Target 2 Securities: Are You on Target? -- Full Text

Read this report to learn the implications of TARGET2-Securities (T2S) on the European clearing and settlement industry—and key things that organizations should consider for a post-T2S strategy.

Introduction
In an effort to eliminate the “Giovanni Barriers”—tax, legal and other considerations feeding the continued fragmentation of the European clearing and settlement landscape—the European Union has launched several initiatives in support of the Lisbon Agenda, intended to make the European Union more competitive. One of the most important initiatives is TARGET2-Securities (T2S), a program that is designed to reduce inefficiencies in the post-trade area.

The concept of T2S is the development of a pan-European securities settlement platform that provides commoditized delivery versus payment (DVP) settlement services in central bank money to all members who join on a single processing platform. T2S, which is core, neutral and borderless, aims at harmonizing settlement processes, including the reduction of cross-border settlement costs. The T2S platform will be available for all Central Securities Depositories (CSDs) that sign the T2S Framework Agreement. It is expected to create a level playing field among CSDs, and thus foster competition and increase cross-border settlement efficiency.

The integrated model for T2S entails the outsourcing of securities accounts from the CSDs and of cash accounts from the National Central Banks (NCBs) to T2S. This will enable real-time DVP settlement in central bank money for all in-scope transactions. It is evident, despite clear progress on the solution requirements of T2S that the deployment of such an integrated European settlement platform will not happen overnight. To connect to T2S, the Eurosystem (ECB and NCBs of the eurozone) as well as the participating CSDs, NCBs, custodians and investment banks need to make substantial investments.

Aside from the required investments to connect to T2S, Accenture believes market players should look at T2S as a catalyst to rethink business models and define a long-term strategy to remain competitive in a post-T2S world. Organizations need to assess the long-term viability of their business offerings, mainly around settlement, custody, cash and collateral management services, as well as customer reporting in the context of the implications of T2S. Finally, market players need to re-evaluate their current client pricing model, taking into account the increased competition, investments and potential reshaping of their businesses resulting from the implementation of T2S.

To date, some of the key European CSDs have confirmed they intend to join T2S (Clearstream Banking AG, Iberclear and Monte Titoli),¹ thereby affirming it will go ahead, even if with further delays; the creation of a critical mass on T2S will be central to its success.

Major Implications of T2S
To assess major implications we explore five key questions we believe one needs to ask now, in 2012, at this “half-way mark” of the program to determine where things stand with regard to engagements made at the launch of the concept in 2006—and to deliver some thoughts which markets players might take into consideration while preparing for T2S themselves.

1. Is T2S really going to decrease Europe-wide settlement costs and foster competition?
   At the beginning of the T2S journey, the expectation was to bring down settlement cost of DVP transactions to the level of domestic settlement. Since then, the market has seen a number of developments that might make it difficult to achieve this goal.
   
   Whilst participation in T2S is voluntary by nature, the market pressure is likely to force CSDs to join T2S. Therefore, assuming that nearly all 30 European CSDs connect to T2S (nine confirmed in May 2012),² the economies of scale generated will support the ECB objective of lowering settlement costs.
   
   With the advent of T2S, CSDs will no longer depend upon agent banks or other local agents to act as intermediaries for cross-border settlements. Instead, CSDs will be able to carry out settlements between themselves and other CSDs. When the number of participants in a settlement chain decreases and the volume of settlements on a single platform increases, costs—and therefore prices—should be reduced. It is expected that CSDs will pass on these savings to the next link in the chain—where relevant, the custodian banks—who, in turn will pass on the lower costs to the end investor.
   
   After the collapse of Lehman Brothers, and with the current eurozone crisis, the initial ECB estimates of growth in settlement volumes made in 2007 were not met. The UK and Nordic markets refusal to join T2S will further reduce volumes that would otherwise have been channeled through the system. As other major non-euro markets, such as Switzerland, will not put their national currency in T2S either, this will further affect expected volumes and economies of scale.
   
   The estimated decrease in settlement cost, announced by the ECB, was based on the assumption that a minimum of 20 percent of non-euro transactions would be settled through T2S. With UK, Swiss and the Nordic markets refusing to put their currencies in T2S, it is questionable whether 20 percent on non-euro transactions can be realistically achieved.³
   
   As a result, the ECB has now revised its original position on costs, stating that settlement costs in the initial days of T2S might not be lower than the current lowest domestic settlement costs. This raises the question whether it is economically viable for CSDs to bring domestic settlement onto T2S. If domestic settlement is currently less expensive than it would be under T2S, why should the CSDs use T2S for domestic settlement? This would provide another reason for the CSDs to maintain duplicate infrastructure, internalizing settlement as much as possible, keeping their local settlement systems for domestic use and adopting T2S for cross border transactions.
   
