The European Post-Trade MarketAn IntroductionWhite Paper
1The European Post-Trade MarketAn IntroductionWhite Paper
2THE EUROPEAN POST-TRADE MARKETAn Introduction
THE EUROPEAN POST-TRADE MARKETContentsContentsExecutive Summary.5.61Introduction2Overview of the Post-Trade Market.18.104.22.168.42.52.6Market basics .Five distinct post-trade functions .Providers of post-trade services .Market-structure development .Market size .Summary .78111314153Safety of Post-Trade Services22.214.171.124Post-trade risks and risk takers . 16Risk mitigation . 17Summary . 194Competition, Efficiency and Governance.126.96.36.199.4Competition for post-trade services .Efficiency of post-trade services .Effectiveness of existing governance structures .Summary .212527305Conclusion31.List of ExhibitsGlossary.33.34References.383
4THE EUROPEAN POST-TRADE MARKETContents
THE EUROPEAN POST-TRADE MARKETExecutive SummaryExecutive SummaryThe European post-trade industry, despite its relatively small size of around 17 billion in revenues,plays a vital role in the securities markets. The post-trade industry is highly specialised. Its mechanisms are not sufficiently transparent to outsiders. Even industry insiders have different views, forexample, on the scope of the industry, and lack a standardised terminology.Against this background, and in the light of the current discussion about new regulation, it is crucialto increase the transparency of the European post-trade industry. This document provides a fact-basedoverview of the market and the players, and elaborates on the safety and efficiency of the Europeanmarket for post-trade services.Post-trade services are required to execute the transfer of ownership and cash after a securities tradehas been made. There are five distinct post-trade functions: clearing, settlement, custody, safekeeping,and the notary function. A number of ancillary banking services exist in conjunction with post-tradefunctions. These banking services are comprehensively regulated under banking law. Various providersoffer post-trade services: central securities depositories (CSDs), international central securities depositories (ICSDs), different types of custodians (global custodians, sub-custodians, agent banks), andother banks. All these institutions compete in the market for post-trade services, which can thus beconsidered open for competition.In general, post-trade services are safe. Acting as agents, post-trade services providers do not assumeany principal risk. They bear operational risk, which they cover effectively. Post-trade services providersperform an important role in reducing the credit, market, and liquidity risks of market participants. Allof the larger domestic post-trade markets in Europe have become more cost-efficient in the last yearsand can be considered just as cost-efficient as the US market. These efficiency improvements havebeen achieved by all players and have resulted in considerable unit-price reductions. Different governance structures have proven equally effective in this regard.The safety and efficiency of European cross-border post-trade markets could be improved further by ajoint effort taken by governments, regulators, and market participants. A step change requires a stagedapproach, starting with the harmonisation of legal and tax regimes across European countries, beforemaking interoperability imperative for all providers. The cost of potential regulation may be high andundesired side effects may occur (e. g. on the industry’s capacity to innovate); the benefits are uncertainand limited. Consequently, any future regulation should be based on a careful cost-benefit analysis.5
6THE EUROPEAN POST-TRADE MARKETIntroduction1 IntroductionLargely unnoticed, every securities trade involves a number of activities after the trade has been made,whether it takes place on- or off-exchange. While post-trade services are crucial for an efficient financialsystem, few outsiders understand the industry’s true complexity and mechanisms. Common terminologyis scarce and general definitions are rare.European securities markets have long remained domestic in scope and have attracted little publicattention. Recent developments, which are driven by an increasing demand for cross-border investmentdue to regulatory changes (e. g. investment rules of European life insurance companies), remote accessto electronic exchange trading, and the introduction of the euro have raised questions on the efficiencyand safety of cross-border post-trade services. 1)To address these questions, the European Commission has focused its attention on the cross-borderefficiency and safety of the European post-trade industry. This supports the Commission’s intent topromote the integration of the European financial market.2) To this end, the Commission plans toregulate the post-trade industry by means of a new directive.3) While the enhancement of efficiency,competition, and transparency is an agreed objective, opinions differ on how to achieve this goal.To prepare the ground for a constructive discussion, this document provides a fact-based overview ofthe post-trade industry. It attempts to make the key mechanisms of the industry more transparent, aswell as to present its relevant functions. Moreover, it tries to consolidate the viewpoints shared by thevast majority of market participants, and assesses the efficiency and safety of the European post-trademarket in order to provide first indications of the areas where regulatory action could be beneficial.The document is structured as follows: section 2 gives an overview of the post-trade market. It definesthe post-trade functions, describes the players, and estimates the market size. With the appropriatedefinitions in place, the remaining sections tackle the two issues that dominate the current debate,namely: how does the industry deal with risks, how efficient is the European post-trade industry, andhow can its efficiency be improved further? The first question is dealt with in section 3. It develops anoverview of the risks related to the post-trade arena and describes how they are mitigated. Section 4addresses the second question. It assesses the market’s competitive landscape, investigates the costefficiency of European post-trade services providers, and analyses changes in efficiency over time.Section 5 concludes on the need for regulatory action.1)2)3)See Padoa-Schioppa, 2001, for an account of recent industry trends.In a recent study for the European Commission, London Economics, 2002, p. 123, argues that full integration of the EU financial markets wouldincrease the level of GDP by 1.1 percent in the long run. 20 percent of this effect are said to be attributed to reduced costs of post-trade services.See European Commission, 2004. In particular, it proposes to remove existing barriers to cross-border clearing and settlement, to apply competition policies continuously to address restrictive market practices, to adopt a common regulatory and supervisory framework, and to implementappropriate governance arrangements.
