Despite a common currency, Eurozone securities do not have a single settlement system. That will soon be changing. TARGET2-Securities (T2S), the European Central Bank’s (ECB) settlement initiative, tackles the fragmented nature of Euro-denominated securities settlement by connecting Central Securities Depositories (CSDs) via an ECB-run network. T2S also creates new opportunities to effectively manage collateral and liquidity. While there are many advantage to the new model, T2S remains one piece to a broader strategic puzzle that must be understood for the greatest positive impact.
What is T2S?
The T2S system creates a de facto single settlement location that is accessed via any one of the connected CSDs. The need for depositories to maintain a web of custodians and sub-custodians across jurisdictions to facilitate settlement for their broker/dealer, bank and investment manager clients will become obsolete. A custodian connected to one CSD that is on T2S can automatically access any other CSD that is also linked to T2S. According to the ECB, the objective is to make cross-border settlement identical to domestic settlement in terms of cost technical processing and efficiency.[1] The system will be phased in over time, starting in June 2015. By the end of 2016 most European CSDs will be on T2S. The final wave is scheduled to onboard in 2017.
The T2S initiative dates back to 1996 when a European Union group was formed to study settlement issues. In 2001 the EU Commission published “Cross-border clearing and settlement arrangements in the European Union“, detailing 15 points that contributed to preventing efficient cross-border settlement within the EU (known as “Giovannini barriers”, named for the Chairman of the group). In 2003 a second report was published on what could be done to tackle these problems.
How will T2S impact the business of settlements? Major custodians pride themselves on being able to satisfy their client’s needs to settle across many markets. Often custodians have local subsidiaries or branches in place that are connected to local settlement mechanisms. Failing that, they hire sub-custodians. This can go away for settlement under T2S, reducing the expense of maintaining those nodes. As long as one connected CSD can settle in a market, all CSDs can. A custodian need only have a relationship with a single CSD to benefit from the capabilities of each connected CSD. The elimination of redundancies combined with the pooling of collateral and liquidity in one place should bring substantial cost savings across the industry.
T2S and Collateral Costs
An immediate benefit of T2S will be the option for participants to consolidate multiple securities settlement accounts into one single T2S account. Similarly they can consolidate multiple cash accounts into one Central Bank dedicated cash account through any participating market. Akin to the consolidation of settlement accounts, directly connected participants to T2S also just need one Central Bank account. For large trading firms with two-way positions on a regular basis, this should result in a substantially reduced need for collateral and liquidity.
A September 2014 Oliver Wyman/Clearstream study, “The T2S Opportunity, Unlocking the hidden benefits of TARGET2-Securities” estimated that capital, funding and operating cost savings will range from €30 mm to €70 mm, depending on the type of participant and size of the business. The study noted four areas where T2S will improve efficiency:
- Delayering of settlement exposures: participants holding cash at the ECB, compared to at a commercial bank, will realize lower risk weightings and save capital.
- Pooling settlement collateral: compared to maintaining balances across various nodes of a settlement network, consolidating cash and securities in one clearing location means less collateral is needed for settlement purposes.
- Net settlements: even though securities settlement must ultimately track back to CSDs in different markets, the cash all clears at the ECB. As a result, cash movements can be netted across markets.
- Simplify operations: eliminating complexity in the settlement process reduces operational and IT costs.
A May 2015 research report by Finadium, “T2S, Collateral and Liquidity: Building a Strategy for Growth,” showed that for both directly and indirectly connected participants, the cost of collateral and liquidity under T2S can be reduced if a smart analysis is conducted in advance. Netting is an opportunity but should not be presumed. Some market participants have netting opportunities in one single market while others see netting across the entire European Union. Still others have no netting gains under T2S due to their tendency towards investing in a single direction only. The internal costs of collateral and liquidity also matter. A trading group charged 150 bps by an internal treasury with no netting opportunities will see T2S differently than a firm with many nettable positions and a moderate internal cost of liquidity. The specifics of a banking and trading book, as well as internal costs of liquidity, matter under T2S.
European and Global Benefits
T2S is a European construct, and as such will serve to aggregate collateral across 22 participating CSDs between now and 2017. The collateral and liquidity benefits to market participants are immediate, focusing on a reduction in required securities and cash held either directly or indirectly. This is just the start however. Integrating domestic CSDs and international CSDs (ICSDs) means that tri-party assets can now be tied into the T2S platform. Some time soon, investors with ICSD tri-party assets may be able to move those assets seamlessly to cover T2S positions. This will result in a dramatically lower cost of capital than what is available today when settling in many diverse markets.
The future expected benefits of T2S on a global scale are already visible. For Clearstream, T2S is an opportunity to develop their collateral management offering since Clearstream customers will be able to treat European domestic and international assets as a single liquidity pool under T2S. In a T2S world, Clearstream’s Global Liquidity Hub will connect safekeeping locations together to allow central bank finance using multi-market collateral. Collateral will be seamlessly transferred at any time between CSD (T2S) accounts and ICSD accounts – ultimately making it easier to move collateral from place to place.
In one example, The Liquidity Alliance, including Clearstream and six other market infrastructure providers worldwide, has announced that participating members will have access to T2S through Clearstream Banking Frankfurt and Iberclear, the Spanish CSD. This means that European securities settlement may be collateralized using the domestic assets of non-European members of The Liquidity Alliance. T2S may have started as a European idea, but collateral and liquidity are global constructs. T2S is emerging as a unifying factor for market participants needing collateral and liquidity worldwide.
This article was commissioned by Clearstream.