   Additionally, CSDs typically handle local market instruments that do not have International Security Identification Numbers (ISINs) and they process settlements in commercial bank money—transactions that are outside the scope of T2S. To be really ready for T2S, the initial investment and adaptation costs for the CSDs will be substantial (we assume investments required ranging from 50 to 100 million euros depending on the market and the integration strategy of the CSD).
   
   Considering this, the ECB has changed its stance on the existing settlement infrastructure of the CSDs; the original position focused on “decommissioning,” then changed gradually to “downsizing/right sizing” and is now fixed on “re-shaping.” Re-shaping, clearly being a much more complex and costly process than real decommissioning of settlement systems, which the markets indicates, CSDs are not fully ready for.
   
   The current eurozone crisis brings new challenges. Among the what-ifs: What would be the impact on the business case of T2S in terms of volumes if one or two countries opt out of the euro before T2S goes live, notwithstanding the most pessimistic scenario of a full euro disintegration?
   
   In summary, industry players need to take this uncertainty into consideration when defining their business models post-T2S and banks, settling via these market players, need to determine how to evaluate and identify those who are able to provide and secure the benefits of a reduction on fees due to T2S from the outset.
   
   

2. Will T2S act as a powerful catalyst for harmonization of post-trade practices in Europe?
   The ECB’s efforts to harmonize CSD activities will likely have many beneficial effects on post-trade services in the Eurosystem. Nevertheless, there are some challenges in the ECB’s offering as T2S focuses on settlement alone; major steps are still needed on corporate actions processing as well as harmonized processing amongst the NCBs.
   
   Since its inception, T2S has played a large role in the harmonization of post-trade practices in Europe levering initial efforts by the two largest CSD groups in Europe; for example, T2S has led to a single operational day schedule with common cut-off times for different markets. T2S also provides harmonized rules for validation, matching, settlement and cancellation of instructions, and serves as a harbinger of ISO 20022 standards. T2S is, therefore, providing an accelerator by mandate to harmonize different market practice and remove inefficient practices specific to certain countries.
   
   While there is always initial resistance to change, the long-term benefits in terms of an increase in settlement efficiency are so substantial that the market would lose out on a long overdue opportunity should it fail to adapt to T2S standards. Even if a given CSD chooses not to join T2S, it will be indirectly forced to align to some of these changes in order to settle with markets who will participate; an impending investment is required regardless.
   
   The ECB has set up a high-level Harmonization Steering Group to look into the remaining topics that would further enhance cross-CSD settlement; for example, T2S will harmonize standards on treatment of pending instructions. Harmonization of corporate actions related to holdings—to derive the full benefits—would be the responsibility of the market and represent a further opportunity to improve efficiencies in the European post-trade landscape.
   
   The fact that the harmonization of processing of corporate actions is out of scope of T2S means that CSDs and other market players will not benefit from the reduction of cross-border links, or a continued dependency on custodian banks for cross-border custody services.
   
   T2S will not harmonize all post-trade settlement related practices from the beginning. Areas such as taxation, harmonization of different settlement cycles (T+2 versus T+3) and introduction of central counter party (CCP) in non-CCP markets, harmonization between direct holding markets and omnibus markets, absolute removal of physical securities, making non-fungible securities fungible and harmonized data archiving periods are some of the matters for further review and inclusion in a post-T2S world.
   
   NCBs still use different collateralization procedures throughout Europe, which need to be harmonized in order to benefit from the full effect of T2S. There has been limited progress on this issue for the past four years. Nevertheless, T2S requirements and specifications still anticipate that T2S will handle all possible collateralization models such as pledges, repos and others. The ECB should verify—before T2S go-live—that only one model exists.
   
   Banks need to evaluate the “knock-on” impacts of system and processing changes due to the new harmonized rules and tools (for example, communication interface and standards, such as ISO20022). T2S will utilize as well as evaluate how to leverage centralization of processing through one or few CSDs in order to minimize impacts.
   
