Liquidity and Collateral: getting the blood to flow again

Cash is a dirty word for some cultures, but not for financial services, on the contrary. But I am not talking about the old images of the stingy bankers holding on to their $ bills or about Scrooge McDuck.

Banks, custodians, CCPs, CSDs and exchanges are the financial institutions that enable the exchange of cash for securities, the movement of cash between bank accounts, the securitization of cash, the transformation of cash into collateral. Without these markets players entire economies cannot function: they are the safe and resilient pipes and the pipe operators that enable companies to be financed, investors to invest, prices to be made, etc.

The difference between Liquidity and Collateral is that Liquidity is the money used for overnight funding during the settlement, is the money that is in the treasury of a corporate or a bank to finance short term money needs, whereas collateral is usually a security that is given as a pledge to guarantee that one has enough money for a transaction, to bear the risk of a transaction, to be able to exchange it against cash if need be in a Repo transaction, at a CCP or a broker. Collateral was historically required to be of very high quality: high grade government bonds, sovereign or agencies. However these have become extremely rare as collateral is required for many more purposes now than ever to guarantee the stability and safety of every transaction. Banks have very little of it because keeping collateral on one’s balance sheet is extremely expensive from a regulatory stand-point. But if nobody oils the pipes, they cannot work anymore. 

We have seen in our recent European Post-Trade Infrastructure Evolution: Switching Gears for the Long Run report that where collateral really needed to be optimized today was before settlement, and across assets and for listed and OTC assets. Until today this was not possible as assets were very rarely optimized between equities and fixed income, and that un-cleared derivatives, never making it to a CCP, where always excluded from cross-margining or netting opportunities offered, except after the settlement at the ICSDs but this is sometimes too late in the trade value chain.

This is changing though as Repo platforms and ICSDs have realized they needed to step in to enhance the fluidity of the financial blood. Today we are seeing a myriad of new initiatives that aim at creating some sort of “Collateral Exchange” whereby securities can be upgraded or transformed into more attractive collateral, or even exchanged against another one that is more useful at the time. Elixium with Tradition and Euroclear, Euronext’s Collateral Exchange, BoNY’s DBVX, 360T with Clearstream, the list is already long and is bound to get longer. We are excited to see how these new solutions will pan out and will be watching this space very closely. More in our two upcoming Celent reports about respectively collateral management and post trade technology.

Regulators to end ASX’s clearing monopoly

In an interesting development Australian authorities are looking to end Australian Stock Exchange’s (ASX) monopoly on equity clearing and relaxing ownership restrictions that removes a potential hurdle to the ASX’s participation in overseas mergers. First, some background: Australia for long was like many other Asian markets with a single incumbent national exchange that is vertically integrated carrying out clearing and settlement activity. Departing from other Asian market practices, regulators introduced competition in the local exchange space by allowing a foreign player Chi-X, which entered the market in 2011 and quickly took significant share away from ASX. However, clearing of trades, including those conducted at Chi-X, was still conducted by ASX as it was the only clearing agency in the country.

Chi-X has been complaining for some time that this situation gives ASX unfair advantage and possibly creates conflicts of interest in that Chi-X has to depend on its competitor for clearing of its own trades. They have therefore called for introducing competition in the clearing space to mitigate the situation, bring down clearing fees, and accelerate innovation. ASX has cut clearing fees in the past, and again indicated that it would further cut fees by 10% from July, 2016. It has also argued that the Australian clearing market size is not big enough to make multiple clearing houses viable.

While the new changes indeed pave the way for newer players to enter, whether and when that materializes would be interesting to see. The Financial Times observes that these changes are “unlikely to result in the establishment of a rival clearing house in the near future”, but will “create a regulatory framework that gives competition authorities the power to arbitrate disputes about access by rivals to the ASX’s clearing and settlement services.” It may be noted that competition in the OTC clearing space was introduced a while back and LCH.Clearnet has already entered and captured significant market share. Merger with an overseas player, in spite of the rule changes, may not be easy. In Asia, the issue of national pride associated with national entities such as exchanges is a particularly important factor, and can make mergers and acquisition by foreign entities tricky, as was seen in Singapore Exchange’s failed bid to acquire ASX previously.

