T2s: Are Firms Missing an Opportunity?

T2S: ARE FIRMS MISSING AN OPPORTUNITY?

In the third article of our series on Post Trade blogs we explore if T2S is delivering on the European Commission’s goal in removing the barriers to growth in capital markets by increasing efficiency and reducing costs.

Target2-Securities (T2S) has been fully operational for nearly two years With firms continually battling cost pressures and looking for more but not all the market is changing its behaviour to optimise the efficiency innovative and sustainable ways to deliver cost improvements, they now opportunities yet. have an opportunity to take stock of the impact of T2S on settlement performance, the cost of settlement (including capital, collateral and In December 2018, the European Central Bank (ECB) published the ECB liquidity) and how this is affected by upcoming regulatory change in the T2S Special Series One Year of Full Operation report outlining settlement form of CSDR (settlement discipline regime) and Basel IV/V (LCR). performance of its T2S securities settlement platform so far1. There is no doubt that harmonising settlement across multiple markets has led to greater settlement efficiency across all participating Eurozone markets (consistently achieving circa 97 percent settlement rate for each month of the first full year2).

With CSDR due to implement the settlement disciplinary regime in 20203, this is good news for direct T2S users and their clearing and custody clients. However, the claim that settlement would be cheaper in a more harmonised settlement environment is yet to materialise as T2S and post-trade service fees have increased as the ECB, central securities depositories and post-trade service providers look to recover their initial investment costs and protect revenue streams.

Similarly, users have yet to optimise cash liquidity opportunities through more efficient use of central bank money and auto-collateralisation. Again, the ECB T2S Special Series One Year of Full Operation report highlights some interesting statistics regarding the use of liquidity for settlement purposes – circa 60 percent4 (as per Chart 3 of the report) of transactions settled overnight but only represented 30 percent of daily average value (see Chart 4 of report)5. Furthermore, only 9 percent of auto-collateralised liquidity was related to on-flow as opposed to91 percent on-stock (as described in Chart 5)6.

1. T2S Special Series, One year of full operation, Issue 7, December 2018. 2. Ibid, page 8. 3. https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/Secondary-Markets/secondary-markets-regulation/csdr-settlement-discipline/ 4. T2S Special Series, One year of full operation, Issue 7, December 2018, page 9. 5. Ibid, page 10. 6. Ibid. WHAT’S THE REAL COST OF T2S SETTLEMENT?

Banks and brokers have historically viewed the cost of settlement to be • CSD/custodian settlement and custody fees (including auto-borrow limited to transaction fees that they are charged by the CSD and custodian fees, asset servicing and tax) for settlement, asset servicing, securities borrowing and custody fees for Liquidity funding costs (including LCR charges, credit/borrowing assets held on their or their clients’ behalf. However, it is critical for firms to • charges, collateral fees) understand all settlement-related costs throughout the entire value chain to help identify where the optimisation and efficiency opportunities exist • Capital costs (including RWA, capital buffers for secured credit facilities and how this impacts their post-trade operating and market infrastructure and credit risk) models. To gain this level of insight, firms need to identify each cost area across the settlement value chain. Firms can break the costs down further by asset class, transaction type (exchange and OTC) and by market to identify consolidation and The key cost layers can be broken down as follows: rationalisation opportunities to achieve economies of scale and reduce operational risk. • T2S fees (if a firm uses a CSD or custodian to access T2S these are likely to be passed on) Let’s take a closer look at the key cost areas where real value can be derived from T2S to deliver significant cost reductions through scale, • CCP clearing fees (including GCM fees if using a third-party clearing consolidation and rationalisation and closer alignment to the T2S agent) infrastructure model and services

LIQUIDITY OPTIMISATION OPPORTUNITIES

Many firms continue to operate multiple euro cash pools and settle in significant fees for unsecured intraday credit in response to increased commercial bank money. This is the result of continuing to manage capital costs against their balance sheet driven by Basel IV and in the future multiple custodian relationships in the Eurozone and a high dependency Basel V. on those providers for cash correspondent services. In some cases, firms Firms can achieve significant liquidity savings through consolidation of use a single custodian but operate on local custody agreements rather their euro cash pools across markets and asset classes and through the than regional or global relationship agreements. Furthermore, the custody adoption of settlement in central bank money in place of commercial networks for both equities and fixed income tend to be disparate due to bank money. Furthermore, capital savings can be realised as central bank being vertically aligned and unilaterally managed according to business money receives more favourable RWA treatment (0 percent) compared to lines. commercial bank money (20 percent). It is likely that going forward the custodian or cash correspondent banks are either going to request 100 percent collateralised credit lines or levy

INTERNALISATION OPPORTUNITIES

It is debatable whether large scale banks and brokers need to retain the clearing and settlement flows leveraging economies of scale to achieve services of custodians for CCP clearing and settlement. Many of these cost and operational efficiency. However, demand is likely to remain for organisations, already have the operational infrastructure and market value-add, complex and local market specific services such as asset infrastructure relationships in place to consolidate and internalise their CCP servicing and tax. ECONOMIES OF SCALE OPPORTUNITIES

As previously stated, many firms still operate multiple custody relationships to achieve lower fee bands for settlement and custody. Also, rationalising within the Eurozone. Notwithstanding the operational risk that is inherent the number of securities accounts simplifies inventory management in such a model (and soon to be further complicated by the introduction and securities lending and borrowing operations, subsequently lowering of the CSDR settlement discipline regime), this cannot be considered as costs. Further consideration should be given to reviewing both issuer and cost efficient. Firms may benefit from a consolidation or rationalisation of investor CSDs relationships in their post-trade service ecosystem, As closer custody providers to drive economies of scale and realise opportunities proximity to the T2S platform would potentially remove a layer of cost.

WHAT DOES THIS MEAN FOR CUSTODIAN BANKS?

The demand for the traditional custody model will not disappear altogether use custodian banks. The likelihood is that most larger firms will opt for a and this will likely come from domestic and smaller cross-border banks hybrid model using direct access for high volume markets and custodians and brokers who do not have the capital, investment appetite or capability for lower volume markets and value add services. to directly connect to T2S or an investor CSD. However, they may wish to The future of custodian services in the Eurozone will be determined by their replicate some or all the T2S model through their custodian to optimise ability to understand and adapt to client business challenges and service operational, cost, capital and liquidity efficiencies. needs and how they can utilise T2S to help their clients achieve their wider There are two core choices of model. Direct access where sell-side firms operational and cost efficiency objectives. settle directly with the CSD(s) and indirect access where firms continue to

AND FOR THE BUYERS OF CUSTODIAN SERVICES?

For the buyers of custody related services there is a real opportunity to collateral and capital efficiencies. The financial and operational benefits leverage T2S to re-shape their post-trade market infrastructure models and from this approach are more realistic goals than adopting other strategic so reduce operational costs and complexity and drive significant liquidity, solutions such as outsourced utilities.

WHAT NEXT?

Firms should look to holistically review their clearing, settlement, collateral liquidity and cost efficiencies across their Equities, Fixed Income, Prime and custody models across all T2S markets to fully understand their Brokerage and Securities financing businesses. operational costs and identify opportunities to deliver operational, capital,

If you would like to know more on how to quantify, qualify and realise T2S driven efficiencies please [email protected] CONTACTS

James Arnett, Partner [email protected]

Dave Grace, Managing Principal [email protected]

Mark Profeti, Principal Consultant [email protected]

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