THE EUROPEAN POST-TRADE MARKETOverview of the Post-Trade Market2 Overview of the Post-Trade MarketThis section describes the market structure of the securities post-trade industry. It identifies five posttrade functions and describes the providers of the respective functions. It briefly assesses key marketstructure trends and concludes with an analysis of the market size. Most quantitative analyses andexamples in this paper refer to EU15, since comparable data is not yet available for EU25. 4)2.1 Market basicsPost-trade services are required after two parties have decided to transfer ownership of a security.Post-trade services deal with the execution of a trade, i. e. realising the transfer of ownership of asecurity from one party to another, and the transfer of cash as payment for the security.5) The needfor post-trade services arises after any trade, regardless of whether the parties trade over an exchangeor over the counter (“OTC”), and whether the trade involves domestic or international securities. Somepost-trade services are not related to a securities transaction, but are needed on an ongoing basis toadminister securities on behalf of the owner, for example, safekeeping or dividend collection.Only if a trade requires the transfer of a security, there is a need for post-trade services.6) The mostcommon securities are equities (shares) and fixed-income securities (e. g. bonds). Equities record theownership in a company and document the rights associated with ownership. Fixed-income securitiescertify the right to obtain interest and the redemption at maturity.If a buy order matches a sell order, the buyer and the seller conclude a trade. A trade is a contract thatestablishes an obligation for a seller to deliver securities against cash and for a buyer to pay cash toreceive securities. In some European markets, a central counterparty (CCP) guarantees the fulfilmentof such obligations by becoming the sole and single counterparty to every buyer and to every seller,thereby assuming the risk that a party to the trade does not deliver.7) In most cases, the services arelimited to the most important securities on the equity market.8) Sometimes, these CCPs are calledequity central counterparties (ECCPs). Bonds and equity trades require essentially the same post-tradeservices. The majority of equity trades takes place on-exchange, while fixed-income instruments areprimarily traded over the counter.4)5)6)7)8)The paper also considers Switzerland, where appropriate, as the post-trade market of Switzerland is closely integrated into the European Union’spost-trade market.Transfer of ownership may be required for reasons other than trades (e. g. when a party has agreed to provide the other with collateral). In thefollowing, this paper focuses on trades.Derivatives usually do not require post-trade services. Even if derivatives have a security as underlying (e. g. stock options, government bondfutures), their trade does not entail “settlement” of the underlying immediately. And even if the contract provides for “securities settlement”,it is rarely eventually settled, as it is almost always netted out or annulled before maturity. In the rare cases where derivative contracts requirephysical settlement, their post-trade treatment is identical to that of securities traded on cash markets.See also Committee on Payment and Settlement Systems/International Organisation of Securities Commissions, 2004, p. 45.13 countries of the EU25 do not have CCPs for their equity markets. Most existing CCPs were founded in the last few years and industryspecialists expect this trend to continue. See, for example, Russo et al., 2004, p. 37.7
8THE EUROPEAN POST-TRADE MARKETOverview of the Post-Trade Market2.2 Five distinct post-trade functionsThis section takes a functional perspective. It describes five distinct functions, which are relevant for thetransfer of ownership and the administration of securities: clearing, settlement, custody, safekeeping,and the notary function (exhibit 1). While different institutions provide one or more of the servicesassociated with these functions, these five functions exhaustively describe the scope of post-tradeactivities both in a domestic and in a cross-border context. The institutions providing these post-tradeservices are described thereafter.Ancillary banking servicesA number of ancillary banking services exist in conjunction with post-trade functions, for examplesecurities lending and overnight credit facilities. These services are important for customers, inparticular in the cross-border context. Banking services are comprehensively regulated under applicable banking law.All five functions have in common that the service provider acts as an agent. The distinction of whethera provider of securities services acts as agent or principal is fundamental, as it involves different risksand public-policy issues. Neither ancillary banking services nor the risk taking – the latter being themain functionality offered by the CCP – are considered as post-trade. 9) Such services, in which theservice provider assumes principal risk (e. g. through extension of a credit facility or novation), arenot regarded as post-trade functions. Furthermore, these services are not necessary to transfer ownership of securities, but they are facilitators for post-trade processes. They are not always used or evenoffered.Exhibit 1: Overview of post-trade functionsTrading(Exchanges,OTC, etc.)Risktaking(Equity illary bankingservices9)Principal businessAgent business(providers assume principal risk)(providers act as agents)Post-trade functionsThis position is also shared by regulators and market players, e. g.: 1. Office of Fair Trading, that distinguishes between CCP and clearing services(see Office of Fair Trading, 2003); 2. State Street, that describes the trading cycle as a matter of brokers, exchanges and central counter-partiesapart from the post-trading arena (see State Street, 2004).