   
3. Will T2S make cross-border transactions as simple as the domestic transactions?
   Currently CSDs either have direct links with one another (the depository link model) or have intermediaries or agent banks (the sub-custodian model) to carry out cross-border transactions on their behalf. One of the most attractive features of T2S is that if the two investor CSDs are connected to T2S, they neither need a direct link nor a connection through an intermediary to conduct cross-border settlements between themselves; T2S would do it automatically. Therefore, except in the case where the issuer CSD and one of the investor CSD is not connected to T2S, T2S has the potential to carry out cross-border settlements in a fully automated straight-through processing (STP) mode.
   
   There are, however, open issues to address. These include determining the parameters used for choosing a CSD and establishing who can maintain static data of, for example, US or Japanese securities in T2S. At present, this data is maintained by each CSD. With T2S, only one CSD would be given the right to maintain security data. This could provide an early mover advantage for CSDs that are among the first to join.
   
   Presence of multiple ISINs for the same security in some markets (for example, in the United Kingdom and Germany) might limit the effectiveness of T2S as a securities settlement system. To make T2S more efficient, the issuer should be able to issue a security in different markets with the same ISIN or security code. Similarly, there are a number of local market practices in Europe requiring certain non-settlement related steps before final settlement can be achieved in T2S.
   
   Unless these barriers are removed, the fully automated STP nature of cross-border settlement via T2S will not be fully realized.
   
   Banks need to evaluate what assets they currently have under management and assess through which intermediary provider they will obtain the best service and leverage T2S in the most efficient, STP and cost-effective manner given the markets with which they do the most business.
   
   

4. Will central bank quality liquidity pooling be a game changer for banks using T2S?
   One of the biggest effects of T2S for multi-country custodian banks is the concept of liquidity pooling. Since T2S is an integrated model, it will have both the securities accounts and the cash accounts on the same infrastructure, with securities accounts under the control of a CSD and cash accounts under the control of a NCB. A multi-country custodian bank could service different securities accounts held in different CSDs in various countries via a single consolidated cash account in T2S, generating savings and enhancing operational efficiency.
   
   With the advent of T2S, for a bank that currently settles primarily, for example, in central bank money in euros and Danish kroner (DKK), just two cash accounts in the respective currencies would be sufficient to serve all clients in all geographies which take part in euro and DKK settlement.
   
   The benefits for non-euro banks are even greater, as T2S would offer them a one-stop shop for new business, providing them with central bank money settlement capabilities in their national currencies within the eurozone. T2S would also foster competition within the NCBs of the eurozone. Once T2S is in place for euro settlements, a bank can choose any eurozone NCB to open an account. An Italian bank could have a cash account in T2S, by opening the account in the books of the NCB of Germany, provided it fulfills all the legal criteria.
   
   Such liquidity pooling places are powerful tools in the hands of banks, helping them negotiate effectively with both the CSDs and the NCBs. A bank with a cash account in T2S could be linked to several Real-Time Gross Settlement systems (RTGS) TARGET2 accounts (the euro RTGS system for cash), creating the possibility to receive liquidity from multiple liquidity providers. This would also reduce the number of settlement failures due to a lack of cash.
   
   These benefits will nevertheless be accompanied by some disadvantages. TARGET2 was built on the principle of liquidity pooling for a bank on a single RTGS account. T2S will split this liquidity on two platforms, TARGET2 and T2S.
   
   This would be step backward, since the NCBs will lose a global view of their total liquidity. In addition, NCBs must build numerous checks and balances for liquidity flowing into and out of their RTGS systems while maintaining control over their banks participating in T2S. Therefore, new operations procedures need to be established. For example, if an NCB (or its participant) erroneously blocks an RTGS account, T2S would be deprived of liquidity, resulting in settlement fails in T2S. Who will be responsible for this?
   
   Although T2S provides a definitive step forward within the domain of securities settlement, it must present a holistic solution in the long term by addressing the remaining inefficiencies in the solution proposed, namely full integration with TARGET2, auto-collateralization solution for NCBs and in the longer term, potentially extend to some custody related processing services.
   
   Banks need to not only reassess their business models on securities settlement but also invest in an understanding on how to minimize inefficiencies presented with T2S on the liquidity side.
   
   

5. Direct connectivity: Is there an actual benefit for the custodians?
   One of the basic principles on which T2S has been developed is that custodians could directly send settlement instructions to T2S instead of routing such instructions through their CSDs. These custodians would be known as directly connected participants. Under this technical connectivity, custodians would continue to maintain their legal relationship with their CSDs.
   