ASX on its part has been active in upgrading its technology and systems to stay abreast with international best practices and ahead of potential competition. In some cases it is taking the lead in the industry and looking to build innovative solutions that could transform trade processing operations. It would be interesting to observe how these initiatives shape up and what impact these changes have on the Australian and global exchange landscape.

The European post-trade landscape: regional integration initiatives paving the way for industry consolidation

The biggest changes in the global post-trade industry are taking place in Europe. The Eurosystem’s attempts to create a single market and associated market infrastructure are transforming for the European post-trade industry. Eurosystem’s Target2 Securities (T2S) project and the CSD Regulations (CSDR), along with numerous other regulations, are reshaping the European CSD (Central Securities Depositories) landscape. As settlement gets outsourced to the T2S platform, CSDs will lose a key revenue stream and will have to find new revenue by developing new offerings. Asset servicing capabilities will be a natural choice for many CSDs, but that may not be a winning proposition because they will face stiff competition from custodians, who have been offering these services for a long time. T2S will allow CSDs to expand their market coverage by becoming investor CSDs and offer domestic clients holdings of foreign securities. Efficient management of collateral has become of utmost importance, and T2S’s single liquidity pool allows CSDs to develop new collateral management solutions for their clients. EMIR requirements requiring holding of initial margin for derivative trades with a licensed securities settlement system enhance their opportunity, and most CSDs are developing collateral management solutions in response. Many CSDs are developing similar solutions to stay competitive in the post-T2S world, and there may be oversupply in the market along with duplication of efforts and investments. It is expected that the industry will go through consolidation. It is unlikely that CSDs will go out of business, at least in the short term, but their role will shrink significantly. In a new report we discuss these and several other key issues relating to the European post-trade market participants, including (I)CSDs and CCPs.

Asian post-trade landscape: CCPs, CSDs aiming for global standards

The Asian financial services market is highly fragmented along national boundaries. Lack of unified political will has resulted in regulatory and market practices that vary widely among the countries. The trading landscape in the Asian countries has undergone radical transformation in the last 10 to 15 years. As the countries in the region slowly open up their economies to the outside world, investors from the developed economies have flocked to emerging Asian countries in search of higher returns and portfolio diversification needs. This has resulted in expansion of products and asset classes. Electronification of trading activities has resulted in growing demand for electronic trading tools and ever-lower latency. Consequently, trading activity is high in the Asian countries; in fact many of them rank highly in the world in terms of equity trading volume at their exchanges as well as in exchange traded and over the counter derivative turnover. Continuous evolution in the trading landscape necessitates changes in the value chain, namely the post-trade functions. Post-trade functionalities generally include clearing, settlement, and custody services that are served by central counterparty clearing houses (CCPs), central securities depositories (CSDs), and custodians. The CCPs and CSDs are fundamental in ensuring smooth, efficient, and stable operations of trading markets. Historically post-trade industry has not received adequate attention, but that is changing now due to greater regulatory focus on managing risks at systemically important institutions. In a recent report we discuss the trends and developments taking place among Asia’s CCPs and CSDs. Some of the highlights from the report include:
  • There is a great deal of “vertical integration” in the Asian post-trade industry, with exchanges holding majority stakes in most CCPs and many CSDs. There is also a trend toward “horizontal integration” among the Asian post-trade players with growing coverage of products and asset classes.
  • Asian regulators have traditionally taken a conservative approach in shaping their financial markets. Therefore since the crisis of 2008, risk management has emerged as the single most important item on the regulators’ agenda. This has brought greater attention to policies and practices at the CCPs and CSDs.
  • Liberalization of Asian economies is creating opportunities for trading and clearing new products and asset classes. The post-trade players are developing capabilities and infrastructure to support new products.
  • Almost every Asian country is mandating central clearing of OTC derivatives and reporting of trades. Incumbent national CCPs are called upon to facilitate central clearing of OTC derivatives.
  • There is not much competition in the Asian post-trade industry, and except in a few markets that is likely to be so going forward.
  • Most Asian post-trade players, particularly the CCPs, are undertaking major technology transformation initiatives spanning years and spending significant resources to upgrade and overhaul their systems and processes.
Find out more about this report here.

