depend on further building and developing the International Market by responding to the market demand for efficient equity financing and processing, curing Europe?s malaise ? a Region divided by fragmented laws and regulatory smog. Essentially the international market provides what the EU can only dream of ? the ability to efficiently trade and settle equity trades regardless of the legal and regulatory regime of the seller, the purchaser and the issuer.
Whether or not it is liked or appreciated and whether by chance or design, the International Market holds the key to Europe?s single market dream or nightmare and the strengthening of the euro on the world stage. As to clearing and settlement, the vision of a European DTCC should be pursued and hopefully realised; the European single market underpinned by a single ring-fenced EU clearing and settlement capability. At the same time the International Market will serve its users, with alternative markets and multiple trading environments, while side-stepping onerous or confused regulatory measures. While the EU single market requires a ring-fenced DTCC, the International Market will require to be served by dedicated clearing and settlement mechanisms, striving for global coverage; further and ongoing restructuring in the clearing and settlement infrastructure is inevitable. The European dream, where all benefit from a strong euro, a single market and a ring-fenced European DTCC, requires enormous ongoing restructuring ? there is no gain without pain ? therein lies the nightmare.
John Gilchrist is the Founder and Managing Director of reGEN, a company dedicated to helping business leaders and executive management reposition in changing markets. John is engaged in an ongoing knowledge exchange programme, meeting with market practitioners, associations and regulators throughout Europe and has clients spanning the width of the capital markets, including stock exchanges, central securities depositories, central banks, banks, insurance groups, payment systems, financial publishing companies and wealth management companies among others.
According to the high-level principles laid down by the European Council, the European Commission prepares and implements the decisions of the Council and the European Parliament. The comitology procedure consists in giving the Commission, assisted by special committees, the power to adopt measures for implementing the general principles enshrined in directives. (Directives themselves are adopted jointly by Council and Parliament.)