   This means that two directly connected participants can send settlement instructions to T2S and settle them on T2S. This would enhance cross-border settlement efficiency even further, eliminating one extra layer of intermediary (in this case, the CSD). These benefits will be available as well to CCPs if their CSDs grant them this direct connectivity.
   
   The big global custodians can therefore centralize their accounts within a few CSDs and use direct connectivity to the T2S platform as a powerful enabler of cross-border transactions. Via direct connectivity, participants can send instructions or queries on account details and positions anytime during T2S operating hours. They can, for example, directly cancel their settlement instructions on T2S or put them on hold.
   
   Direct connectivity, however, does not automatically convey the right to send settlement instructions directly to T2S. It is the CSDs who will ultimately decide what kind of direct services to offer to which participants.
   
   This might mean a CSD can only grant query rights to a directly connected participant in T2S, without giving it the authority to send settlement instructions.
   
   The T2S project could, in theory, still do more for direct participants by defining a minimum set of services that the CSDs would be able to offer to its clients if they were granted direct connectivity. Even if the CSD clients have direct connectivity and are able to send settlement instructions to T2S directly, they will need to continue to send custody instructions to their CSDs as they do today. Thus, for non-settlement activities, CSD–custodian links must be maintained.
   
   If custodians would build an additional link to T2S for direct connectivity, it could represent an increase, rather than a decrease, in back-office costs. The benefits of direct connectivity would be realized only if custodians can use a single account (like a passport) for participating in all CSDs. As this will not be the case, the business case for direct connectivity is significantly lowered.
   
   Custodian banks also are reevaluating their models to minimize the requirement to connect to multiple CSDs as well as T2S leveraging intermediaries with multimarket capabilities.
   
   There could be a scenario where a few bigger CSDs directly connect to T2S, and the remaining CSDs connect to T2S via the bigger CSDs (as a CSD participants, similar to a custodian). Here the smaller CSDs need to do the cost-benefit analysis of connecting to T2S vis-a-vis connecting via a bigger CSD.
   
   A possible three-step transition strategy for the smaller CSDs could be to be indirectly connected to T2S at first, where the instructions to T2S are sent by the intermediary CSD on their behalf. After a stabilization period, the smaller CSD can ask for a direct technical connectivity to T2S to the intermediary CSD, and thereby sending settlement instructions directly to T2S and routing other business functions through the intermediary CSD. Lastly, when the smaller CSDs are fully ready for the entire re-shaping exercise, they can fully transition to T2S.
   
   

Conclusion: Making The T2S Initiative a Reality
The T2S initiative presents a grand vision of unifying the fragmented securities markets in Europe, an exciting opportunity to foster healthy competition and increased efficiencies. There are notable challenges in achieving this ambitious goal; this is reflected in the two delays disclosed since its announcement in 2006 as well as the doubling of development costs since the first development cost estimate was published.

There remain substantial differences over the issues of pricing, governance, service level agreements, contract termination, liabilities regime and other matters. There are also differences of opinion as to whether the T2S testing and migration windows are sufficient. While these issues are to be expected in such a landmark initiative, they will still take time to resolve.

While the ECB faces significant hurdles in implementing T2S, the potential benefits are also significant. Europe has seen rationalization up the value chain with the successful merger of exchanges and Central Counterparties, nevertheless a flurry of CSDs remain dominant in the marketplace. A successful T2S launch will reconfigure this landscape, resulting in streamlined settlement processes, increased competition and lower costs for most players.

In order to make the most of T2S, it is critical to understand in detail the opportunities as well as the challenges it will present for banks, NCBs, custodians and CSDs. Banks, custodians and even CSDs need to reevaluate their current local market settlement links and rethink their service offering in order to leverage new liquidity pooling opportunities.

At the same time they need to assess the strategic, operational and technology impacts that T2S will present for them for settlements on markets in or outside of T2S with the right balance of skepticism and—at the same time—the right level of readiness!

Sources
1. http://www.ecb.int/paym/t2s/about/t2sonline/html/t2s_qr_12_who.en.html
2. http://www.ecb.int/paym/t2s/about/t2sonline/html/t2s_qr_12_who.en.html
3. http://www.ecb.int/paym/t2s/pricing/proposal/html/index.en.html