New SWIFT-Celent reports released on adoption of T2S

SWIFT and Celent have been closely following developments related to the implementation of the Euro system’s Target2 Securities (T2S) initiative and how market participants are gearing up in preparation for the same. As part of that we published a report titled ‘The European Post-Trade Ecosystem under T2S: Dealing with Complexity’ in March, 2013. Last week two new reports were published looking at the progress made in the last 12 months and what are still some of the open questions. The first of these two reports focuses on development pertaining to the settlement function under T2S, while the second one looks at firm strategies and arrangements for asset servicing and securities payments. These new reports, based on detailed interviews with major participants in the European post-trade environment, find that though there has been progress, the strategies of many players remain unclear. We also identify new offerings in post-trade services that are likely to emerge in the post T2S world and the drivers behind them. The press release of these reports’ launch can be found here.

Emerging Trends in the Post Trade Industry

We identified a number of drivers that will have significant impact on the post-trade industry going forward. While some of them act in opposite direction, some reinforce others’ impact. Based on our analysis for each of the several drivers, and interaction with several market participants, we see the following trends emerging in the post-trade business:
  • Regulatory and market pressures will force investment managers to reassess their business models. Limited revenue growth opportunities have meant they are now focusing on optimizing cost and improving efficiencies to remain competitive.
  • There is a move toward automation of processes, upgradation or replacement of legacy systems in the mid-back office, and integration of disparate systems to obtain a more holistic approach.
  • Firms are working under severe budget constraints. A large portion of the technology budget is being spent on addressing regulatory and compliance issues, often in a reactive way. Thus significant investments to achieve true process efficiency and improvement are difficult to come by in the short run. However, automation of large number of manual processes frees up resources, and some firms are looking at the problem from this perspective.
  • Budget constraints are pushing them toward considering outsourcing mid-back office operations. Given that all firms have to adhere to a same set of regulatory requirements, some vendors are considering coming up with a utility model of offering that will allow multiple firms to use a basic core platform to address many of these issues. However, customizing such an offering to suit firm specific needs, especially for large financial institutions, will be a challenge.
  • Growth of alternative trading venues is presenting new opportunities to broker-dealers. They can now internalize trades carried out between two counterparties both of whom are their clients. Institutions with large client base are best suited to take advantage of this. The number of institutions in this market is not large and going further down; therefore share of internalized trades will increase in future.
  • Regulators are trying to achieve harmonization across markets by planning to come up with common legal and tax norms. This trend is particularly visible in Europe. The success of such initiatives depends on political actors and is difficult to predict. They can potentially encourage more cross border trading which should contribute to the growth of settlement volumes.
  • There is also a move toward achieving shorter settlement cycle. While participants in most markets are either operating in, or getting ready for, a T+2 environment, plans to move to T+1 model will have major impact across the board. That is unlikely to happen in the near term.
  • Growth in volumes can be potentially offset by other developments, such as interoperability of CCPs, which can increase netting of trades and therefore suppress settlement volumes. This would be further aggravated by consolidation among market infrastructure providers.
  • Regulators are also promoting competition among market infrastructure providers, particularly among CSDs. Many of them will have to change their business models to stay alive in the market. They will be forced to compete more directly with sub custodians in the asset servicing business. Achieving scale will be important to stay alive in the business and smaller players will be driven out or get acquired.