THE EUROPEAN POST-TRADE MARKETOverview of the Post-Trade MarketClearingThe clearing function provides the link between trading and settlement.10) Clearing services comprisethe validation of trades and the preparation of the settlement process, that is the enrichment of tradeswith information required for settlement (e. g. securities identification codes, settlement date, settlement venue), as well as the validation of the existence of sufficient funds and securities. Clearingensures that all of the prerequisites for the settlement process are in place.SettlementSettlement describes the effective transfer of ownership of securities from a seller to a buyer, and therespective transfer of cash from a buyer to a seller.Historically, the transfer of ownership in securities between two trading parties involved the physicaldelivery of the traded securities. Today, physical delivery is still possible for some securities, but itrarely occurs in practice. Issuers typically issue securities in the form of global certificates (e. g. globalnotes or global bonds), where one certificate does not represent one share or one bond, but an entireissue. In some markets and for some securities, the issue is even “dematerialised”, that is the issueis not evidenced in any physical certificate, but exists only as a database entry (e. g. French equitiesor German government bonds). In all of these cases, securities are not in the physical possession ofthe owner. This is the main reason why, today, transfer of ownership typically occurs by means ofbook transfer.The settlement process can either combine the security and the cash leg in a single legal action ortreat them separately. If both legs are linked, transfer of ownership cannot be legally effective withoutthe cash payment and vice versa. The technical term for this procedure is “delivery versus payment”(DvP). Where delivery of securities and cash payment are not linked legally, the technical term “freeof payment” (FoP) is used.To improve operational efficiency and avoid the interruption of usually highly automated settlementprocesses, the settlement function may be accompanied by a settlement lending facilitation serviceand overdraft credit facilities. This service ensures that the execution (mostly overnight via an automated batch run11)) of the settlement process is not interrupted if one party is inadvertently short inthe security leg. The provision of settlement lending serves as a facilitator to the settlement processand further increases operational efficiency. It is a pure agent business and does not require thetaking of principal risk.12)CustodyThe custody function comprises customer account keeping and the administration of securities onbehalf of customers. It deals with ongoing services for securities owners, for example, capital increases, redemptions, or the collection of dividends and interest. Custody includes reporting and –10)11)12)The Committee on Payment and Settlement Systems, 2003, p. 13, uses the word “clearance” to describe what this publication defines as clearing.A batch run is the process of booking all transactions that have been collected over a certain period of time (usually a day) in one automatedprocessing routine.In these cases, the post-trade services provider only “arranges” that one customer lends securities to another customer. This is different fromso-called “strategic” securities lending, where service providers with a banking license lend securities, thereby acting as principals and offeringa regulated banking service.9
10THE EUROPEAN POST-TRADE MARKETOverview of the Post-Trade Marketdepending on the provider of custody services – may include value-added services, such as collateralmanagement, proxy voting, income processing, tax services, translations, comprehensive portfolioanalyses, etc.Risk takingCCPs stand between the buyer and the seller as counterparty of both contractual partners andguarantee the fulfilment of all transactions. A CCP provides market participants with new possibilities for making further decisions fully independently of each other and limits counterparty risk to asingle contractual partner. This model allows pre- and post-trade anonymity as well as multilateralnetting, i. e. position netting, that offsets all open long and short positions
Post-trade services deal with the execution of a trade, i.e. realising the transfer of ownership of a security from one party to another, and the transfer of cash as payment for the security. 5) The need for post-trade services arises after any trade, regardless of whether the parties trade over